Money Stuff

Scary Acronyms and Bad Behavior

Also subordinated bonds, speed bumps, analyst valuation and ICOs.


After the South Sea Bubble, did people sour on the whole notion of corporate stock for a century? After all, corporate stock was what burned people in that crisis, so how could anyone ever trust it again? "Railway Company Proposes to Issue Stock, the Complex, Risky Instrument at the Heart of Former Crisis," the headlines would blare. "What could possibly go wrong," columnists would ask sarcastically. "This will end well," wits would snark in coffee shops. After the Dutch tulip bubble, did people distrust flowers? "Roses? Get those out of here! Don't you know flowers caused the last financial crisis?"

Anyway the collateralized loan obligation market is doing well. Or as we say these days: "Hunt for Yield Fuels Boom in Another Complex, Risky Security." "CLO" shares two out of its three letters, and many of its structural features, with "CDO," and collateralized debt obligations were at the center of the 2007-2008 financial crisis, and so of course there are worries. "Many people were 'burnt by these acronyms from the crisis,' said Zak Summerscale, head of credit fund management for Europe and Asia Pacific at Intermediate Capital Group," as though the harm was inherent in the acronyms. And there is this guy:

Mr. Champion says he buys senior European CLO tranches and borrows money against them to increase the size of his position between five and 10 times. That can amplify gains -- and losses -- significantly.

"The difference between now and a year ago is the availability of leverage," he said.

"What could possibly go wrong," my keyboard just typed, of its own accord.

I confess that I am fond of securitization and collateralized whatever obligations. Part of this is just a general fondness for puzzles and structure, but that's not the main thing. Really CLOs and CDOs are quite simple. They make use of a fundamental financial idea -- that if you have some cash flows, a senior claim on those cash flows will be safer than a junior claim on those cash flows. Pretty much every company is structured that way; no one thinks it's weird that Uber's bank lenders expect a lower return and lower risk than its preferred shareholders, who in turn expect a lower return and lower risk than its founders. Securitization just generalizes this idea: Instead of slicing up the cash flows of a single operating business, securitization puts arbitrary cash flows into a box and then slices up the returns of that box. The fact that some of the boxes in 2007-2008 were filled with garbage, and were used for nefarious purposes, does not undermine the whole concept, any more than the fact that some 18th-century stock issuers were garbage-y and nefarious undermines the concept of stock.

Eventually there will be a new financial crisis involving, I don't know, cryptocurrency or something, and then perhaps the reputation of structured finance will recover a bit. "An initial coin offering?," people will say. "Isn't that what caused the last crisis? I'd better stick to something safe, like CDO-squareds."


Here is a fascinating story about the workplace environment at Fidelity Investments, in which the bid/ask seems to be that many analysts allege that Fidelity's portfolio managers are difficult, bullying, exclusive and sexist, while the portfolio managers respond that they are difficult, bullying and exclusive, but not sexist.  “If analysts ever felt I was difficult, it has been unequivocally gender-blind,” says one portfolio manager. "I was a tough individual but I was fair as well," says another. And Fidelity's alleged boys' club excluded and pressured some boys:

Informal outings to bars, Red Sox baseball games and poker games hosted by male portfolio managers were particularly fraught, these people say. Some analysts and associates, male and female, felt pressure to go to these events to get a good rating, the former managers and analysts say. Others say they weren't invited, creating what the 2015 report deemed a difficult culture.

There are important ways in which this distinction matters. Legally, for one: Being a jerk to everyone -- or discriminating on the basis of talent or cultural fit or bonhomie or Red Sox fandom -- is part of the grand tradition of at-will employment, while being a jerk just to women is illegal gender discrimination. And yet being a jerk to anyone seems .... less good than the alternative? 

One lesson of financial regulation is that the financial industry is very good at optimizing around regulations. This story makes me a little worried about the possibility of gaming anti-discrimination laws. If a male portfolio manager wants to exclude and bully women analysts, and the law says that he can't just exclude and bully women analysts, then the rational optimization might be for him to exclude and bully a few men as well. "It has been unequivocally gender-blind," he can shrug, and the law can't touch him.

Whatever the legality, though, it is not the reputation you want for your workplace culture. The head of Fidelity's equities division "held an emergency meeting last Monday afternoon with his staff to stress the firm's 'zero tolerance policy' for inappropriate workplace conduct," a meeting that you tend to hold if the amount of inappropriate workplace conduct has been greater than zero. And "Fidelity remains committed to providing all associates with an outstanding work environment and we will always work hard to ensure that we take swift and appropriate action when an individual violates our policies, and more importantly, our values," said a spokesman.

Credit analysis.

