Merchant Banks and Bond Lies

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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Volcker II: The Re-Volckering.

Over the past few years, U.S. regulators have put in place the Volcker Rule, which prohibits banks from engaging in proprietary trading and owning hedge funds or private equity funds. It's been sort of a mixed bag. The division between bad "proprietary trading" and good "market making" is not super clear. People are worried about bond market liquidity, you may have heard. But everyone has sort of muddled along.

Then yesterday, out of the blue, the Fed recommended some further Volckering in a joint report to Congress from the U.S. banking regulators. I mean, the report was expected, but the contents are a bit harsh:

Among several recommendations issued by U.S. banking regulators, one from the Fed urged Congress to prohibit merchant banking, in which firms buy stakes in companies rather than lend them money. In a report released Thursday, the agency also pushed for limits on Wall Street’s ownership of physical commodities after lawmakers accused Goldman Sachs and other banks of seizing unfair advantages in metal and energy markets in recent years.

Here is the report. I once made a dumb chart of what the Volcker Rule allows and prohibits; here is a dumb update for the Fed's (still hypothetical) merchant banking proposal:

In a client memo, Sullivan & Cromwell said:

The recommendations are extraordinary in two key aspects. First, if adopted, they would severely disrupt well-settled financial and economic expectations. Second, and relatedly, there is no identified problem of any significance that has emerged, in the Financial Crisis of 2008, or otherwise, that would have been prevented had these recommendations been enacted previously.

That seems right, though it also sounds a bit like the Volcker Rule, which also disrupted well-settled expectations to solve a problem that did not obviously exist. The Fed's reasoning for banning merchant banking is particularly odd; from the report:

Absent merchant banking authority, FHCs would generally not be able to own up to 100 percent of the ownership interest of a nonfinancial portfolio company or be involved in the routine management of the company. This would prevent FHCs from investing in nonfinancial companies and from becoming exposed to the risk of legal liability for the operations of a portfolio company. Thus, a repeal of merchant banking authority would help address potential safety and soundness concerns and maintain the basic tenet of separation of banking and commerce.

The Fed isn't worried that banks will use their merchant-banking authority to make risky equity investments in tech companies that might fail and leave the banks with losses. It is worried that the banks will make equity investments in companies that might do bad stuff and get the banks sued. I mean. They might! It just seems like kind of niche worry.

Of course there's nothing crazy about a regulatory regime in which banks aren't allowed to make equity investments in non-financial companies. The idea of a bank is that it is a thing that funds itself using "risk-free" liabilities (deposits, etc.) and performs maturity transformation by putting those deposits to work in long-term investments. That is an inherently risky activity, and the purpose of banking regulation is to limit the risk, and one classic way to limit the risk is to require banks to have only senior claims on the investments that they fund -- to make only loans, never equity investments. Merchant banking fits poorly with that standard view, and just on first principles you could want to get rid of it. Still, it seems a little weird to start regulating financial institutions from first principles now

Elsewhere: "Private Equity Tries to Chip Away at Dodd-Frank With House Bill." 

Litvak IV: Litvak Lite.

Sadly, sometimes bond traders and salespeople lie to their customers about how much they paid for bonds. So you want to buy a bond, your salesman says "yeah, I paid 89 for it, I can let it go to you for 89.25," you cheerfully pay 89.25, and you later find out that the bank actually paid 85. What is that? The range of views seems to be:

  1. Good, sharp, money-making practice by your salesman; if you find out, you should tip your hat to him and resolve to do better next time.
  2. Baddish, sharp, nasty practice by your salesman; if you find out, your firm should put his bank in the "penalty box" for a while and not trade with them.
  3. Bad, fraudulent practice by your salesman; if you find out, you should tell regulators, who will fine him and ban him from the industry for a while.
  4. Extra-bad, criminal fraud by your salesman; if you find out, you should tell prosecutors, who will put him in prison for a while.

