Conflicted Trades and Collapsing Bids

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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Conflicts of interest.

One theory that you sometimes hear is that bank employees should eat their own cooking. If you are building credit-derivative horrors, you ought to put some of your own money in those horrors, to prove you believe in them. Sometimes banks -- well, Credit Suisse, anyway -- put this into practice; Credit Suisse paid bonuses one year in the form of "toxic" credit assets, and another year in the form of derivatives counterparty trading risk. The first one worked out great for the bankers involved. (The second was restructured.) But it feels more or less fair: Senior management decided what to give to employees, and it was stuff that the bank believed in even when no one else did. It couldn't sell the assets, but it could give them to employees, and eventually they recovered and made everyone a lot of money. It's a heartwarming story.

This Deutsche Bank story is ... different. It is a story of traders eating their own cooking, all right: Apparently in 2009 Deutsche Bank did some sort of credit index arbitrage trade in which it sold the senior tranche to AXA SA, and the junior tranche to a Monaco hedge fund, Greengate SAM. And six Deutsche Bank employees involved in structuring the trade, including Colin Fan (then-co-head of the investment bank), invested in the junior tranche along with Greengate. And Deutsche Bank seems to have provided them leverage on their investments. And they made a ton of money. According to the Wall Street Journal:

Altogether, internal auditors estimate that the six current and former Deutsche Bank employees have made about $37 million on the trades, which will close off next year, according to the person briefed on the audit. The individuals invested about $4.5 million combined.

Fan may have made $9 million on a $1 million investment. Greengate is up about $80 million. I don't know how AXA's doing. But Deutsche Bank may be down "more than $60 million," depending how you count. 

Internal bank auditors are examining whether Mr. Fan and other employees set up the structure to make Deutsche Bank pay an inflated share of profits and fees to themselves and the hedge fund, while locking the bank into high fixed costs, the people said. The internal auditors are also probing whether the compliance review of the structure was adequate, they said.

It sounds bad! You could just about imagine a good motive: In 2009, when things were tough, Deutsche Bank traders put together a credit trade for AXA and Deutsche Bank. To reduce the risk for those big conservative institutions, they found a hedge fund to take the junior tranche of it, and to assure the hedge fund that they stood behind the deal, they took a bit of that junior tranche themselves. I don't type this with any particular seriousness but, you know, if you are going to think about structured credit products you ought to have a certain amount of imaginative flexibility. The fact that they made a lot of money is no proof of malfeasance: There were lots of opportunities to make money on credit in 2009 if you had a strong stomach. The key questions are about intent and approvals and, most of all, about who thought this was a good idea. It's almost conceivable that traders structured a deal and gave themselves what looked like the worst part in order to get it done. But, really, if they structured the deal and took part of it for themselves, they probably knew it was the best part.

Bidding strategy.

There are times, in the financial world, where you have to offer someone a price, and then you have to do it again a few weeks later, and then again a few weeks later, and then a few more times, and then finally at some point you have to actually pay them the price. But you can change the price each time. What path should your prices follow? A common path is sort of U-shaped, or maybe like a reversed J. You start high to pique their interest and get yourself into the deal. As soon as you're on the inside, you find lots of things to criticize, and start walking down your price to lower expectations. Then as the actual deal gets nearer and competitive pressures intensify, you find your way to raising the price back up a little bit. 

That curve basically describes the underwriters' pricing indications for a typical stock offering. (The U.K.'s Royal Mail privatization is typical, and the government actually published the curve after the fact.) But it is also a plausible mergers-and-acquisitions strategy: Bid high in the non-binding first round to get access to diligence and management in the second round, bid low in the second round to lower expectations, and then maybe creep up a bit at the end to beat your rivals. It's such a normal obvious strategy that no collusion is required; you can pretty much expect that all your competitors will be doing the same thing.

Anyway:

Verizon Communications Inc. and others are expected to bid around $2 billion to $3 billion in the auction for Yahoo Inc.’s core business, less than what the troubled Internet pioneer was expected to fetch, according to people familiar with the matter.

The first-round bids were for $4 billion to $8 billion, which is rather more than $3 billion, though even that is much more than the market valuation of less than zero. The next deadline is the first week of June. "Some offers could still be above the $2 billion-to-$3 billion range, other people said, and it is generally in the interest of bidders to play down their enthusiasm in an auction." My offer to buy Tumblr for like $100 still stands, though now I regret not bidding $2 billion for Tumblr in the first round so I'd be in a position to bid $100 for it now. Obviously no one is expected to stand behind their first-round bids.

