Money Stuff

Governance, Advisers and Derivatives

Also Sergey Aleynikov, the fiduciary rule, and buybacks (and Trump).

Corporate governance.

One way to come at corporate governance is: You have a public corporation, and you want to know how it should be governed. As with anything else, giving one or two people absolute power over the corporation seems bad. It's not their money; it's the shareholders' money. The shareholders should have some say in how it is spent. The managers, unchecked, may turn out to be incompetent, or mad with power, and might not act in the shareholders' interests. That would be bad.

But the other way to come at corporate governance is: You have one or two entrepreneurs, and they start a business, and then they go out to potential investors and ask for money. And the investors say: What's in it for me? And the entrepreneurs give some answer they can live with. Maybe they offer to pay the investors back with interest. Maybe they offer to give the investors a cut of the profits. 

And then the investors say: Okay, but also, we want to pick some people who will be in charge of your company, who will monitor your performance, and who will be able to fire you if they don't like the job you're doing. That is ... a very reasonable request? The investors are putting up the money; they want to control how it is spent. And yet it is also very reasonable for the entrepreneurs to say no. It's their company! Why would they want to give some random outsiders the ability to fire them, just in exchange for some money? It is a puzzle, and it's often one that is mediated by price. Simplistically, the investors should give the entrepreneurs more money if they have more power to control how it is spent. 

If you come at corporate governance from the corporate-governance viewpoint -- "given a corporation, how do you govern it?" -- then you will be pretty keen on shareholder rights and one-share-one-vote democracy and all that good stuff. But if you come at it from the entrepreneurs-and-investors viewpoint -- "given an entrepreneur trying to raise money, what should the terms be?" -- then none of those things feel like givens. Sure, there are some standard terms -- bondholders get covenants, shareholders get votes, etc. -- and those terms are standard for a reason, because long experience has taught investors that they are often good and useful ways of protecting their investments. But even those terms can often be negotiated away, or rather, priced. If the investors are happy, and the entrepreneurs are happy -- or if neither side is happy but both can live with the compromise -- then there's no reason for anyone else to object.

Generally speaking the corporate-governance viewpoint is right! Like, if you do have a public corporation, with professional managers hired by the board, those managers should be answerable to the board, and the board should be answerable to the shareholders, and voting should be fair and takeover protections should be limited and so forth. But if you actually do have some entrepreneurs who run a company, and they are seeking outside money -- if, say, a successful founder-run startup is doing an initial public offering -- then there is some room for the entrepreneurs-and-investors viewpoint. Anyway here is Steven Davidoff Solomon on the Snap Inc. IPO, which will apparently offer non-voting shares to the public:

Without picking on Mr. Spiegel and Mr. Murphy, this type of corporate power concentration in one or two people has too much chance of going wrong — especially someone who might be around for 70 years and is running a company with so much uncertainty in its future. Their vision may change or just go bad, but shareholders who own part of the company are stuck as are the employees and consumers of the company who then are kept in this scenario.

But remember, for Snapchat founders Evan Spiegel and Bobby Murphy, giving shareholders power over their baby has too much chance of going wrong -- especially since they might be around for 70 years and are running a company with so much uncertainty in its future.

Elsewhere in governance: "Avis Uses ‘Poison Pill’ to Block Longtime Investor From Gaining Too Much Control." And: "Why Do Boards Exist?" 

Aramco IPO.

Saudi Arabian Oil Co. is planning the largest initial public offering in history, and it will have to hire banks to underwrite that IPO, and it has started that process by sending out requests for proposals, but in round numbers, for a deal this size, you'd expect it to hire all the banks. Really if you are an oil-and-gas banker and you are left off this deal, you are going to have some explaining to do to your bosses. It doesn't even matter if you don't have a capital-markets business: Aramco won't just hire banks as underwriters; it will hire other banks as advisers to help it choose the underwriters. ("Aramco had been seeking a boutique to help it select banks to underwrite the offering, decide on venues for the listing and ensure the IPO’s smooth execution," and Moelis & Co. and Evercore Partners Inc. are on the shortlist.)

For a potential $100 billion IPO, I am not sure that two layers of banks will be enough. What you need to do is hire a boutique bank to help you choose the banks that will help you choose the banks that will do the deal. In fact, for a nominal seven-digit fee, I would be available to help Aramco structure the process to choose the bank that will help it choose the banks that will etc.

One hears, sometimes, distant rumors of a time when a big company (or government) would have a close advisory relationship with one or two investment bankers, whom it would trust to give it thoughtful unconflicted advice and also to execute transactions. A few people are even alive today who witnessed that time, though their memories are not always reliable. It feels very far away. The investment banking business has become commoditized and conflicted, which creates opportunities for boutiques to give thoughtful unconflicted advice on how to deal with the conflicted commoditized banks who will execute the transactions. But at the very high end, even that business -- the boutique-advice business -- seems a little commoditized.

