Bank Risks and Bond Systems

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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Banks and risk.

Since the 2008 financial crisis, there have been two big impulses in banking reform:

  1. Banks are too risky and we need to make them less risky.
  2. Banks are bad and we need to stop them.

These are overlapping impulses, but they are different, and sometimes in conflict. If you fine banks all the time, they will have less money, and be more likely to fail. More than that, though, if you try to limit the businesses that banks are in and the profits they can make in them, and generally try to make the banks less fat and smug and more haggard and repentant, they will have less cushion to draw on in rough times. And so they'll be more likely to fail. And while their failure will be in some sense a satisfying outcome, for impulse 2, it does seem like, you know, a risk. And impulse 1 was to reduce the risks.

Anyway here is a new paper from Natasha Sarin and Larry Summers with the title "Have big banks gotten safer?" and the Betteridge-approved answer: not really. Sarin and Summers look at various measures of bank equity riskiness -- "price volatility, option-based estimates of future volatility, beta, credit default swaps, earnings-price ratios, and preferred stock yields" -- and find "little support for the view that major institutions are significantly safer than they were before the crisis and some support for the notion that risks have actually increased." They consider three possible explanations for this:

  1. "Market error": Banks were really riskier before the crisis, but the market misunderstood the risks and overvalued the banks. ("Implicitly, this is the view taken by the regulatory community.")
  2. "Bank capital mismeasurement": Banks are really risky today, and all of the regulatory measures on which they seem to be safer -- regulatory capital, etc. -- are false.
  3. "Declining franchise value": Higher capital requirements and so forth have helped make the banks safer, but on the other hand, "other developments have eroded their franchise value thus increasing their effective leverage and riskiness."

Explanation 1 is in some ways the most intuitive: When Citigroup's average pre-crisis price-to-book ratio was 2.31, that clearly reflected market expectations of a future that was very different from the one that actually obtained. But Sarin and Summers don't love it as a complete explanation: "It is easy to understand why excessive optimism about financial stability could have led to the overpricing of bank securities before the crisis. It is much less clear why it should have led to their being insufficiently volatile in response to daily news." They instead mostly opt for explanation 3, declining franchise value: Post-crisis fines, regulations, low interest rates and competition from financial technology firms have made it much less valuable to be a bank, making banks more likely to fail. "There is a possibility that by further eroding bank franchise value, further regulatory actions could actually increase systemic risk," they say.

That seems plausible to me, though I cannot let go of the market error hypothesis as easily as they do. (I mean, there was a pretty big crash, implying some pretty big prior errors.) I also sometimes think that something you might call "bailout value" has gone away. Prior to the crisis, there was an expectation that the government would step in to keep banks afloat; now, the government has created a lot of explicit rules and implicit expectations that that support isn't there any more. People often talk about this in terms of bank debt prices, the idea being that bank debt might be impaired in a pure failure but would be made whole in a bailout. But it strikes me as an equity issue too. In the actual 2008 crisis, the Fed and Treasury bailed out Fannie Mae and Freddie Mac's creditors while more or less zeroing the equity, but they also arranged a bailout of Bear Stearns's and AIG's creditors in ways that preserved some equity value. And they arranged programs like TARP that kept other big banks afloat as going concerns, without any need to directly impair the equity. The political will for programs like that seems to be mostly gone, these days, which could make bank equity investors a lot more worried about the downside risks. I guess that's a form of declining franchise value too.

Elsewhere in big-bank gloom, the U.S. Treasury's blog celebrated Lehman Day yesterday. McKinsey put out a grim report on the future of big banks. Here's "What the Wells Fargo Cross-Selling Mess Means for Banks." And "Europe Said to Threaten Revolt Over Bank Capital-Rule Revamp," as "regulators from countries including Germany and Italy told the Basel Committee on Banking Supervision that proposed changes to how banks assess credit, market and operational risks must be scaled back and slowed down." I guess they are worried about eroding the franchise value.

Can't hurt to ask.

Yet elsewhere in big-bank gloom, "the U.S. Justice Department proposed that Deutsche Bank AG pay $14 billion to settle a set of high-profile mortgage-securities probes stemming from the financial crisis," which is a really big number even among bank mortgage settlements. I mean, not Bank of America big, but still big. Probably too big:

“Deutsche Bank has no intent to settle these potential civil claims anywhere near the number cited,” the bank said. “The negotiations are only just beginning. The bank expects that they will lead to an outcome similar to those of peer banks which have settled at materially lower amounts.”

