Money Stuff

Hedge Funds, Analyst and Car Loans

Also gossip, WhatsApp, equity trading, advertising, art and banknote composition.


What do sell-side equity research analysts do? There are three main theories:

  1. They discover which stocks will go up, and then write research reports telling investing clients to buy them.
  2. They lie about which stocks will go up in order to drum up investment banking business for their employers.
  3. They are in an essentially client-service business of helping their investor clients by providing background research, deep-dive analysis, financial modeling, trade ideas, management access and, yes, sometimes Buy/Sell recommendations.

Theory 1 seems naïve: It's the investors' job to pick which stocks to buy, and it would be strange for them to outsource that job to research analysts with no skin in the game. Theory 2 is the knee-jerk cynical opposite of Theory 1, but it also doesn't seem to fit the facts. Theory 3 is, it seems to me, the realistic theory, describing a business that customers might actually want.

Here is a working paper from Nathan Swem of the Federal Reserve about "Information in Financial Markets: Who Gets it First?"

I compare the timing of information acquisition among institutional investors and sell-side analysts, and I show that hedge fund trades predict the direction of subsequent analyst ratings change reports while other investors' trades do not. In addition, hedge funds reverse trades after analyst reports, while other investors follow the analysts. Finally, I show that hedge funds perform best among stocks with high analyst coverage. These results suggest that hedge funds have superior information acquisition skills, and that analysts assist hedge funds in exploiting information acquisition advantages.

The simple model here is: The hedge funds are good at finding undervalued stocks, so they do, and they tell the analysts, and the analysts write up reports, and the stocks go up until they are fairly valued, and the hedge funds sell them and move on to the next trade. It's an efficient market, but one that relies for its efficiency on hedge funds (who are actually making investment decisions) rather than on research analysts (who aren't). This is perfectly reasonable! As David Keohane puts it at Alphaville:

Hedge funds are on the supply side of tipping. They get the info first and then pass it on to sell-side analysts when it’s strategically useful, ie, when they can benefit from the extra push given by the info getting a wider airing. It makes sense. Hedge funds can be legitimately good at this stuff and we’d imagine the good ones are going to get their tips picked up by the bigger/more influential sell-side folks.

But there are other possible models. For instance, here is Dan Davies in the Alphaville comments:

Basically, as an analyst you call your big hedge fund clients every couple of days, and talk to them about what's on your mind and what interesting things you've found out.  If a big hedge fund finds anything in a published research report that they didn't already know, then the analyst wasn't doing his job with respect to servicing that client.

That is: It's not that hedge funds tell analysts which stocks to buy; it's more that analysts share parts of their ideas with hedge funds in inchoate form, before they end up publishing them in research notes. "The published reports are the tip of the iceberg," Davies writes; "the real product of the analysts is the ongoing conversation."

Either of those explanations -- analysts are doing hedge funds' bidding, or analysts are talking to hedge funds before they publish their notes -- would make you angry if you are a firm believer in Theory 1. The job of an analyst, in that theory, is to discover independently which stocks will go up, and then say so in published research available to all clients at the same time. (Either explanation is just irrelevant to Theory 2, with its curiously narrow focus on investment banking fees.) But Theory 3 -- the idea that research is a client-service business, one that involves a back-and-forth conversation and different services to meet different clients' needs -- can handle them both.

Elsewhere in research, "about 40,000 research reports are produced every week by the world's top 15 global investment banks, of which less than 1 percent are actually read by investors," which seems a little harsh. (And hard to explain on Theory 1!) And here's a study of research in the Chinese financial markets:

The evidence gathered clearly suggest that attractive financial analysts are better able to acquire sensitive information from Chinese company management teams. Compared with their less attractive counterparts, they are more likely to gain advance access to information on pending significant corporate events, and they are more likely to issue a stock recommendation in the quarter before the public announcement of a restructuring, signing of a major contract or an earnings warning. Consequently, they are able to produce more informative stock recommendations.

Subprime car settlements.

It's all happening again:

The AG’s Office found that Santander’s own internal audit concluded that the company’s oversight of auto dealer conduct when making subprime loans was inadequate. Despite identifying a group of dealers that had extremely high default and delinquency rates and other problems, the company continued to fund loans through these dealers. Santander also allegedly identified a group of dealers it called the “fraud dealers,” but continued to fund loans through them.

That's from the Massachusetts Attorney General's announcement of a $22 million settlement with Santander Consumer USA Holdings Inc. for subprime auto lending. (Delaware had a parallel settlement with Santander for $2.875 million.) Santander didn't actually make auto loans, but it did fund loans for car dealers, and then it packaged and resold those loans to investors. And the loans were bad, and Santander knew or should have known, and so forth:

The AG’s investigation, handled jointly with the Delaware Attorney General’s Office, revealed that Santander allegedly funded auto loans without having a reasonable basis to believe that the borrowers could afford them. In fact, Santander predicted that many of the loans would default, and allegedly knew that the reported incomes, which were used to support the loan applications submitted to the company by car dealers, were incorrect and often inflated.

