When Margin Loans Go Wrong
(Bloomberg View) -- Margin lending.
When a bank has a relationship with a trading client, that relationship tends to look like a bunch of contracts. There's a prime brokerage agreement that specifies how much money the bank will lend to the client and on what terms and for what collateral. There's an ISDA Master Agreement that specifies the terms on which the bank will do derivatives with the client. There are securities trades where the bank agrees to sell a bond to the client and the client agrees to give the bank money. They agree on the amount of money when they do the trade.
When a bank has a relationship with an investment banking client, that relationship tends to look like a weird friendship. The investment banker who covers the client goes out to visit the client, and asks about the client's needs, and does a bunch of favors and free work for the client, all without asking anything in return. And then, just by the way, she also suggests a couple of companies that the client might want to consider acquiring, and hints that she might be available to advise on those transactions. And then the client, overcome with gratitude for all of her free work and advice, hires her to acquire one of those companies, and pays her millions of dollars for doing it. But there's no ISDA agreement specifying that the banker gets one merger mandate for every six free financial analyses she performs. It is a subtle gift economy, one in which the banker does everything she can to make it feel like a personal relationship rather than a business one.
These distinctions are not at all absolute. Salespeople are constantly showering the trading clients with gifts -- fancy dinners and sports tickets but also free investment research -- to try to build up the trading relationships, and investment bankers are regularly entering into contracts -- engagement letters and nondisclosure agreements and financing commitments -- with the investment-banking clients. Still there does seem to be at least a rough useful distinction between the cultures, where trading is a bit more explicit than banking, where trading has counterparties while banking has clients, where trading is based on transactions while banking is based on favors, where the value of a banking client is in the personal relationship and the value of a trading client is in the collateral.
Laura Keller has a terrific and harrowing story about Bank of America Corp.'s investigation into how it lost about $300 million on a margin loan to Christo Wiese, the former chairman of Steinhoff International Holdings NV, collateralized by his Steinhoff shares. (We have talked about that loan a couple of times before.) Part of what makes it such a white-knuckle read is just the obvious tension when any bank misplaces $300 million and senior executives start asking why: Someone is going to get in trouble, and everyone would prefer that it be someone else.
Managers assumed someone would catch the blame, setting off a race to protect themselves, the people said. Senior risk officers wrote a memo that some people interpreted to blame bankers, the people said. The banking team argued the loss was a failure from multiple units, with some placing much of the responsibility on equities operatives because it’s their business to finance and manage margin loans. Some equities executives, in turn, said the risk department should have raised alarms if the lending was problematic.
The bankers are in charge of the relationship and of due diligence; the failure of due diligence (and of the company!) is on them. The equities trading desk is in charge of making margin loans; the failure of the margin loan is on them. The risk department is in charge of monitoring risk; the failure of risk management is on them. That last one is particularly rich: One view of risk management is that a trader's job is to manage risk and that the risk department is there to support and supervise that effort. Another view is that a trader's job is to take as much risk as he can get away with and that the risk department is the only place that should think about risk management. If your bank takes the latter view, you will have rather less risk management.
But there is also a more specific tension between the banking culture and the trading culture that I, as someone who once sort of sat in between them, was uncomfortable reading:
The risk managers suggested bankers should explain proposed transactions rather than advocate for their approval, the people said. They cited an email a banker wrote when the loan to Wiese was proposed. The banker said the firm could quickly readjust the loan if an emergency began to arise, thanks to strong contact with Wiese and his relationships with Alex Wilmot-Sitwell and Richard Gush, senior bankers then overseeing Europe and South Africa, respectively, according to an excerpt reviewed by Bloomberg.
Oh no. That is not how margin loans work. A margin loan is a contract. You lend someone hundreds of millions of dollars with a trigger that allows you to blow him out if his stock drops too much. If the stock then drops too much, sure, fine, yes, you call him up and ask him if he's going to post more margin. Maybe you even give him a little more time to post the margin than is strictly allowed by the contract. But if he doesn't answer the phone, you just blow him out.
When your collateral is vanishing and your counterparty's business is collapsing and you have hundreds of millions of dollars at risk, that is the time when you really want to have rights. You really want to be able to do what you need to do to protect yourself, whether or not your counterparty is happy about it. What you don't want, at that point, is a relationship. You don't want to call up your counterparty, get his voicemail, and leave a message like "hey buddy just checking in, have some questions for you about that margin loan, please give me a call back as soon as you get this." Because when your collateral is vanishing and you are desperate to reach him is exactly the time when he is going to turn off his phone.
