Bond Losses and White House Meetings
It's okay to lose money now.
Just from this paragraph, how do you think this story ends?
Disagreements broke out over how to value the bonds. Dixon and risk managers had shouting matches over the right prices, people who saw the fights said. One point of contention was whether the bank should assume the bonds would be held to maturity, or if it should instead assign valuations based on prices they would fetch if they were sold immediately.
Presumably you guessed: "They sold the bonds before maturity, and lost a lot of money." And you are correct: Deutsche Bank AG (the bank in this story) ended up selling some mortgage-backed securities (the bonds in this story) at a loss of almost $550 million. The risk managers were right, and Troy Dixon (the trader in this story) was wrong, at least in the crude sense that the bonds weren't held to maturity.
But you might also have guessed: "And then the Securities and Exchange Commission came after them." That's a reasonable guess. Losing money isn't illegal, but it often comes with a side of illegality. The SEC does not technically care (for the most part) if banks lose money, but it does care if banks' books and records do not accurately reflect the value of their assets. If you buy bonds for $100 on Monday, and you mark them at $100 on Tuesday, and you mark them at $80 on Wednesday, and you sell them for $50 on Thursday, then it is not too difficult, after the fact, to second-guess your marks from Tuesday and Wednesday. The price of a financial asset today is, essentially, a prediction of its price tomorrow. If tomorrow's price is way below today's price, then today's price might have been wrong. It's particularly easy for the SEC to second-guess your marks after the fact if your risk managers were second-guessing your marks at the time. If you get in a shouting match with your risk managers about a mark, and then end up losing money, it is perfectly fair for the SEC to bring up the shouting match in your eventual settlement for mis-marking.
But, nope, in this instance that guess would be wrong. The SEC "isn’t planning to bring an enforcement action," and Deutsche's internal review found no wrongdoing:
The lender’s internal probe found no evidence of inflated values and masked losses, the people said. Instead, they said, the bank determined that the red ink was caused by a failed hedging strategy and because, after Dixon left the firm, it decided to liquidate the bonds quickly. The U.S. agency is not formally closing its investigation, and may return to it if more information emerges, but it is not actively seeking more detail, the people said, asking not to be named because they aren’t authorized to speak publicly.
I don't know enough about the underlying facts to know if this is right, but it is sort of satisfying. It can't always be illegal to have a trade move against you; it can't always be illegal to disagree with your risk managers on marks; it can't even always be illegal to disagree with the risk managers when the risk managers turn out to be right. Sometimes a trader will put on a big position because he thinks it will work out, and will argue passionately for his view, and will persuade his bosses that he's right, and events will still make him wrong.
Meetings are useful.
Especially if they're with the president:
Using novel data on White House visitors from 2009 through 2015, we find that corporate executives’ meetings with key policymakers are associated with positive abnormal stock returns. We also find evidence suggesting that following meetings with federal government officials, firms receive more government contracts and are more likely to receive regulatory relief (as measured by the tone of regulatory news). The investment of these firms also becomes less affected by political uncertainty after the meetings.
That is from a paper by Jeffrey Brown and Jiekun Huang of the University of Illinois. Specifically:
We find that corporate executives’ meetings with White House officials are followed by significant positive cumulative abnormal returns (CARs). For example, the CAR is about 0.865% during a 51-day window surrounding the meetings (i.e., 10 days before to 40 days after the meetings). We also find that the result is driven mainly by meetings with the President and his top aides. We find insignificant CARs for cancelled visits, suggesting that the actual incidence of the meetings matters for firm value.
Why do people go to meetings? Two obvious answers are:
- Because they are useful; or
- To pass the time, feel important, have a brief moment of human connection in a cold unfeeling universe, etc.
I don't know which of those is the more cynical answer. If you told me that corporate executives' White House meetings were worthless photo opportunities that let the executives feel important without doing anything for shareholders, I would not exactly be stunned. But, nope, that's wrong! They're useful. When corporate executives meet with politicians, argue for their preferred policies, and listen to the politicians explain their policies, then the corporations and the policies end up better adapted to each other. I suppose that is mostly good -- it is good when businesses understand the law, and lawmakers understand business -- though you can find obvious ways in which it is bad.
Who picks the index?
