(Bloomberg View) -- Popular and CDS.
Banks and regulators care a lot about the nuances of banks' capital structures. Banks have insured deposits, and secured debt, and senior unsecured bank debt, and senior unsecured holding company debt, and Tier 2 capital securities, and Additional Tier 1 capital securities, and common stock, and other stuff, and the exact hierarchies of when and how those securities get paid matter a lot for regulatory and bank-viability purposes. And when a bank needs rescuing, holders of its most senior stuff -- the deposits, the secured debt -- tend to be fully and seamlessly made whole, while holders of its most junior stuff -- common stock, AT1 capital securities -- tend to get instantaneously zeroed. (In theory, some security in the middle might get like a 40 percent haircut, but in practice the recent rescues seem to be neatly all-or-nothing.)
This is basic, fundamental stuff: The purpose of a bank is to issue cash-like risk-free senior liabilities and invest the proceeds in risky lending activities, and the only way to do that is to protect those risk-free liabilities with a thick cushion of riskier liabilities (and equity) that will be wiped out first if those lending activities don't work out. (Also, I mean, government support.)
But in modern legal systems there is a problem with these hierarchies, which is that everyone who buys a junior claim on a bank and then sees that claim wiped out also automatically gets a lawsuit. If your junior claim is wiped out, you can sue someone -- probably the bank, or whoever acquired the bank -- claiming that your junior claim was wiped out unfairly: The proper procedures weren't followed, or the bank wasn't really insolvent when it was rescued, or it was really insolvent much earlier and its disclosures were wrong, or you were tricked into buying the junior claim by misrepresentations about its safety, or whatever. And you sue, and if you win, you have a senior claim: When a company loses a lawsuit, it actually has to pay up, making that claim unlike junior capital securities with perpetual maturity and long deferral periods.
This is just sort of weird. Here is a story about how Banco Popular Espanol SA's credit default swaps are a mess, which is a small symptom of that larger weirdness:
Credit derivatives written against the failed Spanish lender’s junior debt were triggered in a matter of days and, given that these bonds were now worthless, it seemed self-evident to many that owners of the CDS would get paid in full.
But now a row has broken out over whether the potential value of legal claims bondholders are pursuing over Banco Popular’s collapse should be considered when determining any compensation, clouding the first payout on credit derivatives linked to a European bank since the rules were rewritten to iron out major flaws in 2014.
If you owned Banco Popular Tier 2 capital securities, you got back zero cents on the dollar when Popular was sold to Banco Santander SA by European regulators. But you also got right to work on legal theories for why Popular or Santander or somebody ought to compensate you for Popular's failure, even as Santander itself was setting up a program to compensate retail investors who held those capital securities and even common stock. So there is a non-trivial chance that Tier 2 investors will eventually get some money back, which arguably should reduce their CDS recovery. CDS is meant to pay off the difference between the face value of the bonds and what they're worth after a triggering event. The Tier 2 securities are now certainly worth zero cents on the dollar, suggesting a CDS payout of 100 cents on the dollar, but the package of (Tier 2 security + lawsuit) is probably worth something north of zero. This is an annoying way to think about it, though, and people are annoyed: The litigation claims are uncertain, hard to value, hard to transfer, and generally not the sort of thing you'd expect the CDS to consider. But here we are.
Still, the bigger issue seems to be not CDS settlement mechanics but bank resolution mechanics. If every junior claim in every bank resolution has to be paid out in full, because the junior claim holders are sympathetic retail investors or have good legal theories about how they were misled or whatever, then you don't have much of a bank resolution regime! The point of Tier 2 capital securities is to absorb losses, even in weird messy situations, since after all every bank failure is weird and messy. If they can't do that, then the resolution mechanism isn't working.
Bank governance.