Mortgage derivatives!

Before the financial crisis, banks wrote lots of risky mortgages, packaged them into securities, and sold derivatives on those securities, which all ended up rather poorly. After the financial crisis, banks write lots of safer mortgages, which they then sell to Fannie Mae and Freddie Mac, which then package them into all-but-government-guaranteed securities and sell them to investors. But Fannie and Freddie, as part of their vague quest to one day not be arms of the federal government, also sell other securities to investors, non-guaranteed "credit-risk transfer" securities. If there are defaults in a pool of Fannie/Freddie mortgages, the credit-risk transfer securities bear some of those losses, instead of putting all the costs on Fannie/Freddie/the government. 

If you squint, those securities look a little like the old mortgage-backed securities -- they have default risk! they have tranches! -- and if you are the sort of person who squints at mortgage-backed securities, it's probably because you are building derivatives on them. So here is a story about Vista Capital Advisors, which plans to "create indexes of mortgage securities" -- that is, credit-risk transfer securities -- "which in turn would become the basis for the derivatives." "Derivatives linked to these notes could be a test for how open investors are to new mortgage products a decade after the financial crisis." Sure, why not. If Fannie Mae and Freddie Mac ever are going to be privatized, there will need to be some market mechanism for pricing the credit risk of their mortgages. Selling credit-risk transfer bonds is obviously a step in that direction, but building an index of those bonds, and a derivatives market on that index, seems like a reasonable way to make that market more liquid and efficient. 

Or not? 

But there is also a potential drawback to the derivatives, he said: investors may decide to bet on the credit-risk transfer using derivatives instead of the cash securities, which could end up reducing demand for the bonds. The U.S. government could end up detracting from securities’ popularity if it were to endorse derivatives. 

Is that a thing? Derivatives are a two-sided market; if you want to get long exposure to credit-risk transfer index swaps, or whatever, then someone has to be short. That someone is probably a bank, and the bank probably hedges by buying the underlying cash bonds, meaning that overall demand remains the same. (Overall demand goes up, really, since the hypothesis is that some people will want to get long the index swaps who would not have bought the underlying bonds.) 

Of course it is possible that the bank will instead hedge with someone who wants to get fundamentally short the credit-risk transfer index, and that overall demand for cash securities will go down as the longs and shorts just bet amongst themselves. (There is a theory that the pre-crisis mortgage bubble would have been worse in the absence of synthetic collateralized debt obligations on mortgage-backed securities: If banks didn't have synthetic CDOs to sell to investors who wanted mortgage exposure, they'd have had to originate even more risky mortgages.) But are there any examples of that? I feel like most of financial history has taught us that building a derivatives market for a thing tends to grow the market for the underlying thing. That's why people keep building those derivatives markets.

Elsewhere: "Fannie Mae is backing debt from Blackstone Group LP’s investment in single-family homes, offering an important endorsement to Wall Street’s expanding business of owning and renting houses." And: "Americans Are Flipping Houses Like It’s 2006."

Poor Sergey Aleynikov.

Poor Sergey Aleynikov, the former Goldman Sachs Group Inc. programmer who took some (probably open-source!) code with him when he left for a new job, was just re-convicted of stealing that code, after previously being convicted, imprisoned, un-convicted, re-arrested, re-convicted, and un-convicted of the same theft. What a dumb case.

It is often weirdly hard to distinguish "theft," which is mostly a crime, from just, like, "breach of contract," which mostly isn't. If you and I have never met, and I come up to you and bop you over the head and take $100 from your wallet, that is probably theft and I will go to jail. But if you and I are friends, and you lend me $100, and I don't pay you back, then that's not theft. That's default or bankruptcy or whatever. 

Similarly, if you go into a company's computer system and take its top-secret trading code, and you don't work there, that is pretty clearly hacking and theft and bad and criminal. But if you work there, and you wrote that top-secret trading code, and you download it from your own desktop and take it home with you -- what is that? Four different courts have been very vexed by that question in Aleynikov's case. (The last-but-one court concluded that it's theft if you print out the code, but not if you take it on a thumb drive; the most recent court correctly found that silly.) It is not enough to say that it's theft if the company told you not to take the code. Not all violations of a company's rules are crimes. If you show up to work late and collect your salary anyway, that is probably not theft. If you just reach into the cash register and help yourself to a wad of bills, that probably is.

It is tempting to say that the issue is too vexing to be left to criminal courts. Goldman Sachs can probably take care of itself (disclosure: I used to work there), and if it doesn't like what people do with its secret trading code, it can sue them for money. It is not clear why the U.S. federal and state criminal-justice systems need to also put those people in prison to keep Goldman safe. Anyway "prosecutors have said they aren’t seeking to incarcerate him further," so Aleynikov is probably fine except for the felony conviction and $7 million in legal fees.