That is a wide range! We have talked before about Jesse Litvak, a former Jefferies Group trader who was sentenced to prison, though his conviction was reversed on appeal, as well as some Nomura bond traders who were also charged criminally. And there was Edwin Chin, formerly of Goldman Sachs, who was fined and banned by the Securities and Exchange Commission for much the same activity. Now one of Litvak's ex-colleagues has also fallen into category 3:

Kevin Blaney, a managing director whose tenure on the investment bank’s mortgage-backed securities desk overlapped with trader Jesse Litvak’s, agreed to a suspension that prevents him from having contact with any Financial Industry Regulatory Authority member through Dec. 5, according to a Finra disciplinary action dated Sept. 1. Blaney, who didn’t admit or deny the allegations, was fined $30,000.

The Finra disciplinary action lays out a distinctly Litvak-lite line of conduct; allegedly. This is particularly soft:

In a third instance, a JEFF customer purchased bonds from JEFF at 90-08 and thanked Blaney for working on the trade. Blaney responded, in part, that he had completed a larger trade in the same issue earlier in the day at a "90 [handle]". In fact, the earlier trade was executed at 89-19, which should have been accurately characterized as being executed at an "89-handle."

I mean, not only are we haggling over handles here, but also that misrepresentation couldn't have been material to the customer: He only made it after the trade was finished and the customer had thanked him. How could it have influenced the customer's trading decision? But there were four other, worse incidents. We are still pretty early in the crackdown on bond-trading lies, and everyone is still trying to figure out which sort of conduct falls into which category. It is not obvious why what Litvak did is so much worse than what Blaney did -- such that Litvak got two years in prison (now overturned) and Blaney got a $30,00 fine and a three-month suspension -- but I guess the point is that he just did more of it.

Aluminum Warehousing II: A Pile in the Desert.

We have talked a couple of times about the big alleged conspiracy in which Goldman Sachs somehow cornered the global market for aluminum storage and used its power to drive up the price of aluminum. What I found weird about that theory is that you can store aluminum anywhere. It just sits there! It doesn't spoil, or run away. So I was pleased to read this story about a giant pile of aluminum -- at one point "nearly one million metric tons" -- stacked behind barbed-wire fences in the desert in Mexico. See? You really can just put it anywhere.

This particular story is about tariffs or something:

Aluminum-industry representative Jeff Henderson says he is convinced that China Zhongwang Holdings Ltd., a Chinese aluminum giant controlled by billionaire Liu Zhongtian, tried to evade U.S. tariffs by routing aluminum through Mexico to disguise its origins, a tactic known as transshipping.

“My Moby-Dick has been Zhongwang,” says Mr. Henderson, president of the Aluminum Extruders Council, a U.S. trade group.

Liu denies having anything to do with the pile of desert aluminum (from his "apartment inside the factory" in Liaoning, China, for some reason). It's a fun story -- Rowan Atkinson makes an appearance in a McLaren -- but I find the continuing prevalence of aluminum conspiracy theories strange. Aluminum is the world's most abundant metal. You use it to make beer cans or whatever. You dig it up, refine it, build stuff with it -- it's all just straightforward and useful and industrial and real. And yet there keep being these weird stories about giant stockpiles of aluminum that are used, not to make beer cans, but to game financial-market rules or international tariffs or whatever, as though the highest and best use of aluminum is not as an industrial metal but as a mysterious tool of financial abstraction.

Adjusted adjusted FFO.

Yesterday the Securities and Exchange Commission, and federal prosecutors, brought charges against two former executives at American Realty Capital Properties (now called VEREIT) for accounting fraud. I like to read this as a story of non-GAAP accounting. ARCP is a real estate investment trust, and REIT investors don't care that much about the financial metrics normally presented under U.S. generally accepted accounting principles. Instead, they focus on funds from operations -- FFO -- a non-GAAP measure that is defined by NAREIT, a trade organization, as GAAP net income "excluding gains or losses from sales of property, and adding back real estate depreciation." But actually they often don't even focus on FFO; instead they focus on adjusted FFO -- AFFO -- which "has no standardized definition." So it's an undefined extra-non-GAAP alternative to a non-GAAP number. 

