Hedge-Fund Memories and Bank Fines

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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Hedge funds.

Eulogies for hedge funds are weird:

Sir Chris Hohn, who worked for Richard Perry from 1996 to 2003 in European special situations and now runs The Children’s Investment Fund, a hedge fund with more than $10bn under management, said: “Perry Capital made some of the most exciting and profitable investments of my career during this time … He was a great mentor to me over this period and an excellent investor.”

Oh man, remember ... those ... investments? Memorable investments, those were. Anyway yeah Perry Capital, the pioneering hedge fund whose "assets under management peaked at $15.5bn in October 2007 but had fallen to $10bn in 2015 and then to $4bn this year," announced plans to shut down because "the industry and market headwinds against us have been strong, and the timing for success in our positions too unpredictable." The shutdown makes those unpredictable positions ... less predictable?

Perry Capital’s less liquid positions will be sold over the next year, or longer. Some of them, including its remaining preferred shares in Fannie Mae and Freddie Mac, “will take time, energy and capital to successfully realize an appropriate result,” Perry wrote in the letter. The core team will remain in place to aid in the liquidations and capital will be returned quarterly as transactions are completed.

My casual view of the Fannie Mae/Freddie Mac situation is that the current status quo -- vague government conservatorship, vague talk about change, and absolutely no payments on the preferred stock -- could last a really long time, since no one in government has much of an incentive to change it. If you're going to be on the other side of that trade, you need -- yeah, time, energy and capital. Ideally, you'd be an institution with permanent capital and all the time in the world, not a zombie fund in liquidation. The unpredictable timing for success that makes this a bad period for running a hedge fund makes it an even worse time to shut one down. I guess that's always how it works, though. The market can remain irrational longer than you can hang on to your outside capital, and then what? Perry says: "I decided that it would be better not to be in this mark-to-market world, and focus on longer-term investments."

Elsewhere, Brevan Howard "is on pace to mark its third straight losing year" and is making it up to clients by offering zero-percent teaser rates:

Brevan has told clients it will charge 0% to manage new money they invest in its $14.5 billion flagship fund, people familiar with the matter said. Investors also will pay Brevan 0% to manage money that comes from gains on existing investments in the fund, the people said. The firm still will charge a 20% performance fee on money invested in the fund, the people said.

"Just about every manager is offering lower fees or talking about it," says an adviser. Elsewhere: "In less than a year since the launch of his eponymous hedge fund, Chris Rokos, the former star trader at Brevan Howard, is outperforming his former colleagues with returns of about 8 per cent in 2016." I love reading about Rokos because every time I do I am reminded anew that he is "the 'R' in the Brevan acronym," and that Brevan is an acronym. (Howard is a guy.)

Fining Germans.

The Deutsche Bank news continues to be a bit apocalyptic. There are concerns about a new capital raise:

Despite the denial, speculation abounds that Deutsche Bank will once again be forced to ask investors for more cash at a moment of extreme weakness.

The prospect of another call for cash by the company has led to increased selling by investors, with the view being that even with shares at a bargain basement price, the risks are too great.

There is talk of state aid:

German officials have tried to shut down talk of a potential rescue for the country’s biggest bank, with Chancellor Angela Merkel’s spokesman Steffen Seibert saying Monday there are “no grounds” for speculation over state funding for the $2 trillion-asset lender.

And there are Deutsche Bank's contingent convertible capital securities, which are in a sense supposed to sit between shareholder capital and state aid in Deutsche Bank's capital structure:

Deutsche’s €1.75bn coco bond, which pays a 6 per cent coupon, fell 3.1 per cent to 73 cents on the euro on Monday. While the bond is trading at distressed levels, it is trading above the low of 71 cents it plumbed during the market turmoil of February.