There's a Puerto Rico bill.

If you believe, as everyone seems to, that Puerto Rico's debt is unsustainable, then it probably needs to be restructured, which means that there probably needs to be a binding collective legal restructuring mechanism. So far there isn't, since Puerto Rico is not covered by U.S. bankruptcy law and not permitted to make its own. So this is progress:

After weeks of negotiations, House Republicans have drawn a road map to lead Puerto Rico out of its financial quagmire, with support from the Obama administration.

A bill introduced shortly before midnight on Wednesday would put Puerto Rico’s fiscal affairs under direct federal control and establish a legal framework for reducing its $72 billion load of debt. The rules would be similar to Chapter 9 municipal bankruptcy, but with differences intended to reassure those creditors who believe Chapter 9 is stacked against them.

Obviously the direct federal control is sort of mean, in that it undermines Puerto Rico's self-government. But in any bankruptcy-like situation, both sides have to give something. Bondholders will get haircuts, but they ought to, because it's partly their fault that Puerto Rico borrowed too much. (They were doing the lending!) Puerto Rico's government will lose some economic independence, but it ought to, because it's partly the government's fault that Puerto Rico borrowed too much. (It was doing the borrowing!) Puerto Rico's residents will lose some services, and of all the parties they are probably the least deserving of suffering; it's hard to blame them directly for the borrowing. (They voted for the government, sure, but who understands debt?) It seems to me that every dollar of bond haircuts requires the Puerto Rico side (government or residents) to give something up, and that giving up sovereignty (punishing the government) is perhaps a fairer tradeoff than giving up services (punishing the residents). In practice I'm sure it will be some of both.

Precarious employment.

I almost never understand when bankers and traders get fired and sue their banks. That is just the deal, you know? You get paid very well in exchange for taking on career risk, and if you have a bad trade or the market turns down, then you clean out your desk without complaint. But the weirdest thing is that the people who sue are so often not the ones fired for losing money; they're the ones fired for scandals and catastrophes. If you are fired for foreign-exchange rigging, or for a multibillion-euro pattern of rogue trading, maybe just let it go, you know? Even if you think you did nothing wrong? 

Still I feel a little bad for Giovanni Lombardo, who was fired as a bond salesman at Nomura because his client, Invexstar, collapsed and cost Nomura $40 million in failed trades. Nomura called Lombardo's work on Invexstar "at best incompetent or at worst deceitful," but Lombardo argues that he was just handed Invexstar as a client and that Nomura, not he, should have caught Invexstar head Alberto Statti's prior history of blowing up funds. Maybe? Mostly I just feel bad for him because his lawsuit so vividly captures what it must have felt like for Lombardo to watch his client blow up and take him down with it. And call Invexstar frantically about it:

"Give me a call with a yes or no because here they crucify me," Lombardo said to his client Alberto Statti.

And:

Statti said he “was waiting for payment internally, indicating that we were both stuck in the middle,” Lombardo said in his statement.

"It is a mess, I know, give me half an hour," Statti said, according to the statement.

Imagine that half hour for Lombardo. He had to know it wasn't going to end with good news. And meanwhile his bosses were hovering, polishing the crucifix they had ready for him.

Efficient markets.

I mean sure why not:

Guizhou Red Star Developing Co.’s rally this week prompted regulators to halt trading and left some investors puzzling over what touched off the advance. Could it be that its name closely resembles that of Redstar Group, a fictional acquisition target in the storyline of a popular new Chinese television show?

Redstar Group is a media company involved in a takeover plot in "Ode to Joy," a show "inspired by American-style sitcoms such as 'Friends' and 'Sex and the City.'" Guizhou Red Star makes "inorganic and fine chemicals including barium carbonate and sulfur." So they are very different companies. Also one is fictional. Still the fortunes of the one might affect the price of the other:

Michael Wang, a strategist at hedge fund Amiya Capital in London, which invests in Chinese equities, said it’s possible that retail investors, who account for about 80 percent of trading on the mainland, had something to do with the stock’s run-up.

“I don’t think many do very fundamental bottom-up research as one might do in the west,” Wang said. “They see the equity market a little like playing the lottery.”