This Bloomberg story has a good table of asks versus results in settled mortgage cases, measuring Federal Housing Finance Agency complaints against big banks for mortgage mis-selling against (1) the FHFA's ultimate settlements and (2) the ultimate settlements with the Justice Department and mortgage task force of state attorneys general (which can cover a wider range of conduct than the FHFA suits). Eyeballing it, every dollar in an FHFA complaint seems to lead to between 6 and 13 cents in FHFA settlements, and to usually somewhere around 30 cents in Justice Department settlements. (One outlier, Citigroup, settled with the Justice Department for twice the amount demanded in the FHFA complaint.) The FHFA sued Deutsche for $14.2 billion and settled for $1.9 billion, which gives you a sense both of where the Justice Department got its $14 billion number from and how unlikely it is to be the final result.

Elsewhere, here is a review of Chief Executive Officer John Cryan's options "to inject some fire into Deutsche’s flagging cylinders and convince investors the German bank could be, if not great again, then at least greater than it has been in recent years."


I confess that I did not know that BlackRock's Aladdin analytics and risk management system is an acronym. Good lord: "Asset Liability and Debt and Derivatives Investment Network." This profile of BlackRock and its CEO, Larry Fink, starts with Fink reminiscing about his dark days as a mortgage-bond trader at First Boston in the 1980s, and man is that name ever a 20th-century structured-finance throwback. People at BlackRock are pretty into it, though:

Aladdin fills the monitors of most BlackRock employees. One portfolio manager even went so far as to hang a nearly cinema-size screen on his office wall in order to get the full Aladdin experience. And at the company’s investor day in June, Mr. Fink and other top executives mentioned Aladdin 82 times — more than any other business line — even though the platform represents just 5 percent of the $11.3 billion in revenues BlackRock took in last year.

Or consider a recent marketing video that shows Mr. Fink and other top executives gazing at the camera and intoning one after the other, “I am Aladdin.”

Oh yes, do consider that video. It is quite something. There's a lot going on in the profile, including some discussion of BlackRock's somewhat uncomfortable role as a source of liquidity after the retreat of the bond dealers. But the biggest focus is BlackRock's push for computerization and systematization, which dates back to Fink's days at First Boston, when he uttered the memorable cri de coœur: "We are bringing the computer onto the trading floor, Dexter." It's not just about Aladdin as a system for helping humans track their positions, it's also about de-emphasizing humans generally:

The future of finance, Mr. Fink has argued, lies with rules-based, data-driven investment styles such as exchange-traded funds, which track a variety of stock and bond indexes or adhere to a set of financial rules. The idea is that such an approach eliminates at least some of the potential for human error, while lowering costs.

And so BlackRock executive Mark Wiedman pitches the benefits of bond exchange-traded funds as a technological solution for trading bonds. And then this happens:

Like many top executives here, Mr. Wiedman can get a bit manic when discussing the subject: Midway through an interview, he felt the need to somewhat violently undo his tie and cast it aside.

Imagine the specific sort of passionate intensity that would cause you to somewhat violently undo your tie. To undo your tie. To violently undo your tie. To somewhat violently undo your tie. To somewhat violently undo your tie. And cast it aside. Each word is amazing. I want someone to paint this scene for me.

Radical transparency.

At some point in its constant process of deep and searingly honest self-examination, Bridgewater Associates apparently looked around and noticed that it had way too many people. So it decided to lay some of them off. And since sugar-coating is not really the Bridgewater way, it explained the layoffs like this:

In 2003 Bridgewater had 150 employees; in 2011, when we began our management transition, we had 1,100; now we have 1,700. About 70% of this growth in headcount was in our non-investment areas. As one might expect, some of these areas became bloated, inefficient, and bureaucratic. 

I more or less understand the idea of radical transparency at work, of always telling people exactly what you think about them so that they can improve and everyone can get to the right answer. But ... is radical transparency absolutely necessary when firing people? Do you have to follow "sorry, Bob, there's no room for you here anymore" with "also by the way we find you bloated, inefficient and bureaucratic"? 

Active versus passive.

S&P Dow Jones Indices is out with its mid-year SPIVA U.S. Scorecard, measuring the performance of actively managed mutual funds against their benchmarks, and as always the news is bad:

During the one-year period, 84.62% of large-cap managers, 87.89% of mid-cap managers, and 88.77% of small-cap managers underperformed the S&P 500, the S&P MidCap 400®, and the S&P SmallCap 600®, respectively.

The figures are equally unfavorable when viewed over longer-term investment horizons. Over the five-year period, 91.91% of large-cap managers, 87.87% of mid-cap managers, and 97.58% of small-cap managers lagged their respective benchmarks.

