(Bloomberg View) -- Why banks?
Here is a hilarious paper from Juliane Begenau of Stanford and Erik Stafford of Harvard called "Do Banks Have an Edge?" No, is their answer. You'd be better off just passively buying Treasuries than buying the complicated mix of stuff that banks actually own:
We construct a simple buy-and-hold portfolio that each month purchases a six-year maturity UST and holds it to maturity, such that the three-year average maturity of this portfolio matches that of the aggregate banking sector. This is a highly conservative benchmark as it does not charge for the credit and illiquidity risk that banks have added to their asset portfolios, both of which realized positive risk premia in capital markets over this period. Remarkably, we find that the unlevered bank assets, inclusive of their share of operating expenses, underperform passive maturity-matched investments in US Treasury (UST) bond portfolios over the period 1960 to 2015. This suggests that the specialized asset-based activities of banks have contributed negatively to bank performance over this period.
And you'd be better off borrowing in the market than relying on the deposits that are supposed to give banks their funding advantage:
A second analysis compares the average cost of bank deposits, inclusive of their share of operating expenses, to the average cost of non-deposit bank debt issued in the capital market. We find that the cost of deposits exceeds the cost of debt, suggesting that banks have a funding disadvantage associated with deposits relative to capital market debt.
If you combine the two it's even worse: "passive maturity transformation portfolios have CAPM betas near zero, while portfolios of bank equities have CAPM betas exceeding one," suggesting "that the active components of the bank business model appear to be the source of the systematic risk in banks and to have realized negative risk-adjusted returns offsetting the strong tailwinds associated with the underlying business model of maturity transformation over this sample."
What is going on here? One story you could tell is: Hahaha banks are stupid. They have taken a simple and uncorrelated business model -- borrowing short to lend long -- and turned it into a systemically risky mess that also manages to underperform the simple model. "Since 1960, banks appear inefficient in that they have not covered their opportunity cost of capital."
Another story you could tell is that banks are massive charitable enterprises. Begenau and Stafford find that bank assets have a lower return than Treasuries, sure, but intuitively it is good that someone is making mortgage loans instead of just putting their money in Treasuries. They find that bank deposits are not cheaper than capital-market funding, sure, but intuitively it is good that checking accounts exist. Sure a passive leveraged Treasury portfolio might outperform a big bank, but it might outperform my local hardware store too. I am still glad to have the hardware store; not every business model needs to be optimized to outperform a capital-markets portfolio. Banks oil the gears of commerce even though it's not profitable for them.
If you buy this story, you don't have to necessarily believe that bankers, or bank investors, are the ones funding the charity. Perhaps the story is that society wants mortgages and checking accounts, and so the government provides subsidies to banks in the form of deposit insurance and mortgage guarantees and too-big-to-fail backstops, and banks eat some of those subsidies themselves and pass the rest on to us in the form of underpriced mortgages and free checking. It is not an obviously efficient system. Yet it has the ring of truth to it.
But there's a third story you can tell that has nothing really to do with banking. This story is just that modernity is coming for all of us, and it comes first not in the form of automation but in the form of statistical analysis. Everyone's work product can be decomposed into active and passive share. If you take a rigorous inventory of yourself you will probably find that the passive share is much bigger than the active share, and that there's a decent chance that the active share is negative. Mostly you just do the stuff that everyone else does, which could be done by anyone else, or a robot. Generating uncorrelated alpha probably makes up a pretty small part of your day. Most of what I do is sit in my chair staring blankly into space with an unfocused sense of terror; the time that I spend coming up with brilliant witticisms is like three minutes a day, tops. But no one ever shows up at my desk to run a regression.