On Friday, the U.S. Court of Appeals for the Second Circuit issued a decision in In re MPM Silicones, LLC, a bankruptcy case involving the reorganization of Momentive Performance Materials Inc. The court decided a couple of questions that might be of interest to distressed investors and bankruptcy lawyers: It held that bondholders should not get early-redemption make-whole payments upon bankruptcy, and that if a debtor is going to satisfy secured bondholders' claims in full in a reorganization by giving them new bonds, those bonds should probably have a market-based rate of interest. 

But I want to focus on a boring obvious question that the court also decided, which is that Momentive's subordinated unsecured notes were junior to its second-lien secured notes. This is not, I would have thought, a subtle question of bankruptcy law. This is like: Companies issue bonds, and those bonds have a hierarchy of seniority, and the hierarchy is like first-lien secured bonds, second-lien secured bonds, senior unsecured bonds, subordinated unsecured bonds, preferred stock, common stock, etc. (Momentive also had "1.5-lien secured notes," which slices things rather fine.) And everyone knows that the things higher up in the hierarchy are senior to the things lower down in the hierarchy, and that if the company goes bankrupt the higher-up things should be paid off before the lower-down things get anything. And here that happened: The first-lien notes got fully paid, the second-lien notes got partially paid, and the subordinated notes got zeroed. But what the subordinated note holders here asked is: What if that's wrong? What if the subordinated notes are not actually subordinated to the second-lien notes?

The bankruptcy court and district court responded, effectively, no, come on, we live in a society here. Obviously everyone intended the secured notes to be senior to the subordinated notes; that is the whole point of those words, and of capital structure generally. But on appeal, the Second Circuit took the question more seriously, held that the answer was ambiguous ("Rather, we conclude that the Fourth Proviso renders the definition of Senior Indebtedness ambiguous as to whether it includes the Second-Lien Notes" -- a lovely sentence to show to any young person who is considering whether to go to law school), but ultimately agreed that, as the other courts had held, the junior debt was in fact junior to the senior debt.

This all takes seven pages and I have no huge substantive problem with any of it. But in some ways it ought to be of more interest to distressed investors than the stuff about make-wholes and interest rates. People think about that stuff. This stuff -- the idea that secured notes are senior to subordinated notes -- is too fundamental to think about. When a court starts thinking about it, and finds the relationship ambiguous and the questions difficult, then the whole system starts to feel slippery. If you can't trust the titles of the bonds -- if you can't assume that secured bonds outrank subordinated bonds just by reading the names, but have to carefully parse the indentures and intercreditor agreements and consider how a court will interpret their ambiguities -- then what can you trust?

Speed bumps.

Last year, the Securities and Exchange Commission approved IEX Group Inc.'s application to become a national stock exchange, over objections of many traders and other exchanges that IEX's "speed bump," which delays certain orders for 350 microseconds, unfairly discriminates against some orders and makes markets less reliable. But IEX had a good pitch that the speed bump actually protects investors from being picked off by high-frequency traders, and a lot of investors supported it, and the SEC let it proceed.

Everyone predicted that that would lead to a wave of copycat speed bumps. Back before the SEC approved IEX's application, I wrote:

  1. IEX are nice.
  2. They want to do a new weird thing that will complicate market structure.
  3. Basically every problem in equity market structure comes from introducing new weird things that high-frequency trading firms know how to exploit but that regular long-term investors don't fully understand.
  4. But IEX will be nice about it.
  5. But once you let them do it, you have to let everyone do it.
  6. No one else is nice.

That held up well. One copycat was the Chicago Stock Exchange, which proposed to build a speed bump to give market makers on its exchange a sort of a quasi-last look on prices. Lots of people objected to this speed bump, arguing that it unfairly discriminates against some orders and makes markets less reliable. Unlike with IEX, there was not exactly a groundswell of investor support for Chicago's speed bump, which will mainly advantage market makers. But now the SEC has apparently approved it. Because once you approve a speed bump to advantage one class of traders, it is hard to decline other speed bumps to advantage other classes of traders.

What are analysts worth?

My Bloomberg Gadfly colleagues Shelly Banjo and Nisha Gopalan did a sum-of-the-parts valuation of sell-side equity research analysts and came up with $377,500 per year. One could quibble -- they value an analyst's written work at just $7,500 per year, but I have reason to believe that Gadfly writers get paid a bit more than that for their written work -- but you have to start somewhere.

