Money Stuff

Fraud, Satisfaction and Bubbles

Also VIX worries, earnouts, the fiduciary rule, subscription line financing and various flavors of unicorn.

Fraud and happiness.

This is so lovely and straightforward that I almost can't believe it worked: Three academics, Yuan Ji, Oded Rozenbaum and Kyle Welch, just went and looked at "1,112,476 employee ratings of 14,282 public firms in the period 2008-2015, obtained from the website Glassdoor," to see whether the employee satisfaction ratings predicted fraud. They did:

We find that employee ratings in a year in which fraud occurs, and the preceding year, predict SEC fraud enforcement actions and securities class-action lawsuits. Moreover, ratings in the year following a fraud do not predict SEC fraud enforcement. This finding suggests that employee ratings can be a proxy for real earnings management. In periods when managers struggle to reach performance targets, they may pressure employees to start burning the candle at both ends and impose aggressive performance targets on them (Caskey and Ozel, 2016). Increasing pressure on employees to meet performance metrics may cause them to become dissatisfied and thus the approach may not be sustainable.  Our results are consistent with managers striving towards performance targets by pressuring employees, resulting in employee dissatisfaction. If those high pressure actions toward employees alone are insufficient to reach the targets, managers may resort to financial misreporting.

The related paper is hereRegulators talk frequently about the need to reform the culture of big banks. The sense of bank culture that you sometimes get from those talks is that banks are full of people who delight in fraud, and that they need a new culture to tamp down that delight. Banks, in this model, can have a fun culture, or they can have an ethical one, and they have spent too long having fun at everyone else's expense. It's time to buckle down, cut out the fun, and become boring and ethical instead.

This is an understandable model. I feel like it comes from all the trader-chat enforcement cases, where traders kept sending each other gleeful ungrammatical high-fives for ripping off clients. Perhaps banks attract people who just love fraud, and then create a freewheeling culture that allows those people to find their joy, in fraud.

But those chats always read a little desperate to me: The glee seems fake, the misspelled boasts seems to be forced out through gritted teeth, or fingers. The right paradigm might be more like the Wells Fargo & Co. fake-accounts scandal, where everyone committing fraud was obviously miserable and desperate and didn't bother to hide it under a veneer of cheery electronic chats. Perhaps the choice is really between an ethical fun culture, and an unethical miserable one. (That seems like an easy choice!) Maybe bank employees -- like everyone else -- commit fraud not because it makes them happy, but because they are sad. Maybe the way to fix their culture is just to be nicer to them.

Loan bubbles.

The thing about the housing bubble is that it was a leveraged asset-price bubble. That's how bubbles work. You think the price of Thing X will go up, so you borrow money to buy it, and then someone else thinks it will go up even more, so she borrows more money to buy it from you, and then at some point the price goes down and all the people who borrowed money can't pay it back and bad things happen. That's the standard story of what happened to stocks in the 1920s and houses in the 2000s.

Is it the story of what will happen to cars, or college educations, in the 2010s? I am always a little confused by talk of a "student loan bubble" or a "subprime car loan bubble." People don't, as far as I know, borrow money to buy cars to sell them to a greater fool. They certainly don't borrow money to buy college degrees to sell them to a greater fool. They borrow a lot of money to buy those things, and all that borrowing may have the effect of driving up the prices of those things, and perhaps the borrowing is even unsustainable, but those markets are missing a key bubble dynamic. The underlying things -- the cars, the degrees -- are not really tradable investment assets. If the price of cars, or college degrees, collapses, that won't make it harder for people to pay back their car or college loans. Practically speaking those are cash-flow loans, not asset-based loans.

Here's a story about subprime car loans that actually doesn't lean on the this-is-2008-all-over-again analogy; that was just me being cranky. That said though, it sounds like 2008 all over again! "They provide lenders with incomes that are inflated to get loans approved for car buyers," says a fraud specialist about car dealers, "and in most cases, the car buyer has no idea that this is going on." And there are quotes like this:

"It doesn't matter for car dealers because they don't lose any money if customers don't pay back the loans," Lally said. "At some places, literally all you need is a face to get a loan. Honestly, you probably don't even need that."

No I bet you need a face. Anyway my point is that all this can be bad, without being a systemically dangerous crisis. It does sound bad though.

Elsewhere: "Here's How to Spot a Market Bubble."

People are worried that people aren't worried enough.

I have enjoyed the low-volatility regime that has brought us this recurring section, but I hope that if the VIX ever gets back to like 40 there will be offsetting articles to the tune of "people are worried that people are too worried." But of course it doesn't work that way. The way financial markets work is that the market expresses a consensus, and then if you disagree you complain to a newspaper. If the consensus is calm, you go worry to a reporter. If the consensus is worried, you spout bland optimism in print. Anyway here's Robin Wigglesworth at the Financial Times, on low readings on the Chicago Board Options Exchange Volatility Index:

Yet this tranquillity is unnerving some analysts, who fear it has nurtured a panoply of trading strategies that could unravel if volatility returns to normal. Some analysts even fret that Vix, supposedly a helpful canary in the coal mine for investors, could contribute to market turmoil given an unfortunate confluence of circumstances. 