Given Deutsche Bank's shrunken equity value and the discussions, quickly denied, about possible state aid, it is almost tempting to imagine the U.S. government fining Deutsche Bank out of existence. I mean, the 2008 paradigm really was that if a bank faced big losses, and the government wouldn't help, then that was the end for that bank. But that's not the world we live in now. Now banks are better capitalized, yes, but they also have cocos to absorb some of their more horrible losses. And there is a stock market that discounts those losses into the price early and often, instead of remaining blithely ignorant of trouble. And there are weary but resigned shareholders to tap for dilutive capital raises. State aid is not the first and last option for a bank that runs into trouble; there are more buffers between failure and bailout. The system is more or less working.

Elsewhere in U.S. prosecutors fining German firms whatever the market will bear, "the U.S. Justice Department is assessing how big a criminal fine it can extract from Volkswagen AG over emissions-cheating without putting the German carmaker out of business." That's such a weird way to calculate a fine! In some ways, "the maximum fine we can extract without putting them out of business" is the exact worst amount to extract. If the offense is unforgivable, existential, then the company should be put out of business. And if it's not -- if it's just a thing that companies sometimes do and then regret -- then the fine should not be symbolically enormous. Fining Volkswagen a dollar less than the maximum it can afford sends the message "we wanted to put them out of business, but we didn't quite have the nerve to go through with it."

Research.

Who should pay for sell-side equity research? The best answer that the market has come up with is, approximately, "no one": Research analysts should pluck their nourishment from the air, with money generating itself spontaneously and flowing into their pockets. More practically, that means that buy-side investment clients pay for research, but not directly; instead, they reward research by trading with the analyst's bank and paying commissions on those trades, without exactly putting a price on the research. But Europe's MiFID II "unbundling" rules will prohibit that approach. So someone's gotta pay. Maybe it'll be the buy-side clients, so convinced of the value of the research that they'll be happy to start writing checks for it. It's possible! But Natixis isn't taking any chances:

With brokers increasingly unable to subsidize research with indirect payments, France’s Natixis SA is pioneering a novel approach: charge clients for coverage, a model that has proved fraught with conflicts for debt-rating companies.

Analysts Jean-Jacques Le Fur and Philippe Lanone at Natixis published this month their first piece on Transgene SA, a French biotechnology company that’s worth $125 million, with a two-page note recommending that investors buy the shares. At the bottom of the first page, in bold italics, is a disclaimer that roughly translates to “Natixis has been paid by Transgene to produce financial analysis.”

The issuer-pays model is unusual in equities, but common in credit ratings, and we all know how well that worked out. But honestly I am not that troubled by issuer-paid research: The value in research is in the analysis and management access more than it is in the Buy/Sell rating at the top, and presumably paid research will only be influential (and valuable to issuers) to the extent that it is substantively persuasive. This is importantly different from credit ratings, where the most important thing really is the rating, not the analysis. If you are a fund manager constrained by mandate to buy only investment-grade bonds, you can buy a bond rated BBB- for dumb reasons, but you can't buy a BB+ bond no matter what the report says. Equity research, for the most part, doesn't have that kind of prescriptive power; if it has any power, it has to come from being good.

Elsewhere in sell-side equity research, the Sanford C. Bernstein & Co. analysts who wrote last month about index funds being communist ("The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism") are back with a new note titled "Bernstein Shrugged ... A Response to Questions on Our Note on Marxism & the Markets." It's fun:

The example whereby the fecundity of capitalism is able to multiply the information contained in the price discovery process is a mapping between the financial and the real economy. The use of these price signals in passive management is a mapping from the financial economy back onto itself. This creates a feedback mechanism that is new and is atypical of the more usual "free-rider" problems.

I suppose this is the sort of research that would be less likely to be produced if issuers had to pay for it.

Stress tests.

