Shadow Banks and Investor Meetings

(Bloomberg View) -- Programming note: Money Stuff will be off next week, back the following week.

Market based finance.

The Trump Treasury Department has apparently decided that the term "shadow banking" is a slur and should be avoided:

Treasury prefers to transition to a different term, “market based finance.” Applying the term “shadow banking” to registered investment companies is particularly inappropriate as the word "shadow" could be interpreted as implying insufficient regulatory oversight, or disclosure. Registered investment companies, as described in this report, are regulated by the SEC and provide extensive public and regulatory transparency of fund portfolio holdings on a quarterly, monthly and, in some cases, daily basis

Look. I half get it. "Shadow banking" is a useful term. It means issuing short-dated information-insensitive money-like debt claims and using the proceeds to buy longer-dated risky assets -- doing the core maturity-transformation and risk-transformation functions of banking -- outside of a bank. So money market funds are pretty shadow-bank-y. "Structured investment vehicles" and "asset-backed commercial paper conduits" that issued short-dated money-like claims on pools of mortgage bonds before the financial crisis were quite shadow-bank-y. 

On the other hand, there is no formal definition of "shadow banking," and it is sometimes used quite broadly and unhelpfully to apply to any non-bank doing anything that a bank might do. Lending to companies by private-equity firms for instance, is often called "shadow banking." Big asset managers are sometimes called "shadow banks" just for being big and finance-y. And it does sound pejorative. If I were BlackRock Inc., I'd be annoyed about being called a "shadow bank," and if I were Treasury I'd sympathize with that annoyance.

But "market based finance" is a far, far dumber term. "Market based finance" just sounds like it means, you know, market based finance -- any form of financing that is not bank loans. Bonds are market based finance. Stocks are market based finance. Asset-backed commercial paper conduits are market based finance. All financial things not done by banks -- and most financial things done by banks -- are market based finance.

But there's a reason that people talk about (core) shadow banking as a category: The particular thing that core shadow banks do, issuing money-like short-term instruments to fund the purchase of long-term assets, is risky, and it is risky in the specific way that banking is risky. All finance is "risky" in the sense that prices can do down, but banking and shadow banking are risky in the specific sense that they are subject to run risk: If depositors or quasi-depositors lose faith in the risky assets held by the bank or shadow bank, they will rush to cash out their (short-term, fixed-priced) holdings and create a self-fulfilling crisis.  

This stuff is quite well understood, and the regulatory apparatus governing banks is specifically set up to address it. That apparatus is not about "extensive public and regulatory transparency" of holdings. (Bank holdings are not especially transparent, at least to the public.) It is about capital requirements and liquidity reserves and prudential regulation, and about deposit insurance and a lender of last resort. After the global financial crisis, commentators understood that shadow banks were subject to the same risks as banks, and that runs on shadow banks could cause financial crises. And regulators set to work thinking about how to apply bits of banking regulation -- capital requirements and prudential regulation and liquidity requirements and deposit insurance and access to the Fed -- to shadow banks. And this was a broadly sensible response to the actual risks of shadow banking, that had actually come true in a shadow-banking crisis.

But dropping the term and replacing it with "market based finance" hints at abandoning those efforts. "Market based finance" drops not just the "shadow" part of "shadow banking," but also the "banking" part: It ignores the maturity transformation effects of shadow banking, treating them as just incidental features of regular market transactions. And it suggests that the risks can be mitigated the way other market risks are mitigated, with disclosure and transparency. This did not work particularly well in the financial crisis, and it seems weird to ignore the lessons of the crisis just because the phrase "shadow bank" sounds rude.

Analysts and companies.

Here are a blog post and related paper by Ole-Kristian Hope, Zhongwei Huang and Rucsandra Moldovan, titled "Economic Consequences of Hiring Wall Street Analysts as Investor Relations Officers." That is of course a career path: If you are a Wall Street sell-side analyst writing research reports to help investors understand a company, you might end up getting hired by that company (or some other company) to help it explain itself to analysts and investors. 

