Brambles, Partners and Options

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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Hmm.

The summer before I started law school, 15 years ago, I read a little book by Karl Llewellyn called "The Bramble Bush." It's basically a "Law School for Dummies" type thing from 1930, full of somewhat outdated advice on how to ace your classes and impress your professors. But Llewellyn was a leading thinker of the school of thought known as "legal realism," and "The Bramble Bush" is also a major statement of that philosophy. In a famous passage, Llewellyn wrote:

This doing of something about disputes, this doing of it reasonably, is the business of the law. And the people who have the doing of it in charge, whether they be judges or sheriffs or clerks or jailers or lawyers, are officials of the law. What these officials do about disputes is, to my mind, the law itself.

He went on:

And rules, in all of this, are important to you so far as they help you see or predict what judges will do or so far as they help you to get judges to do something. That is their importance. That is all their importance, except as pretty playthings.

And then I went to law school. And I took the first-year course in Constitutional Law, and I learned about the fundamental principles that rule the United States. And I learned -- or at least was given the general impression -- that, while the country has not always lived up to those principles, in the long run, the Constitution has served as a wise guide and constraint on the power of our rulers, and the foundation of our system of government.

But in the back of my mind I thought about Llewellyn. I thought about the fact that those principles can't automatically enact themselves, that they only work if the human actors in the system choose to follow them and to demand that others follow them. They persist because the people constrained by them believe themselves to be constrained by them. The Constitution, separation of powersreligious liberty, freedom of the press, an independent judiciary, the rule of law, equality of all citizens: There is a complacent sense in America that these things are independent self-operative checks on power. But they aren't. They are checks on power only as far as they command the collective loyalty of those in power; they require a governing class that cares about law and government and American tradition, rather than personal power and revenge. Their magic is fragile, and can disappear if people who don't believe in it gain power. 

Anyway this is a financial newsletter, so I'll tell you that S&P 500 futures were limit down at minus 5 percent overnight, before paring losses. The Fed probably won't hike in December now. Foreign markets have had a wild ride. Treasury yields plunged, I guess an indication that default is not too imminent. Bitcoin rallied. The Mexican peso is ... best not to look. Maybe everything will be fine!

Elsewhere, no one has any earthly idea of what Donald Trump's approach to financial regulation might be. And: "Failed Polls in 2016 Call Into Question a Profession’s Precepts." And: "People." And of course: "Voting On The Blockchain." 

The other Election Day.

Goldman Sachs Group Inc. will announce its new class of partners today. Mazel tov cocktails to everyone! I used to work at Goldman, but that was more than five years ago now, and I suppose there is some chance that no one I know will be on the new partner list. Much worse: There is a non-zero chance that people who were analysts when I first met them at Goldman are now up for partner. It is enough to make one feel both old and poor. On the other hand, as the investment banking industry declines in both prestige and profitability, the day may soon come when the media doesn't care any more about Goldman partner day than it does about any other round of promotions at any other company, and this biennial marker of my own aging will fade from my consciousness. It'll still be nice for them though.

Valeant.

A while back I made what has turned out to be a critical tactical error, which is that I looked into Pershing Square Capital Management, L.P.'s investment in Valeant Pharmaceuticals International, Inc., and calculated two breakeven numbers. One was just the Valeant stock price at which the trade breaks even, flipping from making a loss to making a profit. When I did the math in March I got a price of about $161.21. That is probably no longer valid, but there is honestly no reason for anyone to care about it, and no one does, for the simple reason that Valeant closed at $14.98 yesterday. (That's down 21.7 percent on the day, on the back of terrible earnings guidance and the possibility of more "surprises" ahead.)

But Ackman didn't just buy stock; he also bought and sold options, and those options could turn out to be either assets or liabilities. Ackman spent about $4 billion in cash to buy about 21.6 million shares of actual Valeant stock, which are now worth about $323.4 million based on yesterday's close. But that position can never be worth less than zero dollars. The options, on the other hand: Those can be worth less than zero dollars. And if they're worth less than negative $323.4 million now, then Ackman's whole position would be worth less than zero. I calculated the breakeven for that eventuality at $17.82, in March. Since then, again, the positions have been modified, the stock price has fallen below $17.82, and -- and this was my tactical error -- people keep e-mailing me asking if Ackman's total position is negative. It is in some sense not an interesting question. My little breakeven was arbitrarily defined; there's nothing special about a stock position and an option position adding up to more or less than zero dollars. It ignores option premium and time value and legal costs, and really the important question is the profitability of the trade, not its current book value. 