As with the mortgage settlements, the basic theory is that Santander (through dealers) made loans to consumers that it knew they couldn't pay back, and then sold those loans to investors. To the state attorneys general, it seems clear that this conduct harmed both the consumers (whose credit was damaged and who might have their cars repossessed) and the investors (who bought loans that defaulted). But it's much easier to prove the latter than the former: Taking money from investors and not giving it back seems like fraud, while giving money to consumers and not getting it back seems like a ... present? So these cases tend to be brought on fraud-like theories, focusing on the claim that banks deceived the buyers of the loans (who lost money) rather than the borrowers (who got money, and who probably weren't deceived by inflated claims about their own incomes). But the states' real concern is with the consumers, not the investors: Of the $22 million Massachusetts settlement, $6 million will go to the state and $16 million to consumer relief. Zero dollars, it appears, will go to the investors who bought Santander's loans. 

Insider whatever.

Maybe the most embarrassing insider trading case I've ever seen is this action from the U.K. Financial Conduct Authority against Christopher Niehaus, a former Jefferies Group LLC managing director. There wasn't even any trading! Sometimes Niehaus would share confidential information about clients with another client, and with a friend of his, but neither Niehaus, the client nor the friend ever traded any stock, and Niehaus didn't expect them to. The FCA fined him 37,198 pounds for "failure to act with due skill, care and diligence," not for insider dealing. It was just insider gossip.

But the really sad thing was Niehaus's reason for sharing the information:

Mr Niehaus admitted that the information disclosed was client confidential, that he should not have shared it and that he should have known better. Mr Niehaus also admitted that he would routinely share information relating to his work with Friend A.

Mr Niehaus claimed that he “didn’t know” why he disclosed the information to Friend A and Client A other than he wanted to impress them.

He was a managing director at an investment bank! His friends probably could figure out that he was doing deals. This is not how to impress anyone. Also he did his gossiping over WhatsApp. That's not embarrassing for him, just for me; he's a decade older, but more fluent in social media than I am. It's the FCA's "first action related to a messaging app," reports Bloomberg.

Elsewhere in WhatsApp.

Lots of banks prohibit employees -- or at least traders -- from using personal phones, text messaging, WhatsApp, etc. for work purposes, but "nearly two dozen employees who spoke with Bloomberg say those policies are routinely ignored and the use of personal phones for work is a fact of life." And:

A big reason more and more Wall Street types have turned to messaging apps is because they are tired of having every written word -- work-related or not -- ingested into vast, Big Brother-like databases and scrutinized for tone and taste in ways that strike many as overbearing. They’ve learned even the slightest misinterpretation can land them in hot water -- not only with compliance, but with prosecutors on the lookout for financial crimes.

For most of human history, people could have business conversations without worrying that one day a prosecutor would be able to search a transcript for uses of the word "Muppet." But email and instant messaging created, in Dan Davies's words, a "golden age" for regulators in which "traders have inadvertently made wrongdoing by people in their ranks as easy as possible to detect." That golden age happened to coincide with a global financial crisis, and a lot of wrongdoing was detected. The lesson that banks learned from this episode was that they should build better tools to monitor email and detect wrongdoing earlier. The more intuitive lesson that bankers learned was that they should start using WhatsApp. 

Stock trading is really efficient.

Remember when high-frequency traders were a shadowy elite of stock-market insiders who got rich by stealing billions from ordinary investors, a fraction of a penny at a time? I am constantly reading articles these days about how high-frequency trading firms are sad and merging because they can't make any money. Meanwhile equity trading revenue at big banks is also down. It's almost like the story of high-frequency trading is that some disruptive new firms built electronic systems to displace the inefficient expensive trading services offered by incumbent banks, and then competition drove down prices so much that even those disruptor firms can't make outsized returns any more. But who would find a story like that compelling?


Here is a story about how JPMorgan Chase & Co. used to advertise on 400,000 websites every month, and now it only advertises on 5,000, and "the company is seeing little change in the cost of impressions or the visibility of its ads on the internet." I hope that they don't draw any broader lessons from the experiment: I bank at Chase and work in Manhattan, and I find it very convenient that there are 400,000 Chase ATMs within a block of me at all times. I would be sad if they cut that down to 5,000.

But this is also a fascinating media-business story. JPMorgan was doing programmatic ad buying, buying ad space on thousands of websites in bulk through advertising networks. That is a standard feature of life on the internet, and has led to the rise of huge internet companies, like Alphabet Inc., that run on advertising revenue. Of course there was a pre-internet advertising ecosystem where newspapers and television were much more central. If you wanted to advertise, you'd call up the New York Times and buy an ad, because that was where the ads were. Now the ads are everywhere, so the way you advertise is by sending an order to an ad network and getting filled with a few million impressions, somewhere out there on the internet.

But there is a lot of terrible stuff out there on the internet, and one thing that has happened in the last few weeks has been that reporters at newspapers have called up advertisers and said "hey do you see the terrible stuff that your ads are appearing next to?" And the advertisers have pulled the ads, which has been bad for business at Alphabet (which owns Google and YouTube). The standard internet model of putting ads next to everything is under pressure, as advertisers are realizing that "everything," on the internet, means mostly racist videos.

