Buses, Block Trades and Bailouts

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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Rate rigging.

I became a bit jaded from years of reading misspelled e-mails and chat logs in which traders around the world admitted to manipulating interest rates, but the alleged manipulation of Australia's bank bill swap rate has revived my childlike sense of wonder. Here is a story about a man with the bland title "Managing Director, Group Treasury at Westpac," but the glorious name Col "the Rat" Roden, who allegedly did some chatting.

CBA's trader Garfield Lee, who has since left the bank, features prominently, and in one colourful conversation is told by Roden that BBSW is a "bloody dangerous gane [sic]…full flack [sic] jacket stuff," in April 2010.  

"You say that with the innocence of pol pot in 1980," replies Lee.

Roden also apparently once asked Lee if he'd "been run over by that big fat bus," and illustrated the question with this picture of the BBSW bus:

Whee! Sure, there are typos. Sure, he allegedly once sent an e-mail worrying about the possibility that "(a) bbsw gets recast as something akin libor and (b) I go to jail that would be very bad." But how can you not admire a man with so much dedication to his (alleged) craft of (allegedly) manipulating rates that he felt compelled to draw -- in a text chat -- a metaphorical picture of what that rate manipulation felt like? This is a man, or a Rat, who got a lot of joy from his work as Managing Director, Group Treasury.

Meanwhile in the rest of the rate-manipulating world, Monday's Libor antitrust ruling "gives plaintiffs far more leverage in settlement negotiations with banks," so expect the Libor banks to take more reserves and generally return to the endless post-crisis litigation misery that they thought they'd escaped. What is particularly miserable is that Libor manipulation had vast and zero-sum effects that the banks only partially participated in: If a bank moved Libor up by a basis point to make an extra million dollars on a swap, that might cause payers of other Libor instruments to lose a hundred million dollars -- and cause the people on the other sides of those instruments to make an extra hundred million dollars. But the losers will sue and the winners will stay quiet, so all of the problems will be the banks' problems. Elsewhere, here is Izabella Kaminska on Libor itself as a cartel.

Block trades.

Equity capital markets is a weird business not only because of the flawless physical beauty of its participants (disclosure: I was an ECM banker), but also because the connection between risk and reward is sort of backwards. So here is a Wall Street Journal article about block trades:

Hungry for revenue, Wall Street banks are taking on more risk to help companies sell large chunks of stock.

In block-trade deals, a bank typically buys stock from a company or its private-equity backers at a discount, and then aims to flip the stock to money managers after the market closes that same day. If they can fetch a premium, it is a win for them. But if they can’t unload the shares and prices fall, they bear the loss, minus fees.

That description is right, but if you are "hungry for revenue," a block trade is a particularly unsatisfying meal. Here's an example:

Private-equity firm KKR & Co. sold 15 million shares of Walgreens Boots Alliance Inc. to Citigroup Inc. the first week of May, according to a regulatory filing.

The bankers paid $80 a share and reoffered the shares to clients for $80.10, aiming to make as much as $1.5 million, according to regulatory filings and Dealogic.

That may or may not have worked out for them (the stock fell the next day). But let's say it did. Then they made a spread of 10 cents a share, or about 0.125 percent. Just for fun, I ran a Bloomberg league table on U.S. equity offerings in 2016 so far, excluding initial public offerings and rights offerings. This got me 194 deals for $56.2 billion with average fees of 2.67 percent. That is: The average follow-on (non-IPO) equity offering, by a company or private-equity sponsor or whatever, pays a fee of 2.67 percent. Which is 21 times what Citi made -- at best -- on its Walgreens block trade.