Because they are too busy showing up at the desks of investment managers, where you see this sort of active-versus-passive analysis all the time. Hedge-fund managers come to work and do stuff all day, but statistical analysis reveals that they could be replaced by a set of linear exposures to the seven-factor Fung and Hsieh model. Warren Buffett drinks Cherry Coke and makes folksy sex jokes, but statistical analysis reveals that he could be replaced by leveraged exposure to the betting-against-beta and quality-minus-junk factors. These analyses are sometimes interpreted to mean that "most hedge funds don't appear to be doing any hedging or active management at all," that they "are a scam," that really hedge-fund managers are chucking their investors' money into index funds and going to the beach. But that is not what the analyses mean at all. The hedge-fund managers do stuff; they work long hours and are constantly coming up with ideas and testing them against reality and trying to pursue their edge. It just turns out, upon analysis, that the results of all that effort look like a (particular, arguably cherry-picked) passive strategy. It's not that the hedge-fund managers aren't doing things. It's that they shouldn't.
Similarly, if you work at a bank you are making loans or trading bonds or managing branch networks or doing hundreds of other particular business things. The lived experience of banking is not a passive leveraged long-Treasuries strategy. But statistically that's what it turns out to be. Or actually the passive strategy turns out to be better.
Hugh Kenner writes about pre-electronic computers:
There were automata long before Vaucanson – histories of the subject commence with Hero of Alexandria (first century A.D.). There were mechanical aids to computation before Babbage – Pascal designed a digital adding machine. But Hero and Pascal would not have called their artifacts simulators, but rather toys or tools, utilized by men who were metaphysically something other. The eighteenth and nineteenth centuries were less sure that man was other. To trace, in their automata, an advanced technology derived from looms and watches, enlightens us less than does consideration of their novel uncertainties about where, if indeed it existed, the boundary between man and simulacrum lay. If a man does nothing with his life but spin threads, then just how is a thread-spinning machine not a purified man? And indeed it can replace him.
Once, everyone assumed that the people who managed investments were metaphysically something other than the average market return. The great and terrible innovation of the passive-investing revolution was to make people less sure that the investment managers were something other than the market. If a banker does nothing with her bank but maturity transformation, then just how is a leveraged long-Treasury strategy not a purified bank? And indeed it can replace her.
XIV, etc.
Many financial products are complicated, and many financial products blow up, but it is worth keeping clear in your mind the distinction between the products that blow up because they are complicated and the products that happen to be complicated and happen, independently, to blow up. The latter case is way more common!
So we talked yesterday about the XIV, the VelocityShares Daily Inverse VIX Short-Term ETN, an exchange-traded note that gave investors, roughly speaking, negative 1 times the return on the CBOE Volatility Index (the VIX) each day. One complaint about the XIV is just, you know, it is complicated, there are formulas in the prospectus, etc. Another complaint is that its complication might have caused it to blow up. Actually "might" is too weak a word; as Charles Forelle pointed out, the prospectus says, bold and underlined, that "the long term expected value of your ETNs is zero." Even if the VIX goes down, the XIV -- which is a bet on the VIX going down! -- will also lose money over time. If you bought XIV to bet on vol going down, and vol went down, and you lost money anyway, you might be aggrieved. "What a complicated product," you might complain, correctly, even though you were warned.
But what actually happened is that on Monday the VIX went up by 116 percent, and the XIV went down by 93 percent, and Credit Suisse AG, XIV's sponsor, announced that it would usher XIV off into the great financial-products hereafter. If you bought XIV to bet on vol going down, and vol more than doubled in a day, then you get up from the table, you shake everyone's hand, you say "well played XIV," and you walk away with dignity. You did that! That's on you. Perhaps you didn't understand the intricacies of the formulas in the prospectus, but the intricacies of the formulas didn't matter. You made a bet on the VIX going down, the VIX went up by 116 percent, you lost. That is that.
You can however find people who are not happy about it. Reddit and ZeroHedge are full of them. "Money kept pouring into the ETF but it’s a dangerous product that most people didn’t understand," one of them complained to the Wall Street Journal. Another emailed me to say that "a lot of people literally had no idea how the fund mechanics worked since we didn't read the prospectus and were lured in by the 182% returns," which I found baffling: The only part of the fund mechanics you needed to understand, as it turned out, was that if the VIX doubles in a day then you will lose all your money. But he replied:
When you put it like that, yes it sounds incredibly stupid, and we clearly didn't understand the risks. The context is that XIV was just printing money. Why would you think you could lose everything if you had just almost tripled your money in a year?