Look, as I have often said, it is really weird that markets have not reacted much to, you know, all the weird stuff that keeps happening. But of course a rather famous fact about financial markets is that they overreact to news. The question is whether all of the structural changes that have contributed to calmer markets recently -- increased indexing, quantitative and factor-based investing, central-bank interventions, the ability to trade volatility as an asset class -- are permanent advances in knowledge and technology that have made markets more efficient (and so less inclined to overreact), or whether they are just temporary barriers that have allowed pressures to build up and that will eventually be swept away. 

Also here is Christopher Cole of Artemis Capital Management with perhaps the most heroic effort to anthropomorphize a financial market that I have ever read: 

“Vix isn’t broken, it’s the market that’s broken,” says Mr Cole. “Vix is like a guy who’s getting divorced and losing his job, but is still coming in to work. He’s sitting there seemingly calmly, doing his job, but beneath the surface the stress is there.”

If you see Mr. Vix today, give him a hug, or maybe one of those inspirational wall calendars with kittens. Hang in there, Vixie!

An earnout.

This is from two months ago, but who cares, it is glorious, and I am going to tell you about it. (I learned about it from this Broc Romanek post yesterday.) A company called Vista Outdoor Inc., which sells outdoor sports stuff, bought a company called Jimmy Styks, which makes stand-up paddle-boards. The deal price was $40 million up front, plus up to $40 million in earnouts over the next three years. The way the first-year earnout worked was that Vista would pay the Jimmy Styks founders "$1 million if gross profits reached $9,947,684 and an additional $3.62 in compensation for every $1 in gross profits thereafter (up to a maximum earnout of $10 million)." The point of paying them $3.62 for every $1 in profits is to, in effect, capitalize those profits into the sales price: An extra dollar in year-one profit was worth more than a dollar to Vista, because it was also a good sign that future profits would be higher.

Unless it wasn't! The Jimmy Styks founders stayed on to help run the business, and they seem not to have gotten along with Vista management. "Vista further admits that it did a 'poor' job integrating Jimmy Styks into its larger corporate structure, but alleges (though it is not undisputed) that defendants Reeves and Wilkens exacerbated these problems by repeatedly taking combative stances with Vista's management in profanity-laden emails," says Judge Jed Rakoff in his opinion about the case (citations omitted). Profits were below target, one thing led to another, and the Jimmy Styks founders decided to have Jimmy Styks spend $60,500 to buy a million stickers. ("Haha, this is real dude! 60k worth of stickers!!! We are going to go down in the history books," one founder emailed the other.) Then they planned to buy the stickers from Jimmy Styks themselves for almost $4 million. (Jimmy Styks normally gave the stickers away for free.) That would create almost $4 million of profit for Jimmy Styks, which would turn into $10 million of earnout payments for the founders, which would net them a profit of $6 million over the, sorry, sticker price.

Vista figured this out and blocked the sticker sale, everyone sued each other, and Vista won because "the implied covenant of good faith and fair dealing" -- the contract lawyers' way of saying "come on, man" -- prevents this. I suppose the lesson here is that, if you don't want to go to court over this stuff, you should write your contracts to clearly prevent it. (Like, maybe: Sales to the earnout recipients don't count?) Also there is an amusing footnote about how the Jimmy Styks guys tried to claim whistle-blower protection for complaining about Vista's internal accounting controls. Judge Rakoff notes that these complaints "largely consist of throwing the term 'SOX' in emails, with little or no explanation, in order to gain leverage for a particular grievance." That is how all corporate infighting is supposed to work.

The fiduciary rule.

What does it tell you about the fiduciary rule that (1) big brokerages are shifting to fee-based accounts even before the rule goes into effect (and even though it may never go into effect), (2) investors seem happy about that, and (3) the brokerages are even happier about it?

Besides positioning themselves to better compete with the rise of smaller, independent rivals and investors’ growing preference for passive investments, brokerage executives found that fees for advice and services could be more lucrative over the longer term compared with commissions.

Researcher Morningstar Inc. says fee-based accounts can yield as much as 50% more revenue than commission accounts.

On the one hand, it does suggest that some criticism of the rule -- that it would make retirement advice more expensive -- might be correct. On the other hand, people seem happy to pay more for better, unconflicted advice. And perhaps it doesn't matter much one way or the other: If everyone switches to fee-based accounts without the fiduciary rule, then the debates about the fiduciary rule will seem a little pointless.

Subscription line financing.

We talked about this on Monday (and last year), but here is Oaktree Capital Management, L.P.'s Howard Marks on subscription line financing, in which private equity firms initially pay for acquisitions by bank borrowing rather than capital calls to increase the reported internal rate of return on their limited partners' capital:

Since a fund's total dollar profits and multiple of capital aren't improved by the use of a subscription line, the increase in IRR, while pleasant, might be thought of as illusory. Remember, as I wrote in a 2006 memo with the same title, you can't eat IRR.

My basic point in that memo was that what really matters is how much money an LP makes as a result of having committed to a fund. It's that simple.