But, you know, sure, at $14.98, things seem bad. And the math is actually easy now, after the June modifications of Pershing Square's trades. Again, the 21.6 million shares of stock are worth about $323.4 million. Ackman is also long listed call options on 9.1 million shares of Valeant stock struck at $60 and expiring in January 2019, and short over-the-counter put options on the same number of shares with the same strike price and expiration. (I think he may still also be short $165 January 2017 calls, but we are probably safe to ignore those.) You don't even need any options math here: If you're long a call and short a put at $60, then you are just long a forward on the stock at $60. If the stock closes above $60 in January 2019, Ackman will get to buy the stock for $60 (the calls); if it closes below $60, he'll have to buy the stock for $60 (the puts). So his profit or loss is just the difference between the final stock price and $60, and you can loosely approximate the current value of the trade as: $60 (the forward price) minus $14.98 (the current price) is $45.02; $45.02 times 9.1 million shares is $410.6 million. So his stock position is worth about $323.4 million, his options position is worth about negative $410.6 million, the overall position is worth negative tens of millions of dollars, and it is all a bit of a mess.

Again this ignores the amounts he's spent on option premiums, etc., and is not to be taken too seriously, but people keep asking so there you go. Elsewhere in Ackman bêtes noires, Carl Icahn keeps adding to his Herbalife stake. And elsewhere in Icahn's stakes: "Icahn Doubles Down on Hertz After Missed Earnings Punish Stock."

GSE risk-sharing CDO!

One big post-crisis regulatory theme has been that regulators want to take a pile of risk, and put it in a big box, and slap a bunch of "TOXIC" warning labels on it, so that everyone will be really clear on where the risk is. This is just good useful regulatory tidy-mindedness. For one thing, if you are a regulator charged with looking for systemic risk, it is helpful to have all the risky things clearly labeled, so that you can, for instance, make sure that systemically important banks don't hold too many of them. (Thus banks' holdings of other banks' "total loss absorbing capacity" bonds -- a classic Box o' Risk, with "loss absorbing" right in the name -- are limited, to prevent the contagion of one bank absorbing another's losses.) More generally, you want to make sure that the people who end up bearing the risk in a crisis are people who wanted to bear the risk, and priced it, and went in with eyes open. You don't want the risk to be packaged in weird ways and end up in the hands of school boards, or pensioners, or someone else who's not able to bear or understand it.

But then one big pre- and post-crisis theme in finance is that the fine slicing and attractive packaging of risk is pretty much the whole game. So there are tensions. 

Anyway what do you make of this:

A Florida hedge fund transformed risky Fannie Mae and Freddie Mac debt into investment-grade securities, and it could end up helping the mortgage giants’ efforts to offload more of their risk.

Bayview Financial packaged junk-rated securities issued by the two government-backed companies into $118 million of new bonds last month that Fitch Ratings stamped with grades as high as A-. The sale allows the hedge fund to borrow against its investments in the mortgage debt, giving it fresh funds to buy more assets to boost its returns.

On the one hand, part of the point of Fannie Mae and Freddie Mac credit-risk transfer securities is to package the credit risk of Fannie and Freddie mortgages and sell it to private-sector investors who know what they're getting into and who buy stuff with big red "CREDIT RISK TRANSFER" labels stamped on them. Leveraging that risk by repackaging it into investment-grade tranches creates the danger that some unsuspecting ratings-focused investor will end up exposed to it, in ways that we wanted to avoid.

On the other hand, most of the point of the credit-risk transfer securities was just to move the credit risk of those mortgages into the private sector, and then let the private sector sort it out. And the usual way that the private sector sorts things out is by (1) having a risk-bearing investor take an equity position and (2) leveraging that equity by selling a more senior fixed claim on the asset to a more risk-averse investor. This is how, you know, bank lending works. There is no general rule, in the financial markets, against leveraging risky assets. There are just many specific rules against it, which apply only in specific cases. And there is perhaps a general sense that when it happens someone should write a worried article about it.

Efficient markets.

Sometimes there will be big news about a company, and another company with a similar name or ticker symbol will jump on the news, and we'll all have a good laugh about how dumb markets are. There are two possible sources of the dumbness. One is that humans, scanning a press release quickly, will see that Nest is being acquired and rush out to buy shares of Nestor, Inc. because they look similar. The other is that computer algorithms do the same thing. I'd kind of rather it was the computers? Like, the computers are supposed to make fast probabilistic judgments, winning more of their trades than they lose. They pattern-match with some threshold of reliability, and not every trade works out. The humans actually read the press release! And then buy the wrong company. Seems embarrassing for them.

Anyway in China the questions seem to be different:

Wisesoft Co., whose local-language name “Chuan Da Zhi Sheng” sounds like “Trump Wins Big,” closed 6.4 percent higher with trading volume six times the three-month average. Yunnan Xiyi Industrial Co., or “Aunt Hillary,” tumbled 10 percent.

This was clearly humans, not algorithms. But it doesn't ... seem like a mistake? Like, you can't actually accidentally confuse a small-cap Chinese software-and-heavy-equipment company with a victory in the U.S. presidential election. Those things are not commensurable. It's like confusing Microsoft stock and iambic pentameter. These humans meant to buy the stock, for the homophone. "Chinese investors are no strangers to speculative trading in stocks based on their names." I guess it is not that much sillier than some forms of technical analysis.