That's why! "Why would you think you could lose everything if you had made 4 percent a year for five years," fine, I will allow it. But if you tripled your money in a year, that was the tell.
Elsewhere: "Inside Wall Street's $8 Billion VIX Time Bomb." And: "How Two Tiny Vol Products Helped Fuel Sudden Stock Slump." And:"Market Mayhem Vaults VIX to Top of Financial Glossary Searches." I try not to give investment advice around here but I will say that, in my personal account, if I had just learned about a financial index five minutes ago from Investopedia, my immediate next move would not necessarily be to make levered bets on that index. Not that that is what anyone is doing or anything. I just worry.
Wynn.
You sometimes see public-company chief executive officers, particularly founder-CEOs whose names have been synonymous with their companies for decades, step down as CEOs but keep an office at the firm so they can show up occasionally to intimidate the new guy. You rarely see the CEO step down and announce that he plans to keep living at the company, though. He doesn't necessarily want to intimidate the new guy in his bathrobe. But Steve Wynn is stepping down as CEO of Wynn Resorts Ltd. after allegations of sexual misconduct, and keeping both his shares in the company and also his house there:
Mr. Wynn will continue to live on site in his villa at the casino in Las Vegas for another year and will keep his 12% stake in the company, according to a person familiar with the matter. A company spokesman said the company didn’t have comment on Mr. Wynn’s accommodations or plans for his stake.
It's like when Pope Benedict XVI announced his retirement and his plans to remain at the Vatican. It's tough to be the pope if you're constantly running into the old pope in the line at Starbucks. It'll be that much harder for Matt Maddox, Steve Wynn's successor at Wynn Resorts, since Steve Wynn's name is the company's name and his signature is the company's logo. They should at least change the logo to be "Wynn," but in Maddox's handwriting.
The official announcement of Wynn's resignation is quite something. Both Wynn and his board of directors are stunningly peevish about the societal pressures that forced Wynn out. "It is with a collective heavy heart, that the board of directors of Wynn Resorts today accepted the resignation of our founder, CEO and friend Steve Wynn," says the non-executive chairman of the board. "A rush to judgment takes precedence over everything else, including the facts," says Wynn. Nobody wants him to leave, is the message here, but Society makes certain demands. The subtext might be: We will comply unwillingly with Society's demands and get rid of our CEO who is "an industry giant," "a philanthropist and a beloved leader and visionary." But he won't go far.
Watch out for the fake KodakCoins!
Oh come on:
Eastman Kodak Co. is warning that several fraudulent websites and Facebook accounts are promoting and even claiming to already be selling its planned digital token.
We have talked a few times before about the KodakCoin initial coin offering and it is, ehh, you know. You know. I am curious about the set of people who (1) want to buy KodakCoins but (2) are fastidious about only buying genuine KodakCoins. I just cannot see how it would matter much. Buy the fake KodakCoins, whatever. What difference could it possibly make? This is not investing advice.
Meanwhile, short-selling hedge fund Kerrisdale Capital is out with a research report about KodakCoin this morning. They don't like it. Choice sentences include "In speaking with blockchain and database experts, lawyers, a buyer of media licenses, and a founder of a digital content agency, we encountered a wall of incredulity and ridicule in reaction to nearly every aspect of KODAKOne’s plan," and "Unsurprisingly for such a nonsensical business concept, the team behind KODAKCoin has zero credibility."
Elsewhere: "Meet 'The Wolf of Crypto Street,' an Ohio teenager who used his entire savings to become a cryptocurrency millionaire." I will pass on that, thank you, but you are welcome to meet Mr. Wolf if you'd like. (Skimming the article I see four pictures of him in front of cars and one picture of him in front of a painting of him with a car, so he is that particular kind of online investing teen.) I must say though that:
- Wall Street is a street; Crypto Street is not a street.
- "Wolf of Wall Street" alliterates; "Wolf of Crypto Street" does not.
