Tax Bills and Libor Witnesses

Also ETF lending, Aramco investing, Trump lending and ether stealing.


There is a widespread belief that taxes discourage economic activity. If you tax cigarettes, that will reduce smoking; if you tax labor income, that will reduce work; if you tax capital gains, that will reduce savings; if you tax estates, that will reduce death. This is standard Econ 101 reasoning, but that doesn't mean that it's universally valid. You can't rule out the possibility that someone, somewhere, will think "Higher taxes? That just means that I need to work more hours to pay them!" That someone is literally Steven A. Cohen:

Mr. Cohen, who ran SAC Capital before it pleaded guilty to criminal insider-trading charges in 2013, is nearing a launch of a new firm to manage as much as $20 billion, The Wall Street Journal earlier reported.

He has set that target, which would exceed the $16 billion managed at peak by SAC, partly because he wants to generate income to help pay the large tax bill, a person close to him said.

The "large tax bill" is the one that is coming due soon on offshore deferred compensation: Hedge fund managers used to be able to defer that income indefinitely, but Congress closed that loophole in 2008, and gave the managers until next year to pay taxes on previously deferred compensation. "The deferred fees will be taxed at ordinary tax rates that can be close to 50% depending on where the managers live and work," and the total might come to $100 billion. You might think that a $100 billion tax on hedge fund managers would discourage hedge fund managers! But no, it actually helped push one very famous hedge fund manager out of retirement for one last score. I like to imagine that without the tax change he would have been content to manage his own money in private seclusion, but I am pretty sure that if it wasn't this he'd find some other reason for wanting to run $20 billion.

Another widespread belief about taxes is that they encourage wasteful gamesmanship and structuring to avoid them. (That's how the offshore compensation came into being in the first place.) And that is still true. Here is a wonderful quote from a tax lawyer in his role as spiritual counselor:

“These are smart, aggressive people who don’t want to pay more than they have to and writing a huge check can be quite demoralizing," said Jonathan Brenner, a tax partner at Caplin & Drysdale. “Most recognize they’ve had a good run and now have to pay the piper, though not after first asking six different ways if there’s some silver bullet” to eliminate or reduce the taxes.

It's the Kübler-Ross five stages of taxes: Denial (deferring taxes offshore), anger ("aggressive people"), bargaining ("asking six different ways if there's some silver bullet"), depression ("quite demoralizing"), and finally acceptance (the deadline is next year). To be fair, with taxes unlike with death, a lot of the time you can stop at step 3. Often the bargaining works! The job of a tax lawyer is normally less about counseling people through depression to acceptance, and more about actually finding the silver bullets. If hedge fund managers are asking their tax lawyers six times if there's a magic way to avoid taxes, it's because past experience has taught them that there usually is.

Rabo Libor.

Some traders at Rabobank Groep in London allegedly rigged Libor a bit. U.K. and U.S. authorities were both unhappy about this, but they approached it in different ways. The U.K.'s Financial Conduct Authority compelled two of the traders -- Anthony Allen and Anthony Conti -- to testify, promising not to use their testimony against them; it then used their testimony to bring an enforcement action against a third trader, Paul Robson. (That case was then delayed for the U.S. case.) U.S. prosecutors, on the other hand, pursued a criminal case, and started with Robson, who quickly pleaded guilty to fraud and agreed to testify against Allen and Conti. Allen and Conti came to the U.S. to be tried for Libor manipulation, Robson testified against them, a jury convicted them, and they were sentenced to prison.

They appealed, and yesterday they won their appeal, in a somewhat odd opinion. The problem is that the U.S. Constitution does not allow "the use of compelled testimony in American criminal proceedings applies even when a foreign sovereign has compelled the testimony." The FCA compelled Allen and Conti to testify: If they hadn't talked to the FCA, they could have gone to prison, but anything that they did say to the FCA couldn't be used against them in a U.K. criminal case. It also couldn't be used against them in a U.S. criminal case. But it was used to build the FCA's case against Robson, and as part of that case, Robson was shown their testimony against him, which he read and marked up. And then that case was dropped, and he became a witness against them in the U.S. criminal case. And -- Allen and Conti's lawyers argue -- their FCA testimony informed what he said about them, which is an unconstitutional use of their own compelled testimony against them.

The appeals court agreed. It noted that what Robson said at his FCA testimony -- when he was under investigation -- was different from what he later said in court against Allen and Conti:

Robson agreed that “the testimony that [he] gave to the [FCA] and the testimony that [he] gave before the jury in this trial were very different.” For instance, Robson testified to the jury about an altercation between Stewart and Damon Robbins, an alternate submitter for USD LIBOR, on Rabobank’s London desk. But Robson did not testify about this to the FCA, and the Kastigar hearing raised questions about whether he had even seen the incident at all or merely read about it in the compelled testimony.