TeslaCity.

I have mentioned before how fun it would be to be Elon Musk's lawyer. Here's a story from Seeking Alpha. Tesla Motors Inc. is buying SolarCity Corp. Musk is a major shareholder in both companies, and has pushed the deal. As part of the deal, SolarCity will become a subsidiary of Tesla. SolarCity has a lot of debt in various forms -- project financing, convertibles, etc. -- which will mostly remain outstanding at SolarCity, rather than being assumed or guaranteed by Tesla. (Much of the debt is non-recourse project financing, meaning that it's not even guaranteed by SolarCity.) Or at least that is how reverse triangular mergers often work, and there is no indication in the Tesla/SolarCity proxy or merger agreement that they have different plans. And Tesla's own credit agreement contains a provision (section 10.14) forbidding it from guaranteeing or assuming SolarCity's debt. Because Tesla's lenders had an inkling that something like this might happen.

This is all fine and normal except that someone tweeted at Elon Musk, and Musk could not help replying: "Tesla will def absorb SolarCity debt. Altho extremely unlikely, I would pay it personally if need be. Debts must be honored." How ... binding do you think that tweet is? Also what does it mean? "Def absorb" is not quite the same thing as "directly assume or guarantee." Like, if you acquire a company, and that company owes money, and you don't guarantee that debt, have you still ... absorbed it? "I would pay it personally if need be" is a bit more explicit. I don't know what to tell you, if you own SolarCity debt. But I'm sure Musk is keeping his lawyers entertained.

People are worried about unicorns.

I mean I am sure they are, but the people whose job it is to think about unicorns took a night off to worry about politics instead:

As votes were tallied Tuesday night, the mood among prominent figures in Silicon Valley turned grim. “this feels like the worst thing to happen in my life. i assume we'll get through it, but it sure doesn't feel that way right now,” Sam Altman, president of startup incubator Y Combinator, tweeted.

Silicon Valley, outside of Peter Thiel, has been vocally and lopsidedly anti-Trump in this election, and now ... we'll see? Restrictions on immigration and trade, and a more repressive national-security state, seem like they would mostly be bad for the technology industry. (Again, except maybe for Palantir Technologies, Thiel's Spy Unicorn.) And there are already threats of antitrust and tax crackdowns on Amazon.com Inc., whose founder Jeff Bezos owns the Washington Post, which has reported critically on Trump. Here is Fred Wilson: "What Does Trump Mean For Startups?"

Elsewhere, here is a fintech unicorn called Mozido Inc. that is in a dispute with one of its former board members over a failed effort to raise money from Julian Robertson. "Mozido alleged in a complaint filed in New York state court last week that the former director told Mr. Robertson the mobile-payments company was a 'fraud' that would go out of business." That's a mean thing to say about a company of which you are a director! On the other hand, here's something that Mozido's chief executive officer said about it:

“We’ve got historic situations none of us participated in,” he said. “I guess you could say we should have done our homework more thoroughly before we joined, but we’re putting it behind us.”

The level of enthusiasm all around leaves something to be desired.

People are worried about bond market liquidity.

Look, today is weird, but the earth still turned, the sun still rose, and people still worried about bond market liquidity. Here's "What Happens When Wall Street Pulls Back From Bond Markets."

Movie Stuff.

Yesterday I questioned whether short selling would be a good plot for a movie, and then noted "The Big Short" and "Goldfinger" as counterexamples. Several people pointed out that Auric Goldfinger was really long gold. In fact he loves only gold. I don't know what I was thinking. The Bond movie about a short selling plot is "Casino Royale." Also I guess "Trading Places" is a short-selling movie. Never mind, short selling is the best possible plot for a movie.

Also I realize that some people think that yesterday was 17 Brumaire, not 18, but there are conflicting conversion methods. Wikipedia agrees that yesterday was the 18th. In any case, if you are insisting that it was 17 Brumaire, you have missed the whole point of dating modern events by the French Republican calendar, which is surely not chronological precision. Certainly yesterday was 18 Brumaire in spirit. Elsewhere: Lego 18 Brumaire.

Things happen.

India scraps high-value banknotes in black economy clampdown. Wall Street 'flash crash' accused Navinder Sarao extradited to US. EBA’s Deutsche Bank Test Concerns Brushed Aside by Board Members. Performance Bonds for Bankers: Taking Aim at Misconduct. Big Oil Looks Past Profit Crunch as Cash Flow Cues Recovery. SEC Files Two Fraud Actions. Bias Suits Against Banks by Cities May Divide High Court. Why Twitter Must Be Saved. Penguin fight. More squirrel attacks at Florida senior center. Jim Harbaugh says he models his behavior on SpongeBob Squarepants

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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