But that regular follow-on is riskless: The bankers build a book, set a price, offer the price to the company, the company agrees, and then the bankers buy the shares from the company at that price minus 2.67 percent (or whatever). The 2.67 percent is pure risk-free profit to the bank, a fee for service rather than an at-risk spread. On the other hand, the bank's spread in the block trade -- which, like the regular follow-on, is underwritten, done pursuant to a prospectus, etc. -- is completely at risk: The bank can earn the full spread, or less, or none, or can lose many times what it was hoping to earn. And yet the block-trade spread is smaller. It is a worse trade for the bank in every way

This is not entirely fair: If KKR did a non-block bookbuilt offering of its Walgreens shares, it would probably pay less than 2.67 percent (though more than 0.125 percent), and every so often a bank will end up with more upside on a block trade than it would on a regular bookbuilt deal. And a bank probably won't have to split a block trade with a bunch of other banks, meaning that it can get more market share, and more league-table credit, from a low-paying risky block trade than it can from a higher-paying low-risk bookbuilt offering.

But for the most part you shouldn't read the relative rise in popularity of block deals -- and it is only relative, $30 billion out of $61 billion in follow-on offerings so far this year, versus $34 billion out of $104 billion in the same period last year -- as a sign that banks are taking on more risk to get more revenue. It's a sign of increasing competitive pressure, weakening fee discipline, and decreasing market power for the banks. The banks are taking on more risk to get less revenue.

Fannie and Freddie.

I cannot believe I keep writing this, but, if Fannie Mae and Freddie Mac have $X of capital, and they just hand that over to the Treasury, and then later they have negative $Y of capital, and Treasury gives them back the $Y to keep them solvent, and Y is much less than X, then everything is fine. Fannie Mae and Freddie Mac are wholly owned subsidiaries (I know, I know) of the U.S. government, and they mostly ship their profits up to the government, and every so often the government might have to subsidize a rough quarter. That's it. There's no coming additional bailout, there's no extra risk to taxpayers from sweeping Fannie's and Freddie's profits, the entire debate is just ridiculous. Ugh:

“The most serious risk and the one that has the most potential for escalating in the future is lack of capital,” FHFA Director Melvin Watt said in a February speech. Mr. Watt in the speech noted that the companies’ buffers fall to zero by 2018 and listed a number of issues, including the derivatives accounting, that could lead the companies to need taxpayer funding once that happens.

Whether or not Fannie and Freddie draw government funds is in a sense academic because the Treasury is collecting all the profit anyway. A bailout also wouldn’t be anything like the crisis of 2008. Some worry, however, that a large draw of funds from the Treasury could set off a knee-jerk political reaction with uncertain consequences.

Like, everyone involved knows that this debate is completely dumb, but they have to have it anyway because they worry it might get even dumber.

Nauman Aly.

Maybe the strangest market-manipulation case in recent memory is last month's acquisition offer for Integrated Device Technology Inc. In many ways it seems to have been a standard fake-acquisition scam: Someone bought IDT options, announced a proposed takeover via a filing with the Securities and Exchange Commission, sold the options as the stock went up, and then disappeared, leaving the company scrambling to determine that the takeover proposal was fake. But there was one odd thing about it: The SEC filing claimed that a group led by Nauman Aly owned 5.1 percent of the company, which seemed fake, and that the group had proposed to buy the rest of the company, which also seemed fake, but it also disclosed that Aly owned 185,000 shares worth of options, which seemed real enough. And then, once Aly had sold those options, he made another filing with the SEC, announcing that he'd sold them. It's so weird! As I said at the time:

If you want to pump up a stock with a fake merger so you can sell some options at a profit, it is very important that you announce the fake merger, but you don't need to announce when you've sold the options. There's no meta-rule of stock-manipulation fair play that demands that you tell everyone when you're done with your manipulation. You can just launch the manipulation and wander off, and most manipulators do.

Obviously that was not legal advice. Anyway now we have the SEC's version of the story, and it's (allegedly) what I suspected: The merger filings were fake, the claim that Aly's group owned 5.1 percent of IDT was fake, but the options were totally real, and he really did sell them for a profit. The SEC got a court order to freeze $425,000 in profits in Aly's U.S. bank account, but does not answer crucial questions like why he left the money in a U.S. bank account for so long, or why he thought it was a good idea to take a victory lap in the SEC's filing system. 

Active, passive, etc.