Don't feel too smug if you're a U.S. investor; our algorithms do even less fundamental bottom-up research, and occasionally go around buying one stock because an entirely different company is being taken over. This is just the nonsense you deal with to get efficient markets. The fun question is the insider trading one: As Ben Tompkins asks on Twitter, if an actor on the show had known about the (fictional) takeover before it was public, could he have bought shares in the (real) company with the similar name? I don't want to give you U.S. or Chinese legal advice, or investing advice, or advice about what to watch on television, so I will leave that one as an exercise for the reader. 

Elsewhere in market efficiency, a lot of exchange-traded funds have silly names, with the Direxion bull/bear ETF pairs on oil and gas (GUSH and DRIP) and China (YINN and YANG) being among the silliest.

People are worried about unicorns.

Yesterday I asked for drawings of a drunk unicorn, because this is that kind of newsletter, so here you go. From Mundt on Twitter:

I suppose unicorns, with their billion-dollar valuations, can afford Pappy, though I was hoping for Unicorn Tears Gin Liqueur. From Angus Nicholson on Twitter:

There are others. Elsewhere, here is a video from my Bloomberg Gadfly colleague Shira Ovide about the drying up of initial public offerings and the end of the tech boom. And here is my Bloomberg View colleague Justin Fox on Theranos, public markets and short sellers:

There are lots of good reasons to stay under the radar, and to raise money privately instead of subjecting your company to the glare and sometimes the short-termism of public markets. But when that means you never come up with good answers to the most basic questions about your company’s signature technology, you have a big problem.

Does market efficiency require short sellers? I feel like in some formal sense the answer is no. Like, long investors should be asking those basic questions too, no? And some of them did. It's just that enough of them didn't. 

People are worried about bond market liquidity.

Here is Treasury's long-awaited second post in its bond market liquidity series, "Examining Liquidity in On-the-Run and Off-the-Run Treasury Securities," which discusses the "G-spread," "a measure of the discount in the price of an off-the-run Treasury security versus a hypothetical on-the-run Treasury security of the same remaining maturity and coupon." The conclusion, as usual in these things, is pretty benign -- "While the spreads between on-the-run and off-the-run Treasury securities have widened modestly at times, they remain in line with historical levels and are a fraction of the level witnessed during the crisis" -- and I suppose is not particularly supportive of the Modified Trump Trade (issue new Treasuries to buy back discounted off-the-run bonds) that we've discussed here. 

But events have overtaken Treasury, and its musings about G-spreads now feel a bit, well, off-the-run, because U.K. bookmakers have suspended betting on the casting of the next James Bond movie, and here is a joke:

Jamison Hermann @JamisonAssetTV
Betting on the next 007 is suspended in the UK so I guess people were right to be worried about Bond market liquidity? @matt_levine
Twitter: Jamison Hermann on Twitter

Me yesterday.

I wrote about Goldman Sachs and Tesla and sell-side equity research.

Elsewhere in sell-side equity research: "Analyst Downgrades and Upgrades Stock in the Same Morning." That's ... not great.

Things happen.

How Wall Street Led LendingClub Into Crisis. LendingClub Is Ruining It for the Rest of Fintech. Bayer’s Bid for Monsanto Faces Hurdles. Valeant Gets Notice of Default From Bondholders on Late 10-Q. Lawsuit Claims Another Global Banking Hack. HSBC’s Mackay Says ‘We’re All Stuffed’ If Basel Sticks to Plan. "The financial regulator charged with overseeing U.S. commodity markets has just one specialist examining oil trades." China reopens securitised bad-debt market. UBS Said to Trim Some Securities Jobs as Ermotti Cuts Costs. What the world can learn from Argentina's holdout saga. Money managers seek AI’s ‘deep learning.’ What's Neel Kashkari up to? Who actually owns seven percent of AmTrust Financial Services? "Summary labelling of anything in an article as 'complex' means that the writer does not understand or cannot explain the material." "The wealthiest families in Florence today are descended from the wealthiest families of the city nearly 600 years ago." "Venmo is turning our friends into petty jerks," complains a millennial about a thing that has never happened to me or anyone in my generation. Big pizza. This Google Patent Is Like Human Flypaper for Cars. Yes, you can be fired for being too hot. A Brewery Plans to Deliver Beer by Bald Eagle. 'Lick' your cat with a mouth-held pet brush

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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