The authors describe the benefits to companies of hiring analysts to run investor relations. For one thing, they tend to improve the writing style of a company's disclosure -- making it less complex and more readable -- presumably because, if they weren't writing the disclosure, the lawyers would be.

But here are the real benefits:

Building and maintaining close relationships with financial analysts and institutional investors is a major focus of the IR function. Prior research shows that analyst coverage and institutional ownership are increasing in corporate disclosure, consistent with the notion that the effort analysts expend to analyze the firm is an important determinant of analyst coverage. An analyst has expertise in processing corporate disclosure and understands good-versus-bad disclosure practices from the perspective of investors. If a firm capitalizes on such expertise and deep understanding by hiring a former analyst as head of IR and reshapes corporate disclosure and the way the firm’s story is communicated, the investment community would likely incur lower costs to process corporate disclosure. Consistent with this line of thought, our findings show that firms attract more interest from analysts and institutional investors after hiring a former financial analyst as IRO. In particular, we find a significant increase in analyst following and an increase in the number of institutional owners.

The ex-analyst IR person knows the analysts who cover the company; they used to be her colleagues and competitors. She knows the investors who invest in the company; they used to be her clients. She knows what analysts want, and what investors want. When they call her to ask "hey can you help me with this bit of my model" or "hey can you give me more color on your margins" or "hey your competitor posted good revenue growth, should we assume your numbers are similar" or whatever, she will have the ability and inclination to be helpful.

We talk about those interactions a lot. Here are a few things we can say about them:

1. They are useful to the investors who have them. That's why investors like to talk to companies: It gives them information that is useful to them in their trading. It gives them an advantage over investors who don't have those "close relationships" with corporate management.
2. They are not supposed to be useful to investors. Or rather they are not supposed to be "material." Regulation FD prohibits companies from disclosing material nonpublic information to favored shareholders, without disclosing it to everyone. And yet these private meetings happen, and they seem to be useful, and almost never lead to Regulation FD enforcement.
3. They are useful to the companies who have them. That is a result of Hope, Huang and Moldovan's paper: The IR officers' close relationships with analysts lead to more analyst and investor interest in the company and more liquidity in its stock. Those are things that the company could reasonably want, since they could lead to higher stock prices and easier financing terms. 
4. Every so often they lead to insider-trading charges: The IR officers cultivate such close relationships with analysts or investors, and give those analysts or investors such useful information, that prosecutors decide to characterize the information as a "tip" and the relationship as a "friendship" that creates a "personal benefit" for the IR officer. 
5. But those characterizations are, I think wrong. Instead, what I think happens is pretty much what Hope, Huang and Moldovan suggest. The job of the IR people is to cultivate relationships with investors, which they do in all the ways people normally cultivate business relationships: They give the investors useful business-y information, and they also ask about their personal lives and try to socialize together. This helps the investors' companies -- they get to buy stock with useful information -- and it helps the IR people's companies -- they get to cultivate loyal investors and have better access to financing. It is all very normal and business-y except that it is legally quite shadowy.

SEC enforcement.

Here is a story about how the Securities and Exchange Commission is going to bring fewer enforcement actions -- "be selective and bring a few cases to send a broader message rather than sweep the entire field," according to Steven Peikin, its co-director of enforcement -- and get rid of about 100 of its 1,400 enforcement employees. So that is a meaningful policy change, and one that you would kind of expect from a presidential administration that has never seemed all that bothered by fraud.

But beyond that actual substantive policy change, there is always the dumb symbolism of "neither admit nor deny" settlements:

Mr. Peikin cast doubt about the future of a signature element of the SEC’s enforcement program over the past four years: admissions of wrongdoing. Under former Chairman Mary Jo White, an Obama appointee, the SEC sought admissions of fault by firms and individuals in select cases, rather than allowing defendants to resolve probes by paying penalties but neither admitting nor denying the allegations.