It ... kind of is? I can't get too worked up by subscription-line financing because, while it may be "a performance enhancer that artificially jacks up results," it only jacks up IRR. But if you're an investor in a private equity fund, you can just look at how much money you made! And then you'll know if the fund was good or not.

Millennials.

Sure, oh sure, sure, sure:

Cheddar, an online business news channel that targets millennials, is betting it can coax young viewers to look up from their mobile phones to watch old-time broadcast TV, and it’s giving away antennas with Dunkin’ Donuts to prove it.

I am going to become a zillionaire with my new plan to sell cassette tapes to millennials at 7-Eleven.

Financial advice from celebrities.

Here is Lars Ulrich

For guys who are well past middle age, keeping healthy needs to be respected. We have two employees who take care of stretching us, massaging us. We have a chef. We stay in comfortable hotels. There’s private plane travel.

Seems like good advice.

The Blood Unicorn.

Delaware Vice Chancellor Travis Laster is not so sure about Theranos, Inc.'s proposal to give shareholders more stock in exchange for waiving their rights to sue Theranos and its founder Elizabeth Holmes:

“I have something that sets up like a controller tender offer with disclosure problems with some type of coercion involved,” the Delaware judge said. “And so it's the type of thing that I do think needs, at a minimum, better explanation on both sides.”

When we talked about this exchange offer last month, I asked:

Would you take that deal? On the one hand, the fact that it's on offer suggests pretty strongly both that you have something to sue about and that the shares you're getting aren't worth very much. ... On the other hand, if you did sue, who would you sue? Elizabeth Holmes? Her wealth is mostly in Theranos shares, so that's all you'd really stand to win. Might as well take them now.

Well now Theranos's lawyer is making pretty much the same argument:

“Plaintiffs are saying this company is worthless,” Perla said. “If they are right, then they are doomed with the transaction or without. Either way, there's not going to be enough money for a litigation judgment.”

For now at least, Theranos does have enough money to pay judgments, and is using it for things like a settlement with the Arizona attorney general "which requires Theranos to pay $4.65 million into a state reimbursement fund" to pay back everyone in Arizona who paid for a Theranos blood test.

People are worried about unicorns.

This is very worrying to be honest!

The Unicorn Frappuccino blended crème is made with a sweet dusting of pink powder, blended into a crème Frappuccino with mango syrup and layered with a pleasantly sour blue drizzle. It is finished with vanilla whipped cream and a sprinkle of sweet pink and sour blue powder topping.

Like its mythical namesake, the Unicorn Frappuccino blended crème comes with a bit of magic, starting as a purple beverage with swirls of blue and a first taste that is sweet and fruity. But give it a stir and its color changes to pink, and the flavor evolves to tangy and tart. The more swirl, the more the beverage’s color and flavors transform.

It is from Starbucks. There is a picture. I feel like this is one of those questing myths where no one who encounters the Unicorn Frappuccino lives to tell about it.

In more traditional unicorn worries, Cloudera's planned down-round initial public offering "bodes ill for other tech unicorns." And here is the story of Tilt, which was never quite a unicorn (it topped out at a $375 million valuation, and ended up selling to Airbnb for $12 million this year), but which is otherwise a classic unicorn story of Y Combinator, "30 under 30" lists, fleeces, ping-pong, kickball, exposed brick, venture capital money, a "custom pet portraitist," and not much revenue:

While investors were throwing millions of dollars at the promise of a glittering business involving “social” and “money,” their Mark Zuckerberg-in-the-making was basking in the sunny glow of Bay Area praise and enjoying the ride with his bros. Revenue was not a top priority—a remarkable oversight for any company, and a particularly galling one for a payments company.

Food Stuff.

I guess we need a cross-reference to the Unicorn Frappuccino here. Elsewhere, here's a guy who likes fast food:

“I want the salty greasiness, basically,” Dan said. “It’s kind of like, go big or go home.”

Here's some more from Dan:

“Taco Bell invents new ways to get the same things into your body,” he said. “Their new innovations excite me more than Wendy’s.”

I confess that my enthusiasm for innovation wanes when it comes to getting things into my body. I am fine with the traditional ways of getting things into my body. And: "The hot new trend in food is literal garbage."

Things happen.

Morgan Stanley Beats Estimates as Fixed-Income Revenue Doubles. (Earnings release, supplement.) Markets Start to Ponder the $13 Trillion Gorilla in the Room. Here’s Where London Bankers Are Moving After Brexit. China bank overseer launches ‘regulatory windstorm.’ A 9,800% Stock Increase Exposes Hong Kong's Billionaires on Paper. Mark Zuckerberg Sees Augmented Reality Ecosystem in Facebook. Snapchat beat him to it by a few hours. When an ETF Changes Its Stripes. BlackRock opposes shareholder proposal critical of firm's proxy voting on executive compensation. Supreme Court justices question SEC enforcement tool. Why Lean In Doesn’t Want to Talk About Trump. A Day in the Life of a Food Vendor. The case for being grumpy at work. "After the Long-Awaited Email." Oregon man dies thinking President Trump was impeached after being lied to by ex-wife. Bewildered Beaver Becomes Accidental Leader Of 150 Curious Cows.

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

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