The basic structure of the Federal Reserve's stress tests is (1) you decide how much capital banks need to operate, (2) you decide how much capital they'd have after some hypothetical crisis, and (3) you make sure that the amount in (2) is bigger than the amount in (1). An oddity of the exercise is that the decision in (1) -- your threshold for how much capital banks need -- is going to be influenced by the long history of bank capital requirements, which are usually thought of as buffers against a crisis. So if your best thinking is that banks need 8 percent capital to protect them against a crash, it is weird to run a stress test and require banks to prove that even after the crash they'll have 8 percent capital. After the crash, they don't need that much!

This puzzle is solved to some extent by making regular capital requirements higher than stress-test requirements -- including buffers in the regular requirements that aren't required in the post-stress scenarios -- and to some extent by conceiving of capital requirements as regular run-rate requirements for the business rather than as buffers against disaster. Anyway the latest from the Fed's Daniel Tarullo is that the Fed wants to make the "GSIB surcharge" -- the extra capital requirement for global systemically important banks -- a part of the post-stress requirements:

Because the difference in the external costs of the distress or failure of a GSIB as compared to a non-GSIB is likely to be at least as high during times of macroeconomic and financial market stress as during ordinary times, there is no reason why the GSIB surcharge should not be a part of the post-stress capital regime. A complementary point is that the extra buffer required by the GSIB surcharge also reflects the fact that even the best-conceived annual stress scenarios cannot capture all tail risks in the financial system.

Here is the Fed's proposed rule changes, which would also make the stress tests less stressful for regional banks. The long-term evolution seems to be: People think that post-crisis regulation has been too hard on smaller banks, and not hard enough on the global systemically important banks, so they rules keep getting tweaked.

Payments systems.

"I believe that in cyber, only the paranoid survive," is such a wonderful line, but it was said by Gottfried Leibbrandt, the chief executive officer of Swift, and it's not paranoia if they really are out to get you:

Interbank message carrier Swift said customers had sustained three new cyber breaches over the summer and warned that attacks on banks in the network are continuing.

The company, whose systems are in the back offices of 11,000 financial institutions across more than 200 countries, issued the warnings as it rolled out new mandatory security requirements for customers.

Meanwhile, "Credit Suisse, Ipreo, Symbiont and R3 announced the successful initial stage completion of a project to demonstrate how blockchain technology can be used to improve the syndicated loan market."

Boiler rooms.

I love the diversification in the penny stock world:

The SEC alleges that Craig V. Sizer founded Sanomedics Inc. and Fun Cool Free Inc., which were purportedly in the business of selling non-contact infrared thermometers and software applications respectively, and he hired Miguel “Michael” Mesa to help him attract and defraud investors in both companies.

Think about how controversial it is that Elon Musk runs a car company and meddles in rockets and solar power, or that Jack Dorsey runs an online communications platform and also a payment processor. Medical technology and "Fun Cool Free" are still further apart. The Securities and Exchange Commission's explanation of the disparity is that neither company actually did much of anything, other than spend investor money. Elsewhere, part 5 of the Intercept's penny stock series is maybe about death-spiral convertibles? 

Disney might buy Twitter.

Disney might buy Twitter!

Walt Disney Co. is working with a financial adviser to evaluate a possible bid for Twitter Inc., according to people familiar with the matter.

And:

“It’s a video distribution play,” said James Cakmak, an analyst at Monness Crespi Hardt & Co. “What Disney has to think about is what is its place in a post cord-cutting world. They are investing in technology for distribution -- and this would give them the platform to reach audiences around the world.”

I am an inveterate pessimist about all things Twitter, but I hope this happens, just because it is so fun to imagine the culture clashes. "Imagining a glorious future where ISIS is using Disney software to recruit," Charlie Warzel tweeted, but even imagining a future where Disney publishes that tweet is delightful.

People are worried about unicorns.

The U.S. Department of Labor is worried that Palantir, the Spy Unicorn, is a suspiciously white unicorn, and is suing to get it to change its ways:

Investigators who reviewed Palantir’s hiring operation found that Asian applicants routinely were eliminated in the résumé-screening and telephone interview phases “despite being as qualified as white applicants,” the government said in the suit. “In addition, the majority of Palantir’s hiring into these positions came from an employee referral system that disproportionately excluded Asians.”