I do not find it that surprising that he was more forthcoming after pleading guilty, and while testifying against the people who previously testified against him, than he was while he was under investigation himself? It's a little weird that Robson's testimony about Libor rigging -- which he pleaded guilty to, and participated in -- is inadmissible just because he was aware of what the other guys also said about it. It also makes it harder for U.S. prosecutors to bring criminal cases where foreign regulators have already done civil investigations: The FCA investigation, which was aimed at getting to the truth rather than at punishing people, used compelled testimony with the promise of immunity, and by doing so seems to have prevented a U.S. prosecution

ETF lending.

People who own a stock are betting that it will go up. But other people want to bet that that stock will go down. Those people have a harder time: They have to go find someone who owns the stock to lend it to them, so they can sell it short. You might naively think that would be a hard pitch: "I think this stock that you like is bad, and I would like to profit from its badness; would you help me with that?" But it is not that hard, mainly due to the magic of disaggregation and inattention: The people lending the stock to the short sellers tend not to actually be the ultimate long holders, but those long holders' brokers and fund managers and custodians. So you are free to buy stocks and believe that short-sellers are un-American, while also unbeknownst (or semi-beknownst) to you lending them stock so they can carry out their dastardly deeds.

Also of course the short sellers pay the long owners (or at least their intermediaries) to borrow the stock, which greases the transaction.

Here's a story about how long holders of exchange-traded funds save money by lending them to short sellers:

The way it works is fairly simple. An investor is holding an ETF as a long-term position but is willing to lend the fund’s units to short-sellers, most often hedge funds, that want to bet against it in the short-term, according to Eric Balchunas, an ETF analyst with Bloomberg Intelligence. On average, the fee paid by the borrower enables the ETF holder to recoup 40 percent of the fund’s cost, and in some cases receive full compensation -- or more, according to an IHSMarkit report published last week.

There is an even deeper magic going on here, which is the magic of benchmarking. If you own an ETF as a long-term position, what you want is for the ETF to go up. The more it goes up, the more money you make, and you are doing this for the money. But it is easy to forget this, and to convince yourself that you want something else. Specifically, you might think that you want to avoid fees, and to get an ETF that closely tracks an index. Lending shares is a way to do that: The underlying index for your ETF has an 8 percent return, the ETF has fund costs of 0.1 percent, you get back 0.1 percent in stock-lending fees, so you get exactly the 8 percent return of the index.

In theory, short sellers bring down the price of a stock, or of an ETF, just as buyers bring up the price. And so facilitating short selling -- lending stock to short sellers -- might reduce the performance of the ETF that you are long. But this is hard to measure, and if you didn't lend your stock, wouldn't someone else? So you can just not think about it. The fund costs are easily observable, the stock-lending fees are easily observable, the counterfactual performance-without-stock-lending is not. What you want is to get an 8 percent return when the underlying index returns 8 percent, not to get a hypothetical 8.9 percent return when the underlying index returns 9 percent. You optimize what you can measure, not what you really want.

Stock picking.

Dan McCrum argues that the proposed public offering of Saudi Arabian Oil Co. -- with at least a trillion-dollar market capitalization and perhaps $100 billion of free float -- offers "a unique experiment to prove the value of active fund management." Assuming that Saudi Aramco isn't included in the main U.K. indexes, "not taking a view, or merely tweaking the standard index allocation, will not be an option" for U.K. fund managers, who will have to essentially make a call on whether Aramco will help them outperform the index, or cause them to underperform. Of course you have to do that with every stock! If you are an active manager, you should buy stocks that will go up more than the index, and not buy stocks that will go down. But the stakes are lower if they are in the index, and if they are small: You can just market-weight them and not worry too much about being wrong either way. A trillion-dollar company listed on a U.K. exchange but not included in the indexes, on the other hand, forces a more serious choice.

I think sometimes about the rather obvious argument that indexing isn't "really" passive because you have to choose a particular index. Not even in a nuances-of-index-construction way, like whether your index includes companies with net losses or non-voting shares. Just in a simple dumb way, like, you have to choose whether to invest in a U.S. stocks index or a U.K. stocks index or a bond index or some mix of them. Aramco, to the U.K. stock market, looks a little like an alien visitor from another index, or even an index in itself. The entire FTSE 100 Index of the biggest companies on the London Stock Exchange has a market capitalization of about 2 trillion pounds, the same order of magnitude as Saudi Aramco's expected market cap. There is a market of U.K. stocks, and if you want to invest in "the market," and you're a U.K. stock investor, then an index like the FTSE 100 is a way to invest in that market passively, or to benchmark your active performance in that market. And then there is (or will be) a separate market that is Saudi Aramco, which is a very different creature from the rest of the U.K. stock market, and roughly the same size. And if you want to invest in that market, you buy Saudi Aramco stock.

And by some weird accident of listing standards the market for Aramco might soon sit next to the market for U.K. stocks, and bleed into it a little. And someone whose mandate has always been to invest in U.K. stocks is now confronted with a choice: Is my mandate still to invest in that old, 2-trillion-pound market of U.K. stocks, or is it now to invest in the new, 3-plus-trillion-pound market of U.K. stocks plus Aramco? It's not just a question of stock selection but of benchmark selection, of figuring out what "the market" is before you decide how you will beat it.

