Litvaking and Lending
Is it fraud for a bond trader to lie to customers about the price that he paid for a bond? It is a complex question. On the one hand, lying is bad, and the market price of a bond seems like it would be important information for someone who might buy the bond. On the other hand, maybe it's not actually that important: What matters is what the customer is willing to pay, not what the trader paid, plus if everyone in the bond market is constantly trying to take advantage of one another then the customer probably won't believe the lies anyway. Those were the issues in the lying-about-bonds trial of Jesse Litvak, and while he was ultimately convicted of one count of fraud, his jury seems to have been persuaded that bond buyers don't usually expect salespeople to tell them the truth. Litvak's error was not just lying, but altering a document to do so; customers expect some puffery, but not outright forgery.
But that doesn't answer the general question of: Is it fraud to lie to a customer about the price you paid for bonds? Perhaps there is no general answer, and it is always a fact-specific inquiry. For instance, if the customer tells you that the information is material -- if she explicitly says "the price you paid for these bonds is material to my investing decision, so please do not lie to me about it" -- then it's probably fraud to lie. Or this is almost as good:
Mr. Peters engaged in a chat session with a potential buyer about the price that would be offered for mortgage securities. The customer wrote, “Ok don’t litvak me! Go ahead with that bid.”
The government argues that Mr. Litvak’s name became a verb for lying in the parlance of mortgage bond traders.
Oof! Imagine having your name become a verb for lying among bond traders. The only consolation is that it's a very useful verb! The mortgage bond market is actually pretty sophisticated; these are institutional investors who trade a lot, not mom-and-pop investors. They could just specify "No Litvak" for their trades, and then you couldn't lie about the price you paid to them. Or if they don't choose the "No Litvak" option, go right ahead and lie, they're implicitly cool with it. Market expectations do to some extent determine what counts as fraud, and now there is a simple shorthand way for bond traders to communicate those expectations.
That quote is from this story about a criminal case against Tyler Peters and two other former Nomura Securities International traders accused of Litvak-style misbehavior. Prosecutors want to discuss Litvak's case at the trial, so they can explain to the jury what "don't litvak me" means. It's a reasonable point. Peters's alleged crime is not just that he lied to customers about the price he paid for bonds, it's that he lied about the price he paid for bonds after the customer specified "No Litvak." You can't do that! The rules are the rules; "No Litvak" means no Litvak.
Here is a good overview of the reasons that Goldman Sachs Group Inc. is doing more traditional lending these days. "It’s not quite Bailey Savings & Loan," says an analyst, "but it’s getting closer," and I would watch the heck out of that "It's a Wonderful Life" remake. "No, but you ... you ... you're thinking of this place all wrong," Lloyd Blankfein would explain charmingly, to a mob of panicked townspeople. "As if I had the money back in a safe. The, the money's not here. Well, your money's in Joe's house ... that's right next to yours. And in some aluminum warehouses, and some overnight agency repos, and a bespoke tranche on a credit-default swap index, and a hundred other trades." And they would cheer and toast him as "the richest man in town," because he would be.
It is hard to draw too many general conclusions about Goldman's lending push. In some cases the intent is to make more money by lending:
Fees on the “sell side” are predictable, but usually lower than those earned by the acquiring company’s banks, which raise debt to fund takeovers. Goldman earned $56 million for advising Botox maker Allergan on its 2015 sale; J.P. Morgan earned more than $200 million arranging a loan for the buyer, Actavis PLC.
Goldman has subtly pivoted in such deals, angling for a larger share of the fees that come from providing the money, not just advice, for deals.
In other cases it's to make less money by lending, but make it up in volume:
Goldman is even entering the unsexy world of extending revolving loans, a form of rainy-day credit to corporate clients. It is one of the worst businesses on Wall Street because fees are low and companies tend to draw on the loans only when in trouble. Banks make these “relationship loans” in hopes of building client loyalty for better work later.
And in some cases it's to soften the bank's image:
Goldman was being regulated like a Main Street bank, they argued, but wasn’t reaping the benefits. What’s more, they said, politicians had many Wall Street activities in their crosshairs but tended to view lending as a social good, helping small businesses thrive and families make ends meet.
“The feeling was that nobody was going to get hauled in front of Congress” for writing simple loans, one executive remembers.
