Bond Trades and Merger Codenames

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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Bond trading.

Here's the heartwarming story of a Goldman Sachs high-yield bond trader named Tom Malafronte, who bought bonds when customers were selling them, and sold them when customers were buying, and made $100 million between January and June. Congrats all around! In one sense, this is a story about the recovery of bond trading at the big banks this year, as Goldman, JPMorgan, Citigroup and Bank of America have all beat earnings expectations this quarter on stronger-than-expected bond trading revenues. (Though to be fair, Malafronte's success seems to have come in the previous two quarters.) Banks make money when clients want to trade, clients wanted to trade, and so Malafronte made money. 

In another sense, this is a story about the Volcker Rule: How could a trader make $100 million by buying bonds and then, later, selling them for a profit? Wasn't the Volcker Rule supposed to prohibit proprietary bond trading by banks? "It goes against everything we’ve been seeing the last three years," says a guy. One odd element in the Volcker Rule is that it is supposed to limit banks' bond inventories to the amount necessary to meet "reasonably expected near-term demand" from customers. Malafronte bought billions of dollars of bonds, selling some immediately and keeping others for weeks as their prices went up. Were they all really necessary to meet customer demand? Well, one thing to remember here is that customer demand goes two ways. You might need inventory to satisfy customers' demand to buy bonds -- but your job as a market maker is also to satisfy customers' demand to sell them. If a customer comes to you and begs you to buy $1 billion of bonds, and you do it, you are meeting near-term trading demand from customers. But now you have $1 billion of bonds. It might take you some time to work out of them. The distinction between good "market making" and bad "proprietary trading" is not just about the amount of inventory you have; it's also about how you acquired that inventory. If you go out looking for bonds to buy, that is prop. If the bonds come to you, that is market making. 

In a third sense, this is of course a story about bond market liquidity. People are worried about bond market liquidity, you may have heard, and the specific form of that worry is that banks no longer do the thing that Malafronte apparently did: buy bonds when everyone else is selling, to provide immediacy, cushion downturns and shift demand in time. "Critics have argued that the postcrisis rules on trading have made it harder for the biggest Wall Street banks to buy bonds from investors in times of stress and hold them until markets calm." Critics sure have argued that! But the rules haven't made it impossible, as Malfronte's example shows.

But there's one other theme in this story that is worth mentioning. Here's Malafronte's buddy:

“Tom is a tremendous risk taker,” said Jeff Bahl, who headed Goldman’s high-yield trading desk and worked with Mr. Malafronte before leaving to work with his father at Cincinnati money manager Bahl & Gaynor Investment Counsel. “In any opaque market, such as high-yield, the value of a skilled risk taker will always be there.”

Being a "skilled risk taker" is subtly different from having a large balance sheet, or seeing a lot of customer order flow. There are regulatory and capital and risk-limit reasons that banks might not take on as much trading risk as they used to, but there are also related cultural reasons. If you can't make your own proprietary bets, if your market-making trades are closely scrutinized for hints of illegitimate "prop" behavior (like too much profit), if you are constantly pressured to reduce position sizes and risk, then you won't have much fun trading. And if you're the sort of person who is comfortable taking big positions -- if you're a "tremendous risk taker" -- then market making at a bank may not be as appealing as it used to be. And so banks will have a harder time recruiting and training the next generation of market makers who are skilled at taking risk. (Malafronte himself worked at a hedge fund before coming to Goldman.) The idea that banks will provide liquidity in tough times requires not just balance sheet but also nerve, and no modern trends are making banks nervier.

Elsewhere, Morgan Stanley announced earnings this morning, and guess what: "Morgan Stanley Beats Estimates on Surge in Bond-Trading Revenue." And Goldman's trading revenue is up even as its value-at-risk is down.

Tech M&A.

Colin Powell is a member of the board of directors of Salesforce.com, but he is also former U.S. Secretary of State, and the rule these days is that if you are or were in any way associated with the U.S. government, then your e-mails will be hacked and made public. It is harsh, but I don't make the rules. This is not an ideal situation for a director of a public company; Powell's e-mails were duly hacked, and they include a "draft and confidential" May presentation covering potential acquisition targets for Salesforce. Twitter -- more recently a rumored Salesforce target -- was not on the list. But this is my favorite part:

The presentation listed code names for four of the potential targets, all the names of famous wine-making regions. Demandware, to which about one-third of the presentation is devoted, was called Champagne, while LinkedIn was code named Burgundy. ServiceNow Inc., a business software firm with a current market value around $12.4 billion, was dubbed Sonoma, and also accounted for about a third of the presentation’s slides. Tableau Software Inc., which makes data visualization software, was listed as Tuscany.