Here is a long smart post from pseudo-Jesse Livermore (Philosophical Economics) on active and passive investing. He builds a toy model of a world in which individuals decide how much money to allocate to equities, and how to divide that allocation among active and passive funds, but in which the active funds do all the work of deciding how to allocate the money among stocks:

This fact may be the reason for Samuelson’s famous observation that markets are more efficient at the micro-level than at the macro-level.  If micro-level decisions–e.g., decisions about which specific companies in the equity market to own–are more likely to be made by professionals that possess experience and skill in security selection, then we should expect markets to be more efficient at the micro-level.  Conversely, if macro-level decisions–e.g., decisions about what basic asset classes to invest in, whether to be invested in anything at all, i.e., whether to just hold cash, and how much cash to hold–are more likely to be made at the source level, by the unsophisticated individuals that allocate their wealth to various parts of the system, individuals that are in no way inclined to optimize the timing of the flows they introduce, then we should expect markets to be less efficient at the macro-level.

Some of the active managers outperform, and some underperform, but in the aggregate they can only earn the market return, and once you consider fees they have to underperform the passive funds. So what value do they provide? Livermore locates their value in medium-term liquidity provision, but he also interestingly dismisses another standard possibility, that the value of active money management is that, by making stock prices more efficient, it improves the allocation of capital in the real world:

Personally, I tend to be skeptical of the alleged relationship between equity prices and capital formation.  Corporations rarely fund their investment programs through equity issuance, and so there’s no reason for there to be any meaningful relationship.  This is especially true for the mature companies that make up the majority of the equity market’s capitalization–companies that comprise the vast majority of the portfolio holdings on which active management fees get charged.

To illustrate the point with an example, suppose that the market were to irrationally double the price of Pepsi $PEP, and irrationally halve the price of Coke $KO.  Would the change have any meaningful effect on the real economy?  In a worst case scenario, maybe $PEP would divert excess income away from share buybacks towards dividends, or arbitrage its capital structure by selling equity to buy back debt.  Maybe $KO would do the opposite–divert excess income from away dividends towards share buybacks, or arbitrage its capital structure by selling debt to buy back equity.  Either way, who cares?  What difference would it make to the real economy?  For the shift to impact the real economy, it would have to be the case that money used for share repurchases and dividends and other types of financial engineering is deployed at the direct expense of money used for business investment, which evidence shows is not the case, at least not for large companies such as these.  The companies make the investments in their businesses that they need to make in order to compete and profitably serve their expected future demand opportunities. Whatever funds are left over, they return to their shareholders, or devote to financial arbitrage.

Technology.

In the-future-of-financial-technology news, here is a Vox explainer of Ethereum, the blockchain/smart-contract thing that spawned, among other things, the DAO. Here is "A Current List of Use Cases for Ethereum."

In the-present-of-financial-technology news: "Computerized trading firm XTX Markets Ltd. has come from nowhere to dethrone major banks including Deutsche Bank AG in the rankings of the world’s biggest spot currency traders." (It is now fourth.) Elsewhere, "New York Stock Exchange legend Art Cashin is worried about the rise of robots," possibly a bit late. And: "Nasdaq rejects listing application by cannabis social network."

And in non-financial technology news, Twitter is making some more small tweaks to how it works, in order to annoy current users and baffle new users in slightly different ways. Here is an explainer, and a poem. And: "Google and Levi's Are Now Making Connected Jean Jackets," because nothing goes better with cutting-edge futuristic technology than a jean jacket.

How are things at Harvard?

Disclosure: I went to Harvard, but other than the briefest and most awkward of flirtations with McKinsey, I did not really participate in on-campus recruiting for financial jobs, or hang out with people who did. So while I am aware of the stereotype that elite U.S. universities have a well-travelled pipeline for transforming idealistic young poets into Goldman Sachs interns (disclosure: I worked at Goldman), I don't have much first-hand experience with its workings. This Harvard Crimson article is mostly about how annoying it is both for Harvard students and for the banks that bank internship recruiting at Harvard has been moved up from the winter to the fall ("We’re a little heartbroken because we’re not in the Wintersession period. That was so convenient because there were no classes for students," says an administrator), but it is also worth reading just to get a sense of how efficient and institutionalized the pipeline is, and how emotionally important it is to people. Elsewhere: "Angelina Jolie Will Be Visiting Professor at London School of Economics."