The crux, though, is that "Gadfly not only recommends a tiered pricing system (one price for research, another for corporate access and a third for bespoke projects), but also the consideration of surge pricing, Uber style." In a sense the value of a research analyst is hard to quantify, insofar as banks generally haven't charged for research in the past, and as research tends to be one just element in a mosaic of considerations that money managers use in making decisions. On the other hand, if an analyst tells you to buy a stock, and you do, because of her recommendation, and the stock goes up, then the value of the analyst was quite straightforwardly the amount that the stock went up. If you bought a lot of stock, and it went up a lot, then the analyst could have been worth millions and millions of dollars to you. That is the real surge pricing: If an analyst has a high-conviction, high-value, non-obvious, actionable idea, then that might be worth more than centuries of industry background papers. But actually charging for that value is difficult.

Elsewhere: "Christmas Plans Face Ruin for Finance Industry as MiFID II Looms."


BIND Therapeutics filed for bankruptcy in 2016, but ended up selling its assets for more than the value of its debt, so there was money left over. If you have money left over after bankruptcy, you give it back to shareholders. That's the simple conceptual boxes-and-arrows way that things are supposed to work. But in practice: Who are "shareholders"? How do you find them? What if they've sold their stock? What if they've sold short? Here is a fun blog post about the BIND Therapeutics bankruptcy liquidation trust, which involves debates over record dates, difficulty finding shareholders and getting them to fill out paperwork, short-selling and stock-lending complexities, and generally all the complications that we have come to know and love in the U.S. system of registering stock ownership. We've talked about them in connection with the Dole Food Co. buyout, and also, by analogy, with the Bitcoin Cash fork, and while I have nothing really to add on the BIND story, I pass it along to you on an if-you-liked-those-you'll-like-this basis. "If you like reading something about a bizarre situation you are at the right address here," says the blog post, and what better recommendation is there than that?

Blockchain blockchain blockchain.

"Hey, Matthew," read my inbox this weekend. "Just following up to see if you had any questions about my previous e-mail regarding The Smoke Exchange - the world’s first self-serve advertising platform for the marijuana industry that will operate 100% on cryptocurrencies." Just reading that sentence made me way too stoned to contemplate any follow-up questions, or to remember the previous email, or my name. Days later my sense of reality is still pretty unstable. But, yes, The Smoke Exchange. There is ... did you even have to ask ... there is an initial coin offering

Elsewhere, "'Wolf of Wall Street' warns ICOs are 'biggest scam ever.'" What is the heuristic there? Is it like, scam artists -- as Jordan Belfort famously and confessedly is -- are always happy to tell you that perfectly legitimate things, like the Federal Reserve or the stock market or sure ICOs, are the real scams? Or is it like, scam artists know from scams, and if Jordan Belfort says ICOs are a scam then they are the scammiest scam that ever did scam? In any case, "Mr. Belfort is advising friends and family to steer well clear of ICOs," which means there are people who get investing advice from Jordan Belfort.

House expensive.

Here is a Bloomberg Pursuits story about "one of, if not the, safest home in America," the Rice House outside of Atlanta, which has a bunker and a batcave and bulletproof doors and this listing copy:

"This is a home where you could put a $20 million painting on the wall and sleep comfortably at night," said listing broker Paul Wegener, of Atlanta Fine Homes Sotheby's International Realty. "The same goes for your family."

Wait wait wait. Do you have to hang your family on the wall, for the house to protect them? Also, is the implication here that you are buying the house to protect your art collection, and your family can come along as an afterthought? The house is for sale because "the owner planned the Rice House as a family legacy, only to learn that his son wasn’t interested in living there," and it feels like there is a lot of unexplored drama in this house. Sure it will protect you from intruders, but hurt feelings can penetrate even ballistic doors. 

Things happen.

Merrill Lynch Fined $45 Million by U.K. for Failing to Report Transactions. (FCA order.) Saudi Aramco's IPO, the world's largest ever, is 'on track' for 2018, CEO Amin Nasser says. Qatar Makes Sudden Accounting Change Ahead of Bond Sale. Companies Leave Bean Counting to the Robots. GE's New CEO Vows Sweeping Change After 'Unacceptable' Report. Daniel Loeb's Third Point Takes Stake in Dover, Calls for Split. Tesla Strikes Deal With Shanghai to Build Factory in China. Tech Firms Seek Washington's Prized Asset: Top-Secret Clearances. How Facebook’s Master Algorithm Powers the Social Network. "I don't think it is easy to get around having a part of the economy which is both systemically risky, and also debt-intertangled, as the evolution of shadow banking over the last fifteen years seems to indicate." Trump's middle-class tax increase includes cutting 401(k) subsidies. U.S. business goes in to battle for cherished tax breaks. Very Particular Passenger Sues Airline for Serving Sparkling Wine Instead of Champagne. California Restaurant Admits It's Been Serving Popeyes Chicken for Months.

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