The best thing about investment banking is the code names. You get to feel like a spy! You walk through the airport, talking about Project Burgundy, and for all anyone overhearing knows you could be plotting a coup in a foreign country. But no one involved in the code-naming of M&A deals would last a day as a spy. Like, the point of codenames really ought to be that if the secret board presentation gets hacked, hackers should get only the codenames, not the cleartext. You put only the codenames in writing, and whisper the real names to the board members on a park bench that you have first swept for bugs. But the Salesforce board presentation not only included the real names and logos of all the potential targets, it also included the codenames of the more serious targets, so a hacker who got this presentation would have a master key to any other coded communications. (And it's not like the code is so unbreakable anyway: If your deck says that Burgundy is a professional networking site with an $18 billion market capitalization and $3.7 billion in estimated 2017 revenue, the codename is a pretty flimsy disguise.) I mean, whatever, it's fine, the point of the codenames is to allow you to talk freely in airports and elevators, not to maintain absolute secrecy if a presentation falls into the wrong hands. But now that everyone's e-mail is getting hacked all the time, maybe it's time to take the secrecy a bit more seriously.

Elsewhere in tech mergers and acquisitions, and in e-mail hacking for that matter, Yahoo took pains to point out on its earnings call that there's been no material adverse effect on its business:

If Verizon Communications really wants to renegotiate its $4.8 billion deal to buy Yahoo’s internet operations, it’s probably going to have a fight on its hands.

Yahoo said on Tuesday that it had actually gained a slight amount of traffic since its Sept. 22 disclosure that about 500 million accounts had been hacked. That appears to contradict Verizon’s assertion last week that the damage to Yahoo’s business from the breach could have been severe enough to set off a provision in the sale agreement that would allow Verizon to reopen the deal.

I hope that is causal, and that they have found a few people who are like "yep, I opened a new Yahoo account because of the hack!"

Hmm yes.

Here's Anthony Scaramucci, the Skybridge Capital founder and Trump fund-raiser and adviser, on the Department of Labor's fiduciary rule:

“It's about like the Dred Scott decision,” Mr. Scaramucci said.

He made the analogy because he views the DOL rule as discriminatory, Mr. Scaramucci wrote in a follow-up email.

“The left-leaning Department of Labor has made a decision to discriminate against a class of people who they deem to be adding no value,” he wrote. “They are judging what should happen in a free market and attempting to put financial advisers out of work."

Dred Scott! That's the 1857 Supreme Court decision denying a slave his freedom because African-Americans couldn't be citizens. That is like a rule regulating conflicts of interest for brokers who advise retirement accounts? There is a long history of finance guys making tone-deaf comparisons between mild regulatory changes and historical horrors; remember when an increase in carried interest taxation was "like when Hitler invaded Poland in 1939"? But Scaramucci is also one of Wall Street's leading backers of Donald Trump, who launched his political career by doubting the citizenship of America's first black president, and whose presidential campaign has been based in part on a call to ban Muslims from the United States. And of all the things to compare to Dred Scott, he came up with the fiduciary rule.

It's been fascinating recently to see the backlash in the tech industry against Peter Thiel for giving money to Trump. Facebook and Y Combinator have been criticized for maintaining their ties to Thiel; Ellen Pao's Project Include has cut its ties to Y Combinator over the controversy. But there has been no noticeable financial-industry backlash against Scaramucci and others, like Carl Icahn, who have acted as vocal Trump surrogates as his campaign gets stranger and more insular. No one seems to be boycotting Skybridge's SALT conference yet. Dimensional Fund Advisors co-founder Rex Sinquefield, himself a Trump supporter who calls most of Trump's proposals "fairly bad," may have the best explanation: "His tax policy—that overrides everything else. Nothing else compares in importance to that."

Hedge fund returns.

Yesterday I cited William Cohan citing an anonymous hedge fund investor citing his "guys" finding that Bill Ackman's overall returns to investors have been "zero." I also cited Ackman's publicly disclosed return figures showing mid-teens net annual returns since inception. I have perhaps never received as many e-mails on any other topic as I did on this one. Yes, yes: Ackman's figures are time-weighted returns, while the "guys" were presumably calculating money-weighted returns, and Ackman's performance does seem to have gotten worse as his funds have grown. (Happens to the best of us!) If you invested a dollar with Ackman at the launch of his fund, it has grown at a mid-teens rate, but the average dollar in his fund was invested later and has done worse. So it is not mathematically impossible that Ackman's overall money-weighted returns are zero, though I don't know if they are. I have only that anonymous guy's anonymous guys' conclusion to go on for that.

We also talked yesterday about the New York State Department of Financial Services report criticizing the state retirement fund for investing in hedge funds, and calculating that that choice has cost it $3.8 billion since 2009. But the DFS's ... numbers were wrong?

The analysis is marred by the fact that the DFS goofed up its accounting of the fund’s equity returns. In the fiscal year ending March 31, 2009, the fund reported that its domestic equities portfolio lost 37.9 percent of its value, while international stocks tanked 45.6 percent. Weighted together, equities sank by 40 percent. Yet the DFS report shows equities losing a relatively mild 7.12 percent that year. In terms of absolute numbers, the DFS report implies that equities lost $5 billion in 2009, compared to the actual loss of $24 billion for the fiscal year — a $19 billion error.