There is a reason that banks work the way they do, with a bunch of businesses that seem very different but that all support each other. Merger advice has no obvious connection to retail banking, but acquirers tend to want financing, which requires a lending business, which requires cheap funding, which requires a source of deposits. Competitive pressures push all the big banks to have very similar models, and the logic is so compelling that when the brightest minds at Goldman Sachs go to a Hamptons off-site to brainstorm the future of banking, what they come up with is "what if we started lending money to people?"
Disclosure: I used to work at Goldman, and whenever I missed a deal I was always relieved if I could blame it on the fact that we didn't lend to the company. So I feel for the current generation of Goldman bankers who won't have that excuse.
One of my favorite sub-genres of financial journalism is How's John Paulson Doing These Days? I enjoy its predictability; the answer is always "bad." Here's an entry from the New York Times:
His firm, Paulson & Company, has recorded nearly double-digit losses in several of its larger funds as of the end of March.
Mr. Paulson’s struggles come after a gut-wrenching 2016, when he recorded even steeper losses in those funds, partly because of several wrong-footed bets on drug makers, including the troubled Valeant Pharmaceuticals. That followed a painful 2015, when investors first balked and began pulling their money from his firm.
His main Advantage fund also had double-digit losses in 2011, 2012 and 2014, though 2013 was good.
These stories always have a slight flavor of Let's Check In With the World Coin-Flipping Champion of 2008. Paulson made his reputation with, essentially, one really good idea -- shorting mortgages ahead of the financial crisis -- which has since allowed him to diversify into several bad ideas, and it is fascinating to try to work out the theory of investing skill that explains Paulson. It doesn't seem to rely much on domain expertise, or repeatable processes, or any other constraints that sometimes bind hedge fund managers. Paulson was a merger-arbitrage investor who made money on subprime mortgages and then moved into making big macro bets on gold. If you have a theory of what he is good at, it has to be a pretty broad theory, a notion of the hedge-fund manager as charismatic savant rather than skilled craft specialist.
But even so, what is the generalist theory for giving money to a manager who keeps losing it? One naive model would be: If someone had a really good investing idea, he will have more really good investing ideas. You might think that this theory would be falsifiable by a string of bad ideas, but I guess one lesson here is that you get to amortize a really big success over a long time. If you make billions for clients while everyone else is losing, that buys you the right to keep losing while everyone else is making money.
But there are other models. Perhaps: A person who has a really bad investing idea will probably have other really good investing ideas. This is subtler. It could be a simple mean-reversion idea: A rich successful person who has a loss will surely recover; a string of bad luck can't last forever. (There is also a variant on this idea which runs: Losing a ton of money is an impressive accomplishment on Wall Street, because it means that someone liked you enough to trust you with a lot of money, and you were bold enough to take risks with it.) This model relies on an implicit assumption that success is a matter of skill, while failure is a matter of luck. If you run a successful hedge fund and then it has some down years, well, that is the sort of bad luck that sometimes happens to good investors. The explanation is never that your earlier success was the sort of good luck that sometimes happens to bad investors.
An even simpler model is just: A really rich hedge fund manager must be doing something right. "Even after several years of losing money for his investors, Mr. Paulson remains one of the richest men in the world — with a net worth of about $7.9 billion," and how can you argue with that? "Important people like to deal with other important people. Are you one?" Paulson is, which is nice for his clients.
Speaking of important people, why is Cantor Fitzgerald LP paying Barack Obama $400,000 to speak at its health care conference? The obvious answer is that Obama is a huge popular celebrity and an excellent speaker who will attract and impress clients at the conference, but that answer is so obvious that people seem to want to read a corrupt motive into it. Paying a former president a six-figure fee for a speech seems like a pretty oblique way to persuade future politicians to be "soft on Wall Street" or whatever, and a very straightforward way to get a good speech, but here we are.
Dan Davies thinks they want a good speech. "The fact that there is genuinely relevant business content there means that you can market the event to clients in a way that would be much more difficult for a day at the races, or front-row tickets to a pop concert," he notes, and having a famous speaker can "make the clients feel important, and burnish the image of the banker who organised the event as someone who is at ease in the corridors of power." Also:
The reason that we can be sure that these payments are not purely transactional is that nothing in investment banking is purely transactional. Across fields from advisory to research to capital markets, bankers are used to working on spec, building relationships and trust, and eventually getting paid at the time of a big transaction. This is not a transparent pricing model, and for that reason it is generally hated by regulators. It is, however, a very elegant emergent solution to a serious problem of information economics — the fact that it is impossible to tell whether a piece of content or advice is worth paying for without consuming it. The relationship model lets clients “try before they buy”, at the expense of breaking the connection between any particular piece of service and any particular piece of revenue.
