Troubled Banks and Harvard's Challenges
Today the House Financial Services Committee takes its turn yelling at Wells Fargo Chief Executive Officer John Stumpf about the bank's fake-accounts scandal. Stumpf had injured his hand before his Senate immiseration last week, and I'm expecting him to show up at the House in a full-body cast with a sign that says "what I gave up $41 million, come on," taped to him. Honestly no one seems that mollified by Stumpf's $41 million voluntary clawback? I'm not sure that anyone should be, really, but the tone of Wells Fargo discussions suggest that no one is going to be mollified by anything. Elizabeth Warren has called for a criminal investigation. If I were in Stumpf's shoes I might have resigned before the Senate hearing, but that is just because I don't like confrontation and have no tolerance whatsoever for being yelled at by a room full of politicians. And I guess any actual bank CEO these days has to relish that. Here are "5 Things to Watch at Wells Fargo's House Hearing," though I will be watching for only two things, (1) what sort of physical injury will Stumpf display this time and (2) will he quit during the hearing just to make it stop?
Meanwhile California has jumped on the not-doing-business-with-Wells-Fargo-for-a-bit bandwagon, to express its displeasure about the fake accounts. "Wells Fargo was the second-largest underwriter of municipal debt in California in the first half of the year," behind Citigroup. I asked yesterday what about the Wells scandal makes it so much worse than the mortgage, Libor, FX manipulation, etc., scandals at all the other banks, such that municipalities will drop Wells Fargo -- which defrauded consumers out of about $2.4 million of credit-card fees -- and move their business to Citigroup, which has paid billions of dollars of fines for alleged fraud and manipulation. I have not gotten a really satisfying answer. Recency is the obvious choice. One reader e-mailed:
I sort of picture a world where bankers have signs in their offices like factories with their "Days Since Last Accident" and when it comes time for a pitch you make a deck with a single slide that contains your number. Highest number gets the books.
If banks wanted to be good neighbors to each other, they'd constantly have scandals in rotation, so that each new scandal would distract from another bank's previous scandal. I guess that is how it works.
Dan Davies is pretty chill about Deutsche Bank's capital situation, and has some reassuring words for those "who feel like they had so much fun in September 2008 that they want to believe the same thing is happening again and again." Davies's basic points are (1) Deutsche is not particularly close to failing to meet its capital requirements and (2) even if some combination of horrors brought it below the minimum, there are plenty of options -- "possibly converting CoCos, clawing back bonuses and reducing assets" -- to recapitalize it without state aid. One weird result of 2008 is a sort of permanent cynicism about all financial regulation: Sure, you say, banks' capital levels are higher and they take fewer risks and regulators pay more attention and there are clear bail-in requirements that will put losses on creditors rather than the state -- but nothing has really changed. I don't know. One can't really find out if that's right until there's a crisis, and if the new regime succeeds in avoiding a crisis, then people will still argue that it hasn't really been tested. We can't know that we've prevented bailouts until there's a bailout. It is a difficult logic.
Meanwhile, "Deutsche Bank Is the Darling of the Short-Sellers":
This echo chamber of doom — fed in recent days by a cycle of reports in Germany that the government might step in, only to be followed by denials by Berlin — brings to mind some of the fears over Bear Stearns and Lehman Brothers before those institutions suddenly lost the trust of investors and clients alike in the dark days leading up to the 2008 financial crisis.
Elsewhere: "Why People Have Been Worrying About Deutsche Bank, in 12 Charts." And: "If Merkel Wants to Help Deutsche Bank, She Has Few Options." And: "Erdogan Adviser Says Turkey Should Consider Buying Deutsche Bank." Oh, also: "Commerzbank Plans to Cut Jobs, Suspend Dividend in CEO Overhaul."
Here is an editorial from the Harvard Crimson on "The Urgency of the Present," and it is a good time:
Harvard faces numerous pressing issues: a suboptimal social scene, growing competition from other universities for talent, and critical challenges to diversity and inclusion. Unfortunately, last week brought another, this time in the form of a renewed challenge to the endowment’s stable growth. Specifically, Harvard Management Company announced a $2 billion loss for fiscal year 2016.
Let’s not mince words: this is unacceptable.
It is always pleasing to see students at my alma mater making the case for the core principles of a liberal education, like higher investment returns on the endowment. The problem is how to get those returns. The Crimson has no particular suggestions -- "we don’t know whether the answer lies in increased compensation at HMC, a different asset mix, or a more fundamental strategic rethink" -- and admits that "we are not investment advisors."