Meanwhile Capital Group, an active mutual fund manager, has its own counter-scorecard, finding that "two simple screens – low expenses and high manager ownership – identify a group of funds that, on average, has consistently beaten the indexes over various rolling periods." Among large-cap funds on the "Select Active" list, 55, 65, 76 and 89 percent beat the S&P 500 over, respectively, 1-, 3-, 5- and 10-year periods.

Without taking a side, I will say that this debate does matter. If 90 percent of active managers underperform the index, that doesn't necessarily mean that you should index. It might just mean that you should put your money with one of the 10 percent of active managers who outperform. The problem is how to identify those managers; mutual-fund performance persistence is notoriously weak, and if your chance of identifying the outperforming managers is just 10 percent, it doesn't seem worth trying. But if Capital's screen is right -- if low-expense funds with high percentages of manager ownership do consistently outperform -- then that is an argument for active management. As long as it's the right kind of active management.

Meanwhile, liquid alternatives mutual funds have not had a great run recently, though investors have been slow to notice: "Despite lagging returns and setbacks at several noteworthy funds, retail investors until recently have stuck with them even as they have pulled billions of dollars out of other funds."


"It's hard to imagine a tax code more complicated than the one we already have," says James Stewart, but that is obviously wrong. Here: Take the code we have now. Think of a thing that you like and wish there was more of in the world, say light opera or large clumsy puppies. Now, imagine a tax deduction for that thing. Voilà! You have imagined a more complicated tax code. It really is that easy, which is why it constantly happens. In fact, not only are people constantly imagining a more complicated tax code, they are also constantly creating a more complicated tax code, because there is always some political preference that can most easily be accommodated by giving it a tax deduction. And these deductions create "loopholes," which means that people use them in ways that their creators didn't think of, or did think of but now don't like. So you need more tax complexity to close the loopholes while still accommodating your original preference. And then you just keep doing that forever.

Anyway Stewart's point is that Hillary Clinton's tax plan involves some of this, which is not particularly a surprise. Elsewhere: "Does Donald Trump Pay Any Income Taxes at All?"

People are worried about unicorns.

Honest Co., Jessica Alba's honest unicorn, is making plans to leave the Enchanted Forest, but it may have missed the top:

Unilever, maker of Dove soaps and Axe body sprays, is discussing a deal valued at over $1 billion but significantly less than the $1.7 billion valuation that was placed on Honest in a fundraising round last year, the people said. The talks are at an early stage, and Honest hasn’t ruled out going for an initial public offering instead, one of the people said.

"There have been a string of high-profile startups, including and Dollar Shave Club, that have recently decided to sell to established corporations as the IPO market cooled and investors insisted that startups operate in the black." My casual model of the pharmaceutical industry is that a lot of the research and development into new drugs is done by independent biotech companies, and that once they've found a promising drug they sell out to a big pharma company that has the resources to commercialize and market it. I wonder if something similar is going on in the consumer-products space. You build a startup with an inspiring little-guy (or: famous-actress) back story, you connect with consumers on the basis of your authenticity and scrappy charm, and then, once you've established your niche, you sell out to a giant company to actually make money.

People are worried about bond market liquidity.

That BlackRock profile should count:

Global watchdogs like the Bank for International Settlements and the International Monetary Fund have described these bountiful flows into and out of BlackRock bond E.T.F.s as a liquidity illusion. Which means, according to Ken Monaghan, an investor in high-yielding corporate bonds, that easy-to-trade E.T.F.s have lured “tourist” investors — people seduced by the rich yields, but who may not be able to stomach a sustained market reversal.

And if they all leave at once, watch out.

“E.T.F.s do not create liquidity,” said Mr. Monaghan, of the global fund manager Amundi Smith Breeden. “These new investors are not permanent.”

I assume that this sort of talk inspires a lot of tie-hurling over at BlackRock.

Things happen.

Japan’s Central Bank Splits Over Easing Program. Stimulus fears drag $1tn of bonds back to positive yields. U.S. savings bonds are "one place where a small investor has a big advantage over the institutions." The Guru Who Only Talks to Hedge-Fund Elite. Exxon’s Accounting Practices Are Investigated. Corporate America rallies to Apple’s cause. Bespoke tranches are back. Caesars directors must disclose details of wealth, judge rules. Goldman Sachs summer analysts left hanging after internship. BoE to develop ‘next generation’ payments system. Tesla’s Musk ‘Hopes’ to Roll Out New Autopilot Version Wednesday. Bloomberg wades into the cargo shorts wars. Day care fight club. Gold toilet. David, Your Latest Marketing Report Brought Me to Tears.

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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

To contact the editor responsible for this story:
James Greiff at