The complaint is full of, shall we say, statistical oddities ("For the QA Engineer position, from a pool of more than 730 qualified applicants -- approximately 77% of whom were Asian -- Palantir hired six non-Asian applicants and only one Asian applicant"), but the more important part may be the part about referrals. "The overwhelming preference for referrals, combined with Palantir's failure to ensure equal employment opportunity for all applicants without regard to race, resulted in a discriminatory hiring process against Asian applicants." Palantir is surely not alone in doing a lot of its hiring based on referrals from its current employees and their friends, and the Department of Labor is surely not wrong in worrying that a lot of Silicon Valley referral networks end up being pretty white. If the Department of Labor wins here, a lot of tech unicorns who do their hiring from referrals may get a bit nervous.

Elsewhere: "Rocket Internet would like to see your business idea."

People are worried about bond market liquidity.

"The Bank of England will start purchasing corporate bonds on Tuesday," and you know what that means:

BOE note-buying “is another nail in the coffin of corporate-bond liquidity,” said Jeroen van den Broek, ING Groep NV’s Amsterdam-based head of debt strategy and research. “It creates a real squeeze in the market.”

The problem in bond market liquidity is either not enough buyers, or too many. Elsewhere, ICAP is working on a "Sponsored Access Model" that would let investors trade directly on its interdealer bond trading platforms, if they're sponsored by a dealer. 

Me recently.

I wrote about mini-flash crashes

Also, in Money Stuff yesterday we talked a bit about my plan -- inspired by a Gretchen Morgenson column -- to start an index fund that will always just vote against executive pay and management proposals. Colorful twin hedge fund manager Kevin Gates e-mailed to say:

Years ago, Rich and I tried to start a company called Moxy Vote, to empower retail shareholders to get involved in corporate governance issues.  We got good press and were certainly providing a unique service.  But, the business failed miserably, in large part because retail investors don't seem to really care about corporate governance.  

That sounds about right, honestly! But I still think there's an angle here -- less "investor empowerment" and more "corporate capitalism is bad but whaddarya gonna do" -- and that it has gotten more marketable in the years since Moxy Vote. Also Moxy Vote seems to have been a way to help shareholders vote shares that they own directly; my fund would be a diversified index fund that does the voting itself, a much simpler value proposition. "You get exposure to the S&P 500," I will advertise, "but you get to tell those corporate fat cats exactly what you think of them!" I still think it can work.

Things happen.

Caesars Reaches Restructuring Deal With Its Major Creditors. Caesars owners play a rare game of Texas fold ‘em. Wall Street Shrinks Further in Asia With Goldman, BofA Cuts. CBOE, Bats Deal Creates New Exchange Behemoth. Asset-backed securities issuance revs up as US election nears. Wells Fargo Workers Claim Retaliation for Playing by the Rules. Appeals Court Tosses Antitrust Judgment Against American Express. Venezuelan oil major’s debt swap: the beginning of the end? A New Debate Over Pricing the Risks of Climate ChangeSheila Bair is worried about student loans. Peter Henning on the Cooperman insider trading case. SolarCity Accused of Taking Shingling Technology Secrets. Saudi King Cuts Once Untouchable Wage Bill to Save Money. Endogenous Debt Maturity and Rollover Risk. Mexican Peso Gives Clearest Market Signal That Trump Lost Debate. "During orientation for new employees, Goldman Sachs specifically used to use Mr. Trump as an example of the kind of prospective client to avoid." Distressed debt investors haven't donated much to Trump. Did Trump Just Admit He Doesn’t Pay Any Taxes? Strategist: 'Humanity' Would Be One Loser in a Donald Trump Presidency. Now You Can Spend All of Eternity With Your Pet. Power posing might be fake. Slow burns.               

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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