The former executives are charged with manipulating ARCP's AFFO. The way they allegedly did this is that they (1) decided what AFFO they wanted, (2) calculated the actual AFFO, (3) computed the difference, and (4) added the difference back to the actual AFFO as a "plug":

The scheme involved adding false amounts or a "plug" to several figures without any basis (the "plugged numbers") in an internal spreadsheet that the Company used to calculate AFFO and AFFO per share for 2Q 14 and for the six-month period from January through June 2014—the first half period ("FH14"). With McAlister and the Accountant in his office, Block fabricated these plugged numbers and typed them into the spreadsheet.

I love the mechanical accuracy of that description. Yes, generally, the way you manipulate accounting statements is by typing numbers into a spreadsheet. 

I feel like if I were going to manipulate my accounting numbers, I might be more included to manipulate a super-non-GAAP number like adjusted funds from operations than a GAAP number like net income. But that is a pretty weak preference. Really I would be more inclined to manipulate a number that investors care about than one that they don't, since after all the point of any manipulation is to deceive investors. It just so happens that in the REIT business, the numbers that investors care about are non-GAAP numbers.

Valuation.

Here is valuation expert Aswath Damodaran getting really mad at Lazard and Evercore for their fairness opinions of the Tesla/SolarCity deal: "My first reaction as I read through the descriptions of how the bankers in this deal (Evercore for Tesla and Lazard for Solar City) valued the two companies was 'You must be kidding me!'" There seems to be just a simple category error going on here. Damodaran wants to see valuations of the two companies. But that wasn't Evercore or Lazard's job. Nobody asked them for valuations. They were asked for fairness opinions. It is a very particular and stylized genre. So Damodaran is particularly incensed at this:

Outsourcing of cash flows: It looks like both bankers used cash flow forecasts provided to them by the management. In the case of Tesla, the expected cash flows for 2016-2020 were generated by Goldman Sachs Equity Research (GSER, See Page 99 of prospectus) and for Solar City, the cash flows for that same period were provided by Solar City, conveniently under two scenarios, one with a liquidity crunch and one without. Perhaps, Lazard and Evercore need reminders that if the CF in a DCF is supplied to you by someone else,  you are not valuing the company, and charging millions for plugging in discount rates into preset spreadsheets is outlandish. 

I mean, there is a sense in which he is correct. The banks' main valuation analyses are discounted cash flow analyses, and the key inputs to those analyses are the companies' future cash flows, and the banks made absolutely no effort to determine, on their own, what those cash flows would be. They just took the estimates that the companies gave them. If you were a hedge-fund analyst trying to value the companies for investment purposes, that would be unimpressive work.

But the alternative is for Lazard and Evercore to estimate how much money SolarCity and Tesla will make in the next few years, and how would they know? I mean, they are just bankers; their expertise is in pitching and sourcing and negotiating and executing deals -- and in plugging in discount rates into preset spreadsheets -- not in knowing the future. Knowing the future is hard. Predictions are uncertain. Bankers who came up with their own predictions about how much money their clients will make in the future would get sued all the time, when those predictions turned out to be wrong. So instead they rely on projections that their clients give them, and explicitly disclaim responsibility for those projections. ("With respect to the projected financial data relating to the Company referred to above, we have assumed that they have been reasonably prepared on bases reflecting the best currently available estimates and good faith judgment of management of the Company as to the future financial performance of the Company," says Evercore in its fairness opinion.)