I have never understood why I -- as a citizen, a financial journalist, a connoisseur of fraud -- should care at all about this, but obviously people do. "A move away from seeking more admissions of wrongdoing could expose the regulator to political criticism that it’s gone soft on Wall Street." Yes! True! But that's silly. Going soft on Wall Street, by for instance prosecuting fewer instances of fraud -- as the SEC said it will do -- really ought to expose the SEC to political criticism that it's gone soft on Wall Street. But prosecuting the same number of instances of fraud, in the same way, and demanding that companies pay big fines and change their behavior, but "without admitting or denying guilt," isn't "going soft." It is just using slightly different words to accomplish the same purpose. I suppose that is how politics works: The symbolism is the whole game; the policy substance is irrelevant.

Elsewhere in SEC news, it has announced -- as expected -- that it will waive some of its rules to allow U.S. banks and investors to comply with Europe's MiFID II rules. The key point is this:

The Division of Investment Management provided temporary relief for thirty (30) months from MiFID II's implementation date under the Investment Advisers Act of 1940 ("Advisers Act") to permit a broker-dealer to receive payments in hard dollars or through MiFID-governed research payment accounts from MiFID-affected clients without being considered an investment adviser. 

MiFID II requires brokers to be paid explicitly for research; the '40 Act more or less requires them not to. The MiFID II rule makes a lot more sense in the modern fund-driven market than the '40 Act rule does, and so it has at least temporarily prevailed. 

Will Venezuela pay?

We will find out by this morning: Petróleos de Venezuela SA, the state-owned oil company, has a bond principal payment due today, and if it doesn't pay then investors can put it into default. And everyone's nervous:

A New York-based hedge fund manager who holds PDVSA bonds says he has the oil company, the public credit office, two clearing houses and a settlement service on speed dial, periodically calling each one to beg for any information on payments. A portfolio manager in London has his assistants checking in with Euroclear and Clearstream every few hours. Another investor in New York says he’s had to learn the name of the folks who work in his back office since he’s constantly reaching out to them to ask for updates.

I have never bought a Venezuelan bond myself, but I just assumed that if you were into that sort of thing you'd also be the sort of person who was into, like, really understanding the mechanics of payment systems and clearinghouses and default grace periods and credit-default-swaps auctions and the whole rest of the apparatus. When it comes to Venezuela, you don't just swan around saying "great credit, wave in $10 billion of 'em." You gotta know how the stuff works. You gotta read the indentures. You gotta wander over to the back office and learn people's names and buy them beers. Venezuelan bonds are just ... sort of ... back-office-y bonds, you know? 

Fees and performance.

Yesterday we talked about a Wall Street Journal article called "The Morningstar Mirage," which found -- counterintuitively -- that Morningstar Inc.'s one-to-five-star rating system for mutual funds actually weakly predicts those funds' future performance: Funds that earned five stars for their past performance, on average, end up as three-star funds over the next 10 years, while three-star funds end up as 2.5-star funds on average. Three is more than 2.5, so -- on average -- you'd be better off investing in a five-star fund than a three-star fund. The system works, a little bit.

I had lazily assumed that ratings based on past performance -- like Morningstar's star system -- would have zero or even negative predictive value, so this came as some surprise to me. "Morningstar is better at picking mutual funds than I would have expected," I wrote, a piece of faint praise that Morningstar for some reason quoted on Twitter.

Several readers, though, proposed an explanation. Morningstar rates funds based on net-of-fee performance, and takes into account sales loads. And fees are predictive. Funds that were good at picking stocks in the past will, on average, be average at picking stocks in the future; funds that were bad at picking stocks in the past will, on average, be average at picking stocks in the future; that is in the nature of stock picking. But funds with low fees in the past will probably have low fees in the future, and funds with high fees in the past will probably have high fees in the future. And since net performance is made up of (1) stock picking minus (2) fees, you'd expect funds with low fees to have, on average, persistent slightly-better-than-average performance.