No trader, no risk manager, wants to approve a risky trade on the basis that you can always call up the client and change the trade if it goes wrong. The traders are going to want the protections built into the trade; they're going to want a brutal contract that gives the bank unlimited rights to act in its own interests if anything goes wrong. The bankers, on the other hand, will find that offensive. Why insult the client like that? Give him a gentle contract that doesn't assume the worst, and then, if the worst does happen, rely on the friendly relationship that you have built up with him over time. That is a natural mentality to have if you spend your time building relationships and then being paid fees for services; it is less natural if you spend your time sitting at a desk risking capital. When the bankers are powerful enough to import the relationship mentality onto the trading desk, you get trades like this.
Another extremely recognizable anecdote:
Reached by Bloomberg, [Wilmot-Sitwell] said he wasn’t aware of the banker’s email and disputed the depth it implied of his relationship with Wiese. He said he didn’t have responsibility for covering Wiese’s or Steinhoff’s banking needs.
Ha! The bankers wanted to get the trade done so they dropped the names of a senior banker who was close with the client and could serve as, like, an internal guarantor of the trade. That senior banker, meanwhile, wasn't that close with the client and didn't know he was being used that way.
Look, I am not a knee-jerk crypto-skeptic. I write a lot about the rubes and hucksters and scams in the cryptocurrency sector, but there are also sophisticated investors, many of whom have deep experience in traditional technology venture-capital investing, who are bringing that sophistication and experience to the crypto space. These investors aren't chasing pointless fads; they understand the transformative power of blockchain technology, and are investing in the revolutionary infrastructure that will underpin the future of the internet, the financial system, and the world as a whole. Here, for instance, is a blog post from Union Square Ventures about how it is investing in ... oh, wait ... oh it's CryptoKitties, never mind:
At USV, we think digital collectibles is one of many amazing things that blockchains enable that literally could not be done before this technology emerged.
We also think digital collectibles and all of the games they enable will be one of the first, if not the first, big consumer use cases for blockchain technologies.
So, one, I am not convinced that there were no pre-blockchain digital collectibles -- I think a lot of gamers would disagree with that -- but more importantly, "X literally could not be done before blockchain" is not an especially good argument for X. The question is: Should X have been done before blockchain? Were people really sitting around back in the dark ages of 2006 saying "sure I can get an animated cat on my computer screen but so can anyone else; what I need is a rare animated cat"? Maybe? I don't know anything anymore.
Elsewhere here is "Buy Bitcoins Without Risk of Losing Money: A Guide to Responsible Investing." I know, I laughed too, but it's actually a straightforward and well-known strategy, which is, if you have $10,000 to invest for five years, you spend some of it buying a risk-free security (classically, a Treasury Strip) that matures at $10,000 in five years, and then -- because that Strip costs something like $8,750 today -- you spend the rest buying the risky thing that you really want to buy. (Or, more classically, at-the-money call options on the risky thing.) If you don't think too hard about it -- about time value of money or opportunity cost or liquidity risk or the actual slope of the payoff graph -- then this sort of looks like getting the upside of Bitcoin without the risk of losing money. I am not saying it's a good idea -- this is not investment advice -- but I am saying that it's a good pitch.
It's also sort of a standard pitch in the rest of the financial world, and one I haven't really seen in the Bitcoin world. One slightly more sophisticated variant on it, in the rest of the financial world, is the structured note: Instead of just telling clients to buy Strips and options to get the asymmetric payoff profile that they want, you can take the clients' money, use some of it to buy Strips, some of it to buy options and some of it to pay yourself a fee, and guarantee the clients the asymmetric payoff profile that you think they want. Really who wouldn't want a Bitcoin structured note that gives you your money back if Bitcoin goes down, but gives you Bitcoin's upside if Bitcoin goes up? Isn't that better than just buying Bitcoin? Please do not answer that.
The trick is the marketing: The term "structured note" is in a bit of disrepute these days, while blockchain and crypto and coins and tokens are all very hot. Don't call this thing a "structured note"; call it a "stablecoin," or an "enhanced stablecoin" or something. Don't put the Strips and options into a bankruptcy-remote special-purpose vehicle; put them on the blockchain. Don't just have a contract with investors promising them their payout; have a smart contract with investors automating that payout. Make it crypto enough to attract crypto types, but Treasury-Strip-like enough to attract people who want to keep their money, and you can't lose.