Fiduciary rule.

I just sort of ... care  ... less ... about the Department of Labor's fiduciary rule than everyone else does? Like, I basically think that good investing advice is better than bad investing advice, but I also suspect that bad investing advice may in many cases be better than no investing advice, and that a rule designed to cut off bad investing advice may leave some people with no investing advice. But I do not hold any of those views -- except I guess the first one -- all that strongly. Meanwhile the fiduciary rule's supporters have a pretty obvious moral drum to bang on -- "At Last, Brokers Must Put Your Retirement Needs First," that sort of thing -- while one of its opponents, Trump public-relations guy Anthony Scaramucci, compared the rule to slavery. It all feels a little overheated.

But I love this:

The Financial Services Institute, which represents the interests of independent brokerage firms like LPL Financial, Ameriprise Financial and Raymond James Financial. in July 2015 rolled out a website that advisors could use to have their clients send form letters to lawmakers. The group claims consumers sent a combined total of more than 100,000 letters expressing their opinion of the rule to their senators, local congressman and Labor Secretary Perez.

Here's a sample letter. (It begins "I am writing to you today as a hard-working and concerned investor.") What I particularly like is the chutzpah required, if you are a financial adviser, to tell your customers: Look, the government wants me to work in your best interests, and I don't want to, so can you send this letter to the government telling them not to do that? What are the adviser's fiduciary obligations in advising his clients to send that letter? Is sending that letter a bonding experience, for the adviser and the client? Does it, in a way, count as disclosure of the conflicts of interest? After all, if you send a letter to your congressman telling him to leave your broker's conflicts of interest alone, presumably you are on notice that those conflicts exist. I do all my investing through a web page, but sometimes I feel like I am missing out by not having a broker.

People are worried about unicorns.

I mean, people keep worrying about Snap's corporate governance. But Dan Primack also worries that Snap's IPO won't do much for the rest of the unicorn market, because Snap is so much bigger and sexier and faster-growing than most other private tech companies that they won't be able to ride on its coattails. Its ... flowing unicorn tail, whatever. Elsewhere: "Doubts Arise as Investors Flock to Crowdfunded Start-Ups." 

People are worried about stock buybacks.

BlackRock Inc. Chief Executive Officer Larry Fink doesn't exactly say that stock buybacks led to Donald Trump's election, but if you read between the lines I think you'll see it:

The events of the past year have only reinforced how critical the well-being of a company’s employees is to its long-term success.

Companies have begun to devote greater attention to these issues of long-term sustainability, but despite increased rhetorical commitment, they have continued to engage in buybacks at a furious pace. In fact, for the 12 months ending in the third quarter of 2016, the value of dividends and buybacks by S&P 500 companies exceeded those companies’ operating profit. While we certainly support returning excess capital to shareholders, we believe companies must balance those practices with investment in future growth.

The other day Matt Yglesias tweeted: "Trump's deep roots: Shareholder value theory legitimized greed, eroded public virtue, and ultimately wrecked capitalism." I assume he was kidding a bit, but also ... not kidding ... a bit?

People are worried about bond market liquidity.

Here is my Bloomberg View colleague Noah Smith worrying about bond market liquidity. ("But what is 'liquidity'?") And here is my Bloomberg Gadfly colleague Lisa Abramowicz also worrying about bond market liquidity: "There are some big sinkholes out there, waiting to be discovered as soon as a big investors go to sell their holdings." 

Things happen.

Private equity frets as Congress eyes interest cost deduction. Intesa Weighs Generali Deal That Would Reshape Italy Finance. Morgan Stanley, Citigroup Charged With Misleading Investors About Forex Trading Program. Janus Capital Profit Falls 34% as Investors Withdraw Cash. Commonwealth Bank puts government bonds on a blockchain. J.P. Morgan, Intuit Give Mint, TurboTax Customers Wider Access to Bank Data. Gary Cohn’s Goldman Exit Tops $100 Million. White Male Bank Culture ‘Difficult to Take,’ U.K. Regulator Says. Poland’s Pitch to Brexit Bankers: You Might as Well Move Somewhere Cheap. U.S., U.K. May Lose Luster as M.B.A. Destinations. Trends In Public-Target Mergers: Takeaways From ABA Study. "Palin said in a post on the website Young Conservatives that Trump was practicing 'crony capitalism' that 'amputated' the market’s 'invisible hand.'" Where was the Death Star's exhaust port? "I'd really like my pot back." Feds Release Photo of $20M Found in Box Spring. Put your data on a truck to the cloud. "Mental Viagra." Raccoon pianist. Moon beer.

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    To contact the author of this story:
    Matt Levine at mlevine51@bloomberg.net

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