And so my readers hypothesized that five-star funds tend to slightly outperform one- or three-star funds in the future because they tend to have somewhat lower fees. This is, intuitively, a plausible explanation. In fact it is supported by this 2010 article, "How Expense Ratios and Star Ratings Predict Success," from Morningstar itself. Star ratings predict "success" (using a different measure of success from the Journal's), and low fees predict "success," but low fees are ever-so-slightly better than stars as a predictor:

How often did it pay to heed expense ratios? Every time. How often did it pay to heed the star rating? Most of the time, with a few exceptions. How often did the star rating beat expenses as a predictor? Slightly less than half the time, taking into account funds that expired during the time period.

Again, this is not apples-to-apples with the Journal study, and is seven years old. But it is intriguing. Fees are a good predictor of (relative) future performance. They are a slightly better predictor than the stars, on Morningstar's own account. That suggests that the other information that goes into the star ratings -- past stock-picking success -- adds negative information. (Otherwise the stars would be at least as good as the fees.) Morningstar is good -- well, slightly-better-than-chance good -- at picking mutual funds because it tends to pick the ones with low fees.

Blockchain blockchain blockchain.

Here's a post on "An Open-Source EDGAR Database for Cryptoassets" that makes a variety of interesting points about cryptocurrency, initial coin offerings and governance. Here is one:

Tokens are not claims on assets of the organizations that issue them. There is no precedent for how to manage liquidations.

I predict that in 2018 we will see our first reverse ICO.

A team that raises money suddenly disbands because they decide to work on another, more exciting project or because they decide to retire at the ripe old age of 25. The entity that holds tens of millions of dollars worth of cryptoassets (or more) is suddenly a zombie organization with no liquidation procedures.

The post contemplates "a pre-defined method to redeem tokens in exchange for remaining ether or bitcoin balances existing at liquidation," but then notes a problem: "That would make this pure 'utility token' a security," running into legal problems from the beginning. That's not the only concern, of course: If you build liquidation procedures, while having weak governance rights for investors, there's always the possibility that you get the incentives wrong and the entrepreneurs raise money, take some of it, and "liquidate" back the rest. Existing systems of corporate law, securities law, creditors' rights and bankruptcy are very finely balanced and have been built up based on decades or centuries of experience. (And they still get gamed all the time!) If someone just sits down to write a liquidation procedure for cryptoassets, they'll probably create almost as much trouble as they fix. 

Meanwhile in London, On-Line Plc announced that "At the next Annual General Meeting, the Board also intends to put forward a special resolution to change the Company's name from On-line PLC to On-line Blockchain PLC." The stock price, which had been 14.25 pence on Wednesday, got as high as 84 pence today. (It later lost a lot of those gains, and in any case has a single-digit-million-pounds market capitalization.) "On-Line Plc" is so last-boom; "On-Line Blockchain Plc" really captures the spirit of our current age. More companies should do this. General Electric Co. is having a tough time? General Blockchain Co. wouldn't. Barclays Plc is disappointing shareholders? They'd love Barclays Blockchain Plc. 

Things happen.

Ermotti Reboots UBS Buyback Expectations After Capital Rises. (Earnings release, presentation, quarterly report.) CVS Is Said to Be in Talks to Buy Aetna in Landmark Acquisition. Amazon Threat Causes Shakeout in the Health-Care Industry. Clariant and Huntsman Terminate Planned Merger Amid Activist Pressure. Deutsche Börse C.E.O. to Resign Amid Insider Trading Scandal. How Wall Street Scored Its Big Win in Congress. Nobody knows what's in the Republican tax plan. It’s Going to Stay a Yellen Fed No Matter Who Gets the Job. Billionaire Pharmaceuticals Entrepreneur Indicted in Alleged Fentanyl Fraud Scheme. "The world’s billionaires are richer, older and more sports-obsessed than ever." Paul Newman Rolex. Cheese watch. Buffalo Wild Wings Flies After Going Boneless. Runway seals. "The growly voice, googly eyes, and outsized yearnings mask the heart of a scholar."

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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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