Investment banking is a gift economy in which banks give clients an array of thoughtful but random gifts -- free financial modeling, revolving loan facilities, introductions to potential board and executive hires, the chance to meet Barack Obama -- in the hopes that one day the clients will give them the massive gift of a merger advisory mandate. Of course one concern is that this "uniquely bankerish way to do business" will rub off on politicians too. Davies is surely right that Cantor Fitzgerald is hiring Obama to impress its clients, not to influence regulation. But might some politician observe the transaction and decide to give Wall Street a few gifts while he's in office, in the hopes of one day receiving something in return?
Elsewhere in investment banking as an informal economy, here's a story of how KKR & Co. is angry at Barclays PLC Chief Executive Officer Jes Staley because Staley's brother-in-law ran a company that KKR bought and then had to write down.
"Break up the banks."
Yesterday Donald Trump briefly pretended to be "actively considering a breakup of giant Wall Street banks":
“I’m looking at that right now,” Trump said of breaking up banks in a 30-minute Oval Office interview with Bloomberg News. “There’s some people that want to go back to the old system, right? So we’re going to look at that.”
Bank stocks fell by about a percentage point as algorithms read his comments, and then came right back as the algorithms were like, "oh come on, this guy again." Andrew Ross Sorkin gamely pondered whether Trump might be serious, but I will not, because life is short and yesterday, in the Trump administration, is a long time ago.
Meanwhile Congress seems to be moving ahead with the Financial Choice Act, which would get rid of the Volcker Rule, reduce the power of the Consumer Finance Protection Bureau, and get rid of the Orderly Liquidation Authority mechanism to wind up failing banks. And "since taking office as Treasury Secretary," Steven Mnuchin has "repeatedly indicated that ultra-long issuance was something the administration was looking at." And the Trump administration might replace Comptroller of the Currency Thomas Curry soon. And here is a very funny article about the "shadow Cabinet of Trump loyalists who had been dispatched to federal agencies to serve as the president’s eyes and ears"; the ones at the Treasury Department were stashed in the basement. And: "Populism Is Great for Stock Returns."
And elsewhere in musing about bank breakups:
Ken Griffin, chief executive officer of Citadel, said he would be “really excited” to see a break up of big banks to increase competition and boost the economy.
“Would I argue to break these banks into many, many small banks? No,” Griffin said in an interview Monday with Bloomberg TV. “But should we think about separating the investment banks from the commercial banks, a new Glass-Steagall? I would be really excited to see that. I think it would be great for the economy.”
People are worried that people aren't worried enough.
The CBOE Volatility Index closed yesterday at 10.11, its lowest level since February 2007, and you know what that means:
To some analysts, the VIX’s decline was a worrying sign there isn’t enough skepticism among investors.
Very low VIX levels could “indicate a level of complacency,” said Nicholas Colas, chief market strategist at New York-based brokerage Convergex.
Loosely speaking, the VIX is a measure of the expected volatility of the Standard & Poor's 500 Index over the next month. A month ago, the VIX was trading at around 12.4, and there was much talk of complacency. The realized volatility of the S&P 500 over the subsequent month was about 7.4 percent. The VIX was about 5 points too high, as a predictor of future volatility. (This is usually true.) The VIX was insufficiently complacent; people who used VIX products to bet on low future volatility were wrong because volatility was even lower than they expected.
Is the stock market too complacent? Do investors take serious risks too lightly? I mean, whatever, I don't know. The market reaction to a lot of weird stuff has been weirdly muted, but perhaps that's just because markets have gotten more efficient and less prone to overreact. But in any case, if you're worried about the stock market being too complacent, you can find reasons for your worry in the actual movement of the stock market: If it doesn't go up or down much in reaction to news, sure, go ahead and say it's complacent. But the VIX is not independent evidence of complacency. While everyone has been citing it as a sign of complacency, the VIX has consistently over-predicted volatility.
People are worried about stock buybacks.
Stock buyback authorizations are down 15 percent year-over-year, reports Goldman Sachs Group Inc. research analysts, the lowest pace in five years, due to valuation concerns. “Experience shows that firms repurchasing shares at extremely high valuations regret those actions when the stock price inevitably de-rates,” which does seem like the sort of thing you'd regret.
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