Trump and Deutsche Bank.

Here is a story about Donald Trump's dealings with Deutsche Bank AG, "among the few major financial institutions willing to lend him money." It includes one of my favorite old Trump/Deutsche Bank stories, about the time in 2008 when Trump fell behind on payments on a Deutsche Bank loan on Trump International Hotel and Tower, where he had a $40 million personal guarantee, and to avoid paying he sued Deutsche Bank for $3 billion for causing the financial crisis. Deutsche Bank called this "classic Trump," with what one imagines was an indulgent chuckle, and kept lending to him.

Elsewhere in Trumpy finance news:

S&P 1500 companies whose executives visited the White House during the first five months of the Trump administration enjoyed a share price bump in the three days around the visit that was 0.16 per cent more than would be expected otherwise, the University of Illinois at Urbana-Champaign business school professors found. The equivalent number for executives who visited during the Obama years was 0.07 per cent.

Blockchain blockchain blockchain.

Ah yes perfect: A type of Ethereum smart-contract wallet software turned out to have a bug, and it was duly hacked, and $30 million worth of ether was stolen, but then before the problem got any worse a "white hat" hacker group stepped in and stole the remaining $76 million worth of ether in those wallets and is hanging on to it for safekeeping. "If you hold a multisig contract that was drained, please be patient," say the white hats. "They will be creating another multisig for you that has the same settings as your old multisig but with the vulnerability removed and will return your funds to you there." This is our future of distributed trustless markets run by immutable code: The code ends up being broken, and you just have to trust that the people who stole your money are the people who plan to return it rather than the people who don't. 

People are worried that people aren't worried enough.

Bad news, everyone: The stock market keeps going up! "History suggests the stretch of calm won’t last," though:

The steady performance hasn’t been universally celebrated. Some investors who have missed out on this year’s sharp rally are waiting for cheaper opportunities to get back in. Others are increasingly taking positions in the options market that protect themselves from large price swings.

People are worried about unicorns.

The Enchanted Forest, much like Middle Earth, seems to have a shortage of women, judging by the number of women on the boards of companies that have done big IPOs recently:

Nearly half of the 75 biggest initial public offerings of the last three years involved companies that lacked female directors when they went public, a new analysis found. Most of those 37 concerns still have all-male boards, concluded 2020 Women on Boards, an advocacy group.

Food Stuff.

Here is a Bloomberg Businessweek story about "The Mad Cheese Scientists Fighting to Save the Dairy Industry," which I am obviously extremely here for:

Stuffed Crust was on the minds of everyone at Taco Bell as they welcomed McClintock, who was immediately assigned to the languishing Quesalupa project. “What Taco Bell usually needs is one person who’s entirely dedicated to a product,” she says—and sometimes, it seems, just one component of one product. “So that’s what I was for—there to handle cheese.”

It’s worth pausing to note how serious a paradigm change Taco Bell credits DMI with causing: The company’s innovation team once regarded cheese and sour cream as mere garnishes. Now, dairy is often the focal point. Cheese use at the chain has increased 22 percent since the beginning of the DMI partnership. “Beef and cheese are the most important ingredients to our consumers,” Matthews says. “But really, cheese.” For proof, consult a menu. Eight items currently have the word “cheese” or “cheesy” in their name, vs. three with “steak” or “beef.” 

Alarmingly, there is a graph showing what percentage of menu items have "cheese" in their names at different chains. Taco Bell, at 20 percent, is near the bottom. The top slot, at 38 percent, belongs to Dunkin Donuts. Please people do not put cheese on your donuts.

Things happen.

ECB Leaves Guidance Unchanged as Anticipation for Autumn Builds. When Will the ECB Pull Its Trillions From the Markets? Morgan Stanley, Goldman Earnings Highlight Firms’ Diverging Paths Since Crisis. Deutsche Bank Preparing for Hard Brexit, CEO Cryan Tells Employees. Citigroup Said to Open Frankfurt Hub as Banks Consider Post-‘Brexit’ Moves. Frankfurt "is taking an early lead in attracting banking businesses in anticipation of Britain exiting the European Union." Goldman Partners Mark End of Era as Stock Holding Drops Below 5%. Fannie-Freddie Reform Might Hinge on Keeping Small Lenders Happy. Happy seventh anniversary, Dodd-Frank! New York Attorney General Opens Inquiry Into Student Loan Collection. Dalian Wanda, in a Switch, Sells Assets to 2 Chinese Companies. Greenwich Luxury Listings Tumble as Sellers Discount or Drop Out. Screaming About Stocks into a Well: A Text Adventure. Placebo surgery. A podcast about Phil Ivey's baccarat edge sorting. Stun-gun-wielding rabbi kidnappers fail to convince court they were just practicing their faith. Is this eight-hour sheep epic 'the dullest movie ever'?

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