Elsewhere, here's a new plan for a pointless stablecoin:
The currency aims to avoid the wild price swings of many cryptocurrencies by tethering itself to reserves deposited in a basket of fiat currencies at commercial banks. Holders of Saga will be able to claim their money back by cashing in the cryptocurrency.
If your cryptocurrency requires you to trust banks to give you fiat currency, you could just have a bank account. What problem does this solve? If you trust fiat currencies to hold their value better than cryptocurrencies, and you trust commercial banks to keep your deposits safe, why slather an extra layer of blockchain guff over your fiat bank deposits?
And here's "What the First Token Hostile Takeover Could Look Like." The key steps are (1) do a fork where you distriute new tokens to holders of the old token that you are trying to take over and then (2) announce an incentive in which you will give extra new tokens "to users that burn (i.e. send to provably unspendable addresses) their existing OLD tokens," which if your new fork is popular enough will cause most of the old tokens to disappear. And here is a story about efforts by a crypto startup called Mainframe to get around securities restrictions on initial coin offerings by dropping tokens out of balloons at cryptocurrency conferences, which, no, just no. And here is Emin Gün Sirer on claims about child pornography on the blockchain.
What does Elon Musk's utility function look like? Yesterday Tesla Inc. shareholders approved a comically large pay package designed to keep Musk employed as Tesla's chief executive officer. When we last talked about this pay package I mentioned how superfluous it seems to be. If Musk hits all of his revenue and earnings targets over the next 10 years, and grows Tesla to be worth $650 billion, then he could make more than $50 billion from his new package. But if Musk grows Tesla to be worth $650 billion over the next 10 years -- whether or not he hits those revenue and earnings targets -- then he will make more than $130 billion just from the Tesla shares he already owns. The extra $50 billion on top of the $130 billion would be nice, I guess, but ... how? Like what will he do with it? Buy more flamethrowers?
You can sort of see Tesla's reason for giving him the extra $50 billion: He doesn't need to be CEO to keep his existing shares, which are worth billions of dollars, but he does need to stick around in management to get the extra $50 billion. It's designed to keep him at his job, "a sum so large it might just ensure that Musk’s array of other passions and esoteric side projects won’t steal too much time from his work at Tesla." But what's in it for Musk? He is fabulously wealthy now. If he stayed at Tesla without this pay package and made Tesla worth $650 billion, he would be ridiculously, world-historically wealthy. If he stays at Tesla with this pay package and makes Tesla worth $650 billion, then, you know, same. He has tethered himself to Tesla in exchange for amounts of money that, while comically large to me or you or the average billionaire, are still quite small compared to his existing fortune in most relevant states of the world. I sort of don't understand why Tesla is paying him in money, or rather shares, both of which are things he has a lot of. They should promise to, like, send him to Mars (and bring him back), or make him immortal, or something. I guess that is hard to commit to.
Really what Tesla is doing here is not motivating Musk with money, but expressing -- awkwardly but earnestly -- its love for him. That is hard to do in thoughtful ways. What do you get a man who has everything? How do you buy a thoughtful gift for a billionaire aficionado of rocket ships and sports cars and flamethrowers? At some point, the only way to express your love for him is with more money, even if that's the last thing he needs.
People are worried about bond market liquidity.
Here is some very classic bond-market-liquidity worrying, specifically the exchange-traded-fund flavor:
Investors are shorting the shares of some ETFs that buy securities like high-yield debt, which may be hard to sell if markets turned suddenly, a fear stoked by increased volatility this year. ...
ETF shares are created by so-called authorized participants—broker dealers who buy the securities that make up an index tracked by a fund and exchange them for new ETF shares.
When investors want to redeem their shares, the process works in reverse and the ETF must sell the securities. If market liquidity tumbles, some investors worry that the funds won’t find buyers for those bonds.
Man, just last month we talked about record outflows from a big corporate bond ETF, and how corporate-bond trading prices were basically unchanged by those withdrawals. When investors wanted to get out of bond ETFs, they did, and everything was fine. Those big withdrawals were in investment-grade bond funds, not high-yield, and of course tomorrow can always be different from yesterday, but, you know, it is evidence. "The whole worry that bond ETFs were going to cause a liquidity crisis seems increasingly embarrassing and we should probably never talk about it again," I wrote, but in my heart I knew that was a vain hope and that we will never stop talking about how bond ETFs are going to cause a liquidity crisis.
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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.
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