People are worried about unicorns.

Section 220 is a section of the Delaware General Corporation Law that allows stockholders to demand to inspect the "books and records" of a Delaware corporation, and that is commonly used by activist shareholders to annoy corporate managements in the ancillary skirmishes in a proxy fight. But now it is also being used by tech startup employee-shareholders to demand financial statements from their non-public employers:

To take advantage of the law, stockholders must simply prove they own at least one share and send the company an affidavit that states which documents they want and why. The magic words for unlocking financial information? “ ‘For the purpose of valuing my shares,’ ” says Michael Halloran, a securities lawyer with Pillsbury Winthrop Shaw Pittman LLP.

It is perhaps a bit much to ask of a unicorn employee that she be (1) a coding ninja or whatever, (2) an expert in the Delaware General Corporation Law, and (3) skilled enough in financial valuation that she can determine what her shares are worth based only on grudgingly provided financial statements. Sometimes it is useful to have public financial statements and a market price.

Elsewhere, on-demand startups have lost their cachet:

A startup calling itself the Uber for x, y or z merited at least a look from a venture-capital firm a few months ago. Now VCs are more likely to roll their eyes and say: “Come on, not another one.”

But Uber, the ur-Uber, keeps attracting investment, as do its direct competitors:

On Tuesday, two of the world’s largest automakers, Toyota and Volkswagen, said they were stepping up to invest in technology start-ups that are working to change the way people travel by car. Toyota said it had formed a partnership with and invested an undisclosed amount in Uber, the biggest ride-hailing company. Gett, the app popular in Europe, said it was working with Volkswagen, and the automaker was investing $300 million in the start-up.

People are worried about bond market liquidity.

I wonder if Vladimir Putin is worried about bond market liquidity:

Barclays has dealt a new blow to Russia’s ambition of making a successful debt market comeback by announcing that it will not include the country’s new bond in its indices “due to concerns in relation to the bond’s investability”.

Obviously being in the index enhances liquidity, but you need "investability" to get into the index, and that is "a test Russia’s bonds appear in danger of failing without confirmation that they can be held through internationally recognized settlement houses Euroclear and Clearstream." 

Meanwhile in the U.S.:

The U.S. Treasury department has no plans now to publicly disclose trading data on the $13 trillion Treasury debt market and will wait until it has the data in hand to develop any policy proposal, a top Treasury official said on Tuesday.

Because, of course, disclosing that data might be bad for liquidity. And in Europe: "Draghi in QE Quandary After Draining Bond Market by $800 Billion."

Things happen.

Bank of America Tipster Gets to Keep His Reward. Greece Wins Pledge for Debt Relief as IMF Bows to Euro Proposal. Monsanto Rejects $62 Billion Bayer Bid, Still Open to Talks. A Hewlett-Packard Spinoff Is Preparing to Split Again. Beware the Fine Print in Boardroom Battles. Dealpolitik: Tribune Uses ‘White Squire’ to Fend Off Gannett. Steven Davidoff on new Delaware appraisal legislation. China central bank sets renminbi fix at 5-year low. Dan Loeb's Third Point Opens to New Money. Goldman Plans $1.5 Billion Fund to Take Minority Stakes in Private-Equity FirmsProductivity Tumbles at Investment Banks. Commerzbank Drops Case Against Bankers Fired Over U.S. Probe. U.S. swaps regulator approves rule closing cross-border loophole. Canal Fever Sweeps Globe Again as New Era in Trade Nears. Patrick Iber and Mike Konczal on Karl Polanyi. What's Peter Thiel up to? A Financial Times inquiry into Donald Trump's fashion sense, a New York Magazine scoop on his seating plan, and a Gawker investigation into his hair. Perfect wave pool. The median U.S. age is 37. "The beauty premium can be actively cultivated." "A journalism that simply instantiates the metanarrative of least resistance, and looks for whatever sequencing of phenomena would suggest the most synchronicity with the past (and present), is no longer palatable to the overwhelming majority of young people in this country."

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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