I enjoyed this story about how State Street Corp.'s SPDR S&P 500 Fossil Fuel Free exchange-traded fund invested in offshore-drilling companies, coal-and-gas-burning utilities, and gasoline refiners. (Last year it changed its name to the "SPDR S&P 500 Fossil Fuel Reserves Free ETF": It avoids fossil fuel reserves, not fossil fuels.) This is going to be an increasingly important issue in investing. Investors want passive index investing; they want funds that make rule-based investments across an entire investable universe, without making their own judgments about which companies are good or bad. But that investable universe will never be "all the financial assets in the world" -- that would be too hard to define, or to invest in. Someone will always have to define the investable universe. "All the large-cap U.S. stocks" is itself a contentious universe to define, but "all the socially responsible large-cap U.S. stocks" is hopeless. Someone has to make choices about what it means to be socially responsible, or fossil-fuel-free, or whatever it is that you want. That can be an investor, or a fund manager, or an index provider, but it's definitely going to be someone. Those choices are never imposed by outside reality; they can never be purely "passive."
The investing store.
Yesterday I described retail brokerages as investing stores, which stock some products and sell them to you based on a complex web of considerations that include both looking out for your interests (to build customer loyalty) and looking out for their interests (to make money). Unsurprisingly, people did not like this metaphor. I meant it mostly descriptively, not normatively. Certainly if I hired a financial adviser, I would prefer to hire one who was a fiduciary rather than a salesperson, though I prefer even more to buy index funds from a website without ever talking to a person. And I am sympathetic to the argument that most regular people should get financial advice from fiduciaries rather than salesmanship from brokers, that many people who get salesmanship from brokers incorrectly think that they are getting advice from fiduciaries, and that that misunderstanding is largely the industry's fault. As Jason Zweig put it, "the appeal of 'investing stores' is the lie that they AREN'T stores." My main point was not that the investing store is the good and right way to do things, but rather that it is the way things are (often) done, and you should understand that reality when you walk into the investing store.
But my other point was that, you know, stores exist, and they are generally fine, and most of the time most people are mostly satisfied with most of the stuff they buy in stores. There are reputational and customer-loyalty reasons for stores to sell customers stuff that satisfies their needs, and not to sell them stuff that blows up. (There are usually legal liability reasons not to sell stuff that blows up, too.) Those considerations are attenuated with financial products -- most consumers have a hard time figuring out if the financial products they've bought are any good, even after they've owned them for years -- which is why people want financial advisers to be held to a higher standard than the average salesperson. But they still exist. In deciding to stop offering Vanguard Group mutual funds (but continue offering Vanguard exchange-traded funds), Morgan Stanley presumably considered its customers' demand for those funds, and decided that most of them would be mostly satisfied with something else.
Those who don't like the store metaphor often prefer a doctor metaphor. Cullen Roche, for instance, suggested that financial advisers "should operate more like doctors who can choose any of the appropriate medicines to meet client needs." Leaving aside the actual financial conflicts in the U.S. medical system, you can see the appeal of this argument. Investing, like health care, is hugely important, expensive, and overwhelmingly technical. Many people have no idea what they are doing and have to rely on experts for advice. It makes sense for that advice to come from someone whose only goal is to give people the best possible advice, not to sell high-margin products.
And yet financial advisers aren't doctors. They are money doctors, maybe; they cut open your money and take some out, hopefully making the rest of your money healthier. If someone asks you why you went to medical school, a plausible answer is "ever since I was a kid I have dreamed of saving people's lives." That is not a plausible answer if someone asks you why you went to Morgan Stanley. Even "ever since I was a kid I have dreamed of helping people with asset allocation" is not all that plausible an answer. I mean -- it happens! And most financial advisers, and even most commission-based retail brokers, probably believe they are helping their clients, and take satisfaction from doing so. (So do lots of people in other sales professions! Most people who buy things are happy that they bought them!) But as a whole you would have to say that finance tends to be less self-consciously altruistic than medicine. That doesn't mean that you couldn't have a fiduciary standard, or that you couldn't expect financial advisers to act in their clients' best interests. But it does mean that, even with a fiduciary standard, you will constantly be discovering that financial advisers are motivated by money.
Everything is seating charts.
The Berkshire Hathaway Inc. annual meeting is this weekend and so of course there'll be a lot of this sort of thing:
On Saturday, he’s up by 3 a.m. and arrives at the convention center by 4 a.m. to secure a good spot in line. He uses an entrance for upstairs seating that, he says, saves him about 20 seconds. He positions himself near a middle door because, he says, the outer ones sometimes don’t open right away.
When the arena opens at 7 a.m., he dashes down a flight of stairs, across the arena, up another set of stairs and past the front two rows to his favorite seats—all while songs such as Pink Floyd’s “Money” blare through the sound system.