A fairness opinion is not a real valuation, not a pure effort to estimate the value of a company from first principles and independent research. A fairness opinion says: Given certain explicit assumptions that we've agreed on with management, and running those numbers through certain standard valuation techniques, you can get a pretty wide range of values, and the price of this deal is within that range. It is a sanity check on the deal price; it is confirmation that the deal price can be justified by a rational process in a plausible world. That is not nothing! But it's not much more than that.

Doom.

The other day I asked on Twitter: "what is the investing thesis if you think there's a 20-50% chance we're living in a sim?" That was in response to a Bank of America research note about "future reality" that posited a 20 to 50 percent "probability that we are already living in a simulated virtual world." Welp, today Peter Berezin of BCA Research is out with a note titled "Doomsday Risk" that discusses alien life, the doomsday argument, the multiverse, and the possibility that we are living in a computer simulation. It also contains the glorious sentence "If the probability of doomsday is large, interest rates should be higher than they are today; if there are multiple versions of 'you' within a multiverse, you should prefer equities over bonds." You see:

The possible existence of a multiverse where there are myriad versions of “you” also raises interesting investment considerations. For instance, consider the question of whether you should purchase a $2 lottery ticket which gives you a one-in-a-billion chance of winning $1 billion. Since the expected payoff on this ticket is $1, you would be forgiven for not buying it. But what if you knew that there were some universes in which you would definitely win? Would that make you more inclined to buy the ticket? I suspect many people would say yes, because by purchasing the ticket they could derive utility from the knowledge that they would be billionaires in some distant galaxy or altered quantum state.

Many people? Really? I can tell you that I get precisely no utility from knowing that I'm a billionaire in a distant galaxy; it just grinds my gears that alternate billionaire me won't help out with my mortgage in this galaxy. Also I tend to start from a premise of market efficiency, and what does that tell you about all this stuff? Surely Berezin is right that "if the probability of doomsday is large, interest rates should be higher than they are today," but they're not. So one nice thing that you can say about prevalent low/negative interest rates is that they're a sign of the not-Apocalypse.

Oops.

"TiVo Shares May Have Plunged Due to Ticker Symbol Confusion," it says here. Markets are, you know, kind of mostly efficient. There are still anomalies that you can profit from. But many of them are pretty dumb. 

People are worried about non-GAAP accounting.

See the thing about American Realty Capital, supra

People are worried about unicorns.

Here is a story about how workers who are over 40 are not always welcome in the Enchanted Forest, and how they respond with approaches that include lawsuits, plastic surgery, "creeping on potential employers" (what?), and "a youthful, asymmetrical haircut." On the other hand, here is a story about how Airbnb is trying to cut down on discrimination on its platform. And here is a story about how Palantir, the Spy Unicorn, harnesses the tools of improvisational comedy to somehow be even more terrifying than I had thought.

People are worried about bond market liquidity.

Here is "In Search of Answers: The ETF Market’s $3 Trillion Liquidity Questions." And in government bond markets, people really want Ghanaian bonds, and Irish bonds, and the Bank of Japan "could be running out of government bonds to buy."

Me earlier.

I wrote about Wells Fargo's millions of fake bank accounts. Related: "When Tough Performance Goals Lead to Cheating."

Things happen.

Saudi Arabia Said Poised to Add Boutique for Aramco IPO. UBS wealth management quants. Low-productivity jobs. After 11 Years, It’s Finally Spitzer v. Greenberg. More on the Muddy Waters/MedSec partnership. Wall Street on Alert to Danger of Donating to Trump-Pence Ticket. Big Banks Don’t Follow Goldman on Trump Donation Ban. Ex-Deutsche Bank Trader Pleads Not Guilty in Libor Case. Bankers Wanted: Lenders in Sunny Athens Struggle to Fill Spots. The Caribbean Is Running Out Of Coconuts. Alphabet and Chipotle Are Bringing Burrito Delivery Drones to Campus. Bollinger Bands. 1-877-Kars4Kids. Nuclear ants. Bear product testers. Implausible urinal.

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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