The next year, when markets sharply rebounded, the DFS report errs in the other direction, claiming equities gained 26.6 percent, compared with actual returns of 53.2 percent.

Where the state’s top financial cop got those numbers is a mystery. “The figures used in the chart are baffling and seem at odds with the known facts, like much of the report,” a spokesman with the state comptroller’s office said.

Oops! The point here is that if you want your hedge funds to provide returns that are uncorrelated to the stock market, you should expect them to underperform your stocks in a bull market like the one we've had over the last few years. What you want is for the hedge funds to outperform your stocks in a downturn, which they did in 2008-2009 -- but the DFS just pretended that they didn't. That will mess up the comparison.

Privilege.

Can putting "Interests: Polo" on your resume help you get a fancy job? The answer is yes, at least at law firms, at least if you are a man, at least according to a fake-resumes experiment:

In the experiment, privileged applicants listed expensive, exclusive sports like polo and sailing, and mentioned a penchant for classical music. Less-privileged applicants preferred country music and track-and-field sports.

Rivera and Tilcsik sent the mock applications to 316 law firms, and of the 22 interview invitations they received, the privileged men had a call-back rate of 16 percent, which was more than four times the rate for privileged woman, less-privileged women, and less-privileged men combined.

On the other hand, "privileged women" (that is, resumes with female names and polo interests) did not get any advantage, and in fact were penalized, because they "were viewed as being the least committed to their careers." The old-fashioned assumption seems to be that if you're a man who enjoys sailing and polo, you'll fit right in at a fancy law firm, while if you're a woman who enjoys those things you'll want to leave at the first opportunity. Anyway if you are a man looking for a fancy job, why not try pretending to like polo and classical music and see what happens? And let me know? 

People are worried about unicorns.

Can you be an oil unicorn? Reuters says yes: "Double Eagle Energy Permian LLC is a unicorn roaming the barren landscape of West Texas," an oil and gas company preparing for an initial public offering with a value of "nearly $3 billion," "triple the $1 billion threshold for a so-called unicorn, the moniker most often used in Silicon Valley for high-value private companies." I sort of thought that the "unicorn" label was limited to private venture-backed tech companies, and companies that aren't really in the tech industry but are part of the same lifestyle gestalt, like Blue Apron or whatever. "Unicorn" implies not just a billion-dollar valuation but also a certain hoodies-and-air-hockey vibe that is hard to maintain on an oil rig. Also if your company is already a double eagle -- two animals -- it seems hard to fit a unicorn in too, though after my experience with the Ant Unicorn you should look forward to an illustration of a double eagle unicorn in a future edition of Money Stuff.

Elsewhere in initial public offerings -- though not unicorns -- here's a weed REIT. It's called "Innovative Industrial Properties," and I have to say, if you're looking for a place to grow drugs that won't arouse any suspicion, or any interest of any kind, a building owned by Innovative Industrial Properties seems just about right.

And elsewhere in Silicon Valley, and real estate, "soaring apartment costs in Silicon Valley are fueling popular support for an idea bitterly opposed by many landlords in America’s technology capital: rent controls."

People are worried about bond market liquidity.

Here is a New York Fed staff report on "Market Liquidity after the Financial Crisis," which comes to the same conclusion as every other regulatory study: "Overall, our findings, and those of recent papers we survey, do not suggest a significant decline in bond market liquidity." And here is a U.S. Treasury blog post on "Lessons Learned from Transparency in Corporate Bonds and Swaps," with those lessons being particularly applicable to proposals to increase post-trade transparency in the Treasury market:

Evidence from corporate bond and swaps markets suggests that public transparency in those markets has likely reduced transactions costs and provided other benefits, while the net effect on market makers is unclear and would benefit from further evaluation.

Things happen.

Banc of California Drops Amid Accusations From Short Seller. Banc of California Rebounds After Reporting Results Early. The $100bn marriage: How SoftBank’s Son courted a Saudi prince. Credit Suisse traders are prepping one of the biggest hedge fund launches this year. Are Fund Managers Doomed? Index funds vs. the market portfolio. Index funds vs. fundamental or equal weighting. One Place Where Passive Investing Doesn’t Rule: Bonds. Russia’s Incredible Vanishing Middle Class Ruffles Central Bank. Leonardo DiCaprio Cooperating With 1MDB Probe. FINRA Fines Merrill Lynch $2.8 Million for Systemic Reporting, Books and Records, and Related Supervisory Violations. Spinal Tap bassist sues Vivendi for $125m. CBS Orders "Candy Crush," a New One-Hour, Live Action Game Show Series Based on the Globally Renowned Mobile Game Franchise. Emotional support duck.

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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