So what do you do, if you're JPMorgan, and a New York Times reporter calls you up to tell you that your programmatic ads are appearing on a fake news site? You might cut back your programmatic buying, and buy advertising only on individual sites that serve up content that you trust. ("JPMorgan has limited its display ads to about 5,000 websites it has preapproved, said Kristin Lemkau, the bank’s chief marketing officer.") That would be great for the newspaper business! Traditional news organizations, after all, put a lot of money and effort into making sure that their websites are free of fake news and racist rants. If there's a backlash against the just-put-it-anywhere ethos of advertising on the internet, that will benefit traditional arbiters of truth and newsworthiness. It's a nice revenge of traditional journalism against Google.


Part of me hopes that Larry Fink will buy this installation after the Whitney Biennial ends, except that it sounds ... sort of ... bad:

The piece, titled “Debtfair,” makes a case that the economics of American art are flawed because of artists’ debt. BlackRock, the artists said, invests in that debt.

Occupy Museums, the group of artists and activists responsible for the exhibit, plotted the growth of BlackRock’s assets on a 17-by-30-foot wall next to measures of student-loan delinquencies and a rise in the price of art. Near the ceiling is a trimmed 2015 quote from Mr. Fink that reads: “The two greatest stores of wealth internationally today [are] contemporary art […and] apartments in Manhattan.”

I think we are about a decade away from an art world in which artists will put little kneeling figures of Steve Cohen in all of their works, like donor portraits in Renaissance religious art, but you can tell that the artists are a little uncomfortable about it.

People are worried about bond market liquidity.

Here's a Federal Reserve discussion paper by David Arseneau, David Rappoport and Alexandros Vardoulakis on "Private and Public Liquidity Provision in Over-the-Counter Markets":

We show that trade frictions in OTC markets result in inefficient private liquidity provision. We develop a dynamic model of market-based financial intermediation with a two-way interaction between primary credit markets and secondary OTC markets. Private allocations are generically inefficient because investors and firms fail to internalize how their actions affect liquidity in secondary markets. This inefficiency can lead to liquidity that is suboptimally low or high compared to the second best, providing a rationale for the regulation and public provision of liquidity. 

How should you make banknotes?

Somehow the Bank of England is making polymer banknotes out of animals, which is controversial, so it's thinking about making them out of palm oil instead, which is also controversial:

To replace the tallow in some future polymer notes, the BOE is considering the use of palm oil -- cited by researchers as a cause of deforestation, pesticide pollution and greenhouse-gas emissions. It’s also blamed for the displacement of indigenous people and the use of forced and child labor.

It's almost like there is no such thing as ethical consumption under capitalism. England should convert to using bitcoins, which are made out of electricity. But so much electricity.

"Why you shouldn’t answer the phone when your bank calls."

The answer, according to Maria LaMagna, is that it's probably a phishing scam, but the real answer is that you shouldn't answer the phone when anyone calls. Probably delete all your emails, too, just to be safe. And WhatsApps from investment bankers.

Food Stuff.

"Spaghetti Donuts Are Here — and You Can Get Your Own Starting This Weekend." There is a surprisingly long article about this. Elsewhere, McDonald's Corp. will switch from frozen to fresh beef in its Quarter Pounders. "I'm just terrified about this," says a Quarter Pounder eater. Also: bugs


In Money Stuff yesterday, I wrote that David Einhorn could buy General Motors Co. stock for $35, sell the dividend rights for $19, sell the appreciation rights for $33, and make $8 per share doing it, except that it would be too weird to work. A few people pointed me to sort of similar schemes that had sort of worked in the past, but only one person emailed to complain about the math. I'm a little embarrassed for all of us, frankly. Anyway $19 plus $33 minus $35 is $17.

Things happen.

Senate Narrowly Passes Rollback of Obama-Era ‘Auto-I.R.A.’ Rule. SEC Charges Pastor With Defrauding Retirees. EU Signals U.K. Will Get Only a Year for Post-Brexit Trade Talks. David Rubenstein interviews Jamie Dimon. Sears and Its Hedge Fund Owner, in Slow Decline Together. ‘You Are All Liars:’ Toshiba Shareholders Vent After Westinghouse Bankruptcy. Uber faces prospect of further barrier in Waymo court showdown. Ford Hires BlackBerry Employees to Work on Connected Cars. Dropbox Secures $600 Million Credit Line Ahead of Expected IPO. Deutsche Bank, Mirror Trades, and More Russian Threads. Fifa hands corruption probe files to Swiss prosecutors. The Law and Economics of Shadow Banking. Airlines Make More Money Selling Miles Than Seats. Twitter got worseCheddar. Rover and DogVacay merge to dominate the pet-sitting market. Tyrannosaurus rex was a sensitive lover, new dinosaur discovery suggests. At a spa in Japan, you can get a back massage from a cat. Is Gringotts Wizarding Bank too big to fail?

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