But it's not like the seasoned professionals are doing all that great, at Harvard or otherwise. "It’s tougher to be a hedge fund investor than ever before," says Julian Robertson. "I’ve never seen anything like the massacre of the hedge fund business this year," says Josh Brown. "Peak Finance Looks Like It's Over," says my Bloomberg View colleague Noah Smith.
It seems to me that there are two basic models of how investing could work over time. One is sort of a random walk: Some stuff makes money sometimes, other stuff makes money other times, it's always hard to know which is which, and the trick is to find a good manager who knows. This is sort of the default model that everyone has in the back of their minds, the model that those Harvard kids are using. Just figure out how to buy the stuff that will go up, and buy it. Or: Figure out who will figure it out, and give them your money.
The other model is sort of a random walk with drift: Some stuff makes money, some stuff doesn't, but over time we as a society learn to identify which is which. We learn to index, to look at value and momentum factors, not to invest in tulip bubbles, whatever. The learning is imperfect, and there are setbacks -- sometimes we invest in mortgage bubbles -- but over time the drift is in the direction of knowledge. This would seem to make the investing business harder over time. If asset returns are widely dispersed and hard to know, then there will always be a mystique around someone who knows them, and that person can always charge 2 and 20. If markets become more efficient over time, and asset returns approach their correct risk-adjusted level, and this gets easier for everyone to figure out, then the opportunities to make outsize returns -- and charge for them -- will keep shrinking. And people who thought they were exceptional -- hedge fund managers, Harvard -- will revert to the mean, and feel disappointed and adrift.
The basic idea of smart beta is that there are statistical relationships that can predict which stocks will outperform. So the value factor, say, suggests that stocks with low prices relative to their book values will outperform. So you buy more of those stocks. Other factors suggest other relationships. But there are also meta-relationships, ways to predict which factors will outperform:
A timing model that revolves around buying the three factors with the poorest recent performance and rebalancing, would have beaten the market by 3.3 percentage points per year, (with some extra volatility) compared to 1.4 percentage points for a strategy that chased the most successful recent factors.
Quite an industry is developing around timing and recombining factors.
Of course once you have a list of meta-factors -- ways to combine factors in ways that will outperform -- then you can start on a list of meta-meta-factors, ways to combine the meta-factors in ways that will outperform, in saecula saeculorum. We are at, like, stage 2 of this process or whatever, but in the limit your factors will be perfect and you can go home.
Elsewhere in quantitative strategies, "Quant Who Coined Risk Parity Says Wall Street Has It All Wrong":
“Every time people talk about it as a leverage bond portfolio, I just cry,” Qian said. “It’s not leveraged bonds. It’s a leveraged portfolio.”
We all get a little sensitive about our work, I guess. Sometimes people call this newsletter "Money Talk" and I shake with anger.
Here is Cardiff Garcia on money-market fund regulations:
Ever since the financial crisis, US and global regulators have been arduously executing a project of illusion reduction — that’s what regulation is, mostly — and moving in the direction of a world where the only assets allowed to maintain the illusion of perfect insensitivity to new events are those assets provided by (or guaranteed by) the official sector, which can be defined as the combination of the US government and the Fed.
In doing so, the pursuit of safe assets becomes even more intense in a world already starved of them. To burst the illusion of safety in a particular financial asset is akin to shrinking the institutional money supply. But that is a tradeoff now considered worthwhile by regulators, a necessary price to pay for a stabler financial sector.
I feel like I don't see enough writing about the macroeconomic effects of forcing investors to confront the risks of their risk-free assets, but I like the idea that "to burst the illusion of safety in a particular financial asset is akin to shrinking the institutional money supply." For instance, by discouraging investors from treating banks' money-market instruments as risk-free, new regulations have pushed up Libor, which is sort of like an interest-rate increase. (Sort of.) Is that what we want? Or: Are interest rates so low in part to provide room for this sort of quasi-monetary quasi-tightening?
Elsewhere in monetary policy, this Financial Times op-ed from a member of Donald Trump's economic advisory council is maybe the weirdest thing I've ever read about economics. Does Trump want higher rates? Lower rates? Less currency manipulation? More currency manipulation? A less politicized Fed? A more politicized Fed? Maybe a gold standard? There are no answers, just hints in every imaginable direction. Scott Sumner says: "Does Trump favor tighter money or easier money? Neither, he favors teasier money. He likes to tease us with ambiguity."
Speaking of vast conspiracies, David Dayen's eight-part series about a guy who was suckered by a penny stock pump-and-dump has gotten very strange indeed. The guy has somehow developed a theory that UBS is using penny stocks to help its clients shelter their taxes:
UBS’s clients, according to DiIorio, purchase the penny stocks because they know they will drop in price. That way, they can use capital losses to offset any capital gains in the brokerage account, “resulting in a reduction in their reported income-tax liability and the underpayment of millions in taxes,” according to DiIorio’s 2013 complaint to the SEC.