You want to be the Coyote of Crypto Valley? The Badger of Blockchain? The Baboon of Bitcoin? The Eagle of Ethereum? The Bactrian Camel of Bitcoin Cash? The Dog of Dogecoin? The Kangaroo of KodakCoin? Fine, whatever, knock yourself out. But "the Wolf of Crypto Street" tells me you're not even trying.
Elsewhere in crypto:
- "Get Ready for Most Cryptocurrencies to Hit Zero, Goldman Says."
- Sarah Meyohas, one of Money Stuff's favorite artists for her oil portraits of stock-price charts, also did an ICO avant la lettre way back in 2015; here is a recent story about that.
- "Bitcoin: why is it so male-dominated?"
- "The Bitcoin Boom Could Be Great for Sex Businesses."
People are worried that people aren't worried enough.
I mean, no, it'll be another few days before anyone can worry about that with a straight face, but here is a paper by Söhnke Bartram, Gregory Brown and René Stulz called "Why Has Idiosyncratic Risk Been Historically Low in Recent Years?"
Since 1965, average idiosyncratic risk (IR) has never been lower than in recent years. In contrast to the high IR in the late 1990s that has drawn considerable attention in the literature, average market-model IR is 44% lower in 2013-2017 than in 1996-2000. Macroeconomic variables help explain why IR is lower, but using only macroeconomic variables leads to large prediction errors compared to using only firm-level variables. As a result of the dramatic change in the number and composition of listed firms since the late 1990s, listed firms are larger and older. Larger and older firms have lower idiosyncratic risk.
People are worried about unicorns.
And here is a paper by Craig Doidge, Kathleen Kahle, Andrew Karolyi and René Stulz called "Eclipse of the Public Corporation or Eclipse of the Public Markets?" (free version here):
Since reaching a peak in 1997, the number of listed firms in the U.S. has fallen in every year but one. During this same period, public firms have been net purchasers of $3.6 trillion of equity (in 2015 dollars) rather than net issuers. The propensity to be listed is lower across all firm size groups, but more so among firms with less than 5,000 employees. Relative to other countries, the U.S. now has abnormally few listed firms. Because markets have become unattractive to small firms, existing listed firms are larger and older. We argue that the importance of intangible investment has grown but that public markets are not well-suited for young, R&D-intensive companies. Since there is abundant capital available to such firms without going public, they have little incentive to do so until they reach the point in their lifecycle where they focus more on payouts than on raising capital.
It is a theme that we have discussed frequently. Private companies that need money can raise it efficiently in the private markets without the hassle of going public. The result is that private markets are where companies go to raise money to build their businesses; public markets are where companies go to do share buybacks.
Doidge et al. attribute this shift in large part to the rise of companies that rely on intangible assets:
Public markets are better suited for firms with mostly tangible assets than for firms with mostly intangible assets. This is especially true when the usefulness of the intangible assets has yet to be proven on a large scale. Sometimes the market is extremely optimistic about some intangible assets, which confers a window of opportunity on firms with such assets to go public. But otherwise, firms with unproven intangible assets may very well be better off to fund themselves privately. Accounting information conveyed by U.S. GAAP for such firms is of limited use because GAAP treats investments in intangible assets mostly as expenses, so that these assets may very well not show up on firms’ balance sheets. Private funding allows firms to convey information about intangible assets more directly to potential investors who often have specialized knowledge, something that they could not convey publicly.
Also, "Once an idea is made public it becomes possible for other firms to use it," so firms with intensive intangible research-and-development programs might not want to sign up for the disclosure obligations of public markets.
Things happen.
How Bets Against Volatility Fed the Stock Market Rout. Banks Cheer Return of Wild Markets. Quants Embrace Recent Selloff Even as Everyone Blames Them For It. Cboe says Vix products not to blame for market rout. Trend-followers’ fallout ensnares Winton Capital. "You have to have had that stage where you’re looking at the screen through your fingers to really appreciate risk-reward in this industry." Brussels warns on volatility risk to booming eurozone. Papers with shorter titles are better. Can You Still Date a Co-Worker? Donkey falls through roof of home in Brazil.
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Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
To contact the author of this story: Matt Levine at mlevine51@bloomberg.net.
To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net.
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