That's a guy's plan to get a seat at the annual meeting. That's all. A seat in an auditorium for a corporate meeting. You can watch it on your computer. "People who stand outside for hours in the dark say they do it to pay their respects to a company they admire and to mingle with like-minded investors." The magic of Warren Buffett and Berkshire Hathaway is their ability to spread a thick treacly layer of love over ruthless capitalism. Whatever the purpose of a corporation is, it is not served by people standing in line at 3 a.m. to pay it their respects. The corporation does not feed on respect; it feeds on money. And yet somehow, year after year, Berkshire Hathaway's shareholders line up to bring it their tributes of love.
People are worried that people aren't worried enough.
Here is a claim that people are worried, but they are not doing their worrying through options on the S&P 500 index, so the VIX -- which has achieved widespread acceptance as a measure of investor worry -- is not actually reflecting their worry. On the other hand, here's a guy who's worried, and who's expressing it by buying out-of-the money VIX calls for about 50 cents of premium, which has earned him the imaginative nickname "50 Cent." "So far, $88m of the $120m in option premium spent by '50 Cent' this year has expired worthless." And here is a claim that XIV -- the VelocityShares Daily Inverse Vix Short-Term Exchange-Traded Note, which bets that the VIX will go down -- is "a magic money tree."
People are worried about unicorns.
Here is my Bloomberg Gadfly colleague Shira Ovide on the quiet deflation of the unicorn bubble, as evidenced by the down-round initial public offering of Cloudera Inc.:
Failure is common -- even celebrated -- in technology. But there's a category of Cloudera-type companies no one wants to talk about that are neither crazy successes nor obvious flops. They were simply wildly overvalued in the startup funding hot zone of 2014 to 2015, and they likely can't sell or go public at anything close to earlier valuations.
Private markets, as I keep saying, are the new public markets, and one thing that they have imported from public markets is stock-price volatility. You could have a simple old-fashioned model of venture-backed companies in which they either work or they don't: They build a team, build a product, and work toward commercial viability; if they achieve it, they go public at a huge premium to their last venture capital round, and if they don't, they quietly vanish. But this model no longer fits the unicorns. They work! Commercial viability is not the problem. "These are all good companies with real businesses," Ovide notes. But they are big, mature-ish companies, and like many public companies, their businesses have ups and downs. And so do their stock prices.
Elsewhere: "Uber faces criminal probe over software used to evade authorities." And: "A Brooklyn cafe that created a 'Unicorn Latte' is accusing Starbucks of 'overshadowing' its health-conscious drink with the sugary Unicorn Frappuccino in a new lawsuit."
People are worried about unicorn marks.
There is a lot going on in this profile of Nick Adams, who manages hedge funds for Wellington Management Co., particularly in this paragraph:
Inside Wellington, Mr. Adams also attracted attention for what some colleagues regard as eccentricities. He owns a miniature potbellied pig, named Mona Lisa, that he walks outdoors on a leash and takes with him on private jet flights. He persuaded Boston’s Ritz-Carlton, where he keeps an apartment, to waive its policy against pigs by describing Mona Lisa as a therapy animal, people familiar with the matter say. He attracted attention from the local tabloid press by divorcing his wife and marrying his first cousin.
But the real eye-popper is about Adams's investments in some private financial-technology stocks:
Regulators allow investment managers to largely set their own valuations for hard-to-trade assets such as stakes in startups. Wellington periodically increased its valuations for Mozido, Powa and other such investments in his portfolio. Mr. Adams’s funds, like many hedge funds, collect 20% of annual investment gains as a year-end performance fee.
In December 2015, Wellington boosted its estimate of what Powa was worth, investor documents indicate. Mr. Adams didn’t tell investors that one month earlier Wellington had hired consulting firm Deloitte LLP to advise on whether the company was insolvent, according to documents in U.K. insolvency proceedings.
Huh! Turns out, yep, it was insolvent; Powa went bankrupt in February 2016, a few months after being marked up at year-end by Wellington. "Wellington agreed to reverse its boosted valuation for Powa, and to refund fees that it had collected on Mr. Adams’s overall portfolio as a result."
People are worried about bond market liquidity.
Every month or so there's a new article about how people are worried that post-trade transparency requirements will reduce bond market liquidity. Here's one:
Rules taking effect next year risk sapping liquidity from corporate bonds because they’ll require traders to publish prices minutes after most transactions, according to market participants scheduled to speak at the International Capital Market Association’s conference in Luxembourg this week. It will be even worse for a small part of the market that has to publish prices before trades take place.
At an intellectual level I can understand these claims, but it does seem sort of weird to say that a rule to make the bond market more like the stock market will make it less liquid.
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