There seems to be no evidence at all for this theory, and the SEC ignored it. One useful thing to remember in these situations is the First Law of Tax: It is better to have more money than less money. There are tax-sheltering strategies involving paper losses from depreciation, or offsetting gains and losses on options strategies, or what have you, but just losing all your money on a penny-stock scam is never a good tax sheltering strategy. Sure you get back 35 percent of it in tax deductions! (Maybe: Capital-loss deductions are limited.) But you lost 100 percent of it! That's more than 35. Come on.
For a long time, the way that stocks were traded is that you and I met under a buttonwood tree, and I agreed to sell you 100 shares of Amalgamated Spats for $10 each, and then we'd go back to our offices at the end of the day, and I'd tell my clerk to bring you the shares, and he would go to the vault and get the share certificates and set out for your place, but it would be snowing so he'd have to turn back, but eventually after an arduous five-day journey he'd get you the share certificates and you'd get me the money and the trade would be, as we say, "settled."
Then all the share certificates were put in one big vault at the Depository Trust Company, and computers were invented, and all of these settlement mechanics now occur abstractly and electronically. But they still took five days until 1993; now they take three days. I have never really understood why. I assume that the various computer programs implementing the procedures are old, and do their best to replicate the arduous journeys of yore. But anyway the big news in securities settlement is that soon it will take two days:
The Securities and Exchange Commission today voted to propose a rule amendment to shorten the standard settlement cycle for most broker-dealer securities transactions from three business days after the trade date (T+3) to two business days after the trade date (T+2). The proposed amendment is designed to reduce the risks that arise from the value and number of unsettled securities transactions prior to the completion of settlement, including credit, market, and liquidity risk directly faced by U.S. market participants.
When people talk about blockchain revolutionizing the financial system, I tend to think there are three ways for settlement to go:
- The current, not notably efficient, system, in which stock settlement takes three days and syndicated loan settlement takes like a month.
- Some much faster and more efficient system created by just, like, trying to take a bit less time. Update your computer programs, or just, as here, decree that settlement will take two days instead of three.
- Ideal perfect blockchain instantaneous settlement.
I'm sure No. 3 is ideal and perfect, but No. 2 does seem like low-hanging fruit.
Bitcoins in space.
"The first-ever peer-to-peer financial transaction in space," announces a voice in this video, which mostly shows one of those novelty bitcoin coins attached to a ballon and floating up to the edge of the atmosphere. Then someone sends the balloon a bitcoin. Then ... I don't know, there's some high-fiving I guess. If you're ever in the neighborhood of that balloon on the edge of space, stop by and it will buy you a beer with its bitcoin. As with a lot of blockchain projects, this seems like proof that something can happen, without much worrying about why anyone would want it to.
Elsewhere in blockchains in weird places, here's Alexandra Scaggs on, among other things, Bit Bastion's "plan for a 'DAO City' in a Honduras Zone for Employment and Economic Development." And elsewhere in random weird stuff, here's the "Black Shoals Stock Market Planetarium," which is "a kind of parody of the trading desk of the übermensch - the Mount Olympus from which they would survey their creation."
People are worried about unicorns.
I don't have much, but here is "This Chart Shows Most of Fidelity’s Unicorns Already Had Their Horns." If you think of private tech companies as sort of an undifferentiated "startup"/"venture capital" space, you will be confused. (Why are these startups so big, and so institutional, and why do they have big mutual funds as shareholders?) The trick is that there are small startups funded by venture capital, and big public companies funded by mutual funds, but now also a vast middle ground of unicorns that look more or less like public companies except for being private. So why shouldn't Fidelity invest in them?
People are worried about stock buybacks.
This section has really transformed into a drumbeat of people worrying that there aren't enough stock buybacks:
S&P 500 companies spent $127.5 billion buying back shares in the second quarter of 2016, a 21% drop from the first quarter and a 3.1% decrease from the same period of 2015, according to a report by S&P Dow Jones Indices.
In fact, it’s the least that the S&P 500 companies have spent on repurchases in two years.
So more long-term investment in research and development then?
People are worried about bond market liquidity.
Deloitte surveyed fund managers about how they think about fair-market valuation of their investments, and guess what they're worried about?
It is no surprise that liquidity is rising in importance on valuation agendas. The most recent credit crisis is not that far behind us, and the SEC’s actions over the past year show it is intently focused on keeping liquidity considerations in the foreground.
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