Elsewhere in bank capital structures, here are a blog post and related article by David Min of the University of California, Irvine, arguing that "the synchronization of corporate governance and financial institution governance is largely the result of historical happenstance, rather than an intentional policy decision." That is: People tend to think that public companies are owned by their shareholders, and that corporate directors and officers have a fiduciary duty to maximize shareholder profits. This view is controversial, but popular and broadly useful. But banks are not like other public corporations, and extending the shareholder-value model to them leads to weird results:
First, financial institutions are highly leveraged, and this leverage heightens the creditor-shareholder conflicts in bank governance and suggests that more weight should be given to creditor interests. Second, the government insures (either explicitly as in the case of deposit insurance or implicitly as with “too big to fail” guarantees) the vast majority of financial institution debt liabilities, which transforms these creditor-shareholder conflicts into taxpayer-shareholder conflicts. Finally, because bank failures can lead to financial crises, which create huge costs not borne by bank stakeholders, the logic of shareholder primacy may be inapt for financial institution governance, insofar as this logic ignores the large negative externalities of bank failures that are not borne by bank stakeholders.
On the other hand, even if banks do work for their shareholders, maybe they have the right shareholders? Here are an April blog post and related paper by Yesha Yadav at Vanderbilt Law School about "who actually supplies equity capital to banks," mainly big asset managers:
In bank governance, then, without their own money invested and also constrained by low fees, asset managers might be less likely to fall prey to the risk-seeking tendencies of the usual bank shareholder. In other words, this passive posture might prove a boon for bank regulators to the extent that asset managers—looking after others’ money and unable to charge users to pursue aggressive action—may be less motivated to advocate for overly risky strategies. Still, this passivity itself can be problematic. Asset managers may give managers or more aggressive shareholders too wide a berth to take outsize risks and potentially place the banking system at risk.
Also the biggest fund firms own all the big banks. We talked last week about a Bank of England staff blog post arguing that common ownership of banks by large fund firms might "be good for financial stability," because "common ownership also entails common exposure to contagion effects" and "large institutional shareholders could have strong incentives to reduce moral hazard faced by managers." This is the flip side of worries that common ownership of regular companies might discourage those companies from competing effectively. With banks, you really don't want ruthless shareholder-focused competition; you want stability, and big institutional investors might help provide it.
How's Martin Shkreli doing?
The main point of this story is that Shkreli sent a threatening letter to the wife of a former employee at his hedge fund, telling her "I hope to see you and your four children homeless" and "I will do whatever I can to assure this," but for me the best part was this:
Mr. Pierotti joined Mr. Shkreli’s hedge fund, MSMB, in August 2011, to start a consumer fund. With Mr. Shkreli’s blessing, he testified, he put all of MSMB Consumer’s money into one stock, Rick’s Cabaret, a chain of strip clubs.
“One day, Martin came in and said, I want it all sold today; I need the money,” Mr. Pierotti testified. Mr. Pierotti liquidated the fund, he said.
Soon after, when Mr. Pierotti walked into the MSMB offices, he saw “guys were packing computers and the flat screens into, like, rolling suitcases,” he said. “The bills had not been paid.”
That's the Martin Shkreli-est thing I have heard yet. He started a hedge fund, and he put all the money in one stock, and that stock was a chain of strip clubs. It is like a creepy teen's fantasy of being a hedge-fund manager. One consistent theme throughout the rise and fall of Martin Shkreli has been that people who worked with him, even those who eventually turned against him, think he's a genius. And his eventual success -- parlaying a series of utterly failed hedge funds into a public pharmaceutical company that he built from almost nothing -- supports that story. But I must say that his early hedge funds were hilariously dumb and bad.
Should index funds be illegal because people are worried about stock buybacks?
No, I kid, but here is an interesting take on the "short-termism" debate by Alex Edmans, who argues that efforts to encourage longer-term shareholding are missing the point:
What matters is not whether shareholders hold for the long-term, but whether they trade on long-term information. So how can we ensure the latter? By encouraging them to take large stakes. Gathering information on a firm’s intangible assets is costly, and so not worth doing if you own only a tiny bit of stock in a company. Small shareholders have little “skin in the game” and so will not bother to bear this cost, and so will base their trading decisions on freely available short-term information. Large shareholders – blockholders – do have incentives to gather intangible information. Doing so not only deters manipulation, but also actively encourages long-term investment. If earnings are low, “the market sells first and asks questions later” as the adage goes. But blockholders, due to their large stakes, have the incentive to ask questions first. If they find out that low earnings are due to investment, rather than inefficiency, they will not sell – and may even buy more.
What does that say about our modern world of large diversified asset managers? The teachings of modern finance -- diversification, efficient markets -- argue against building large concentrated stakes and spending a lot of time gathering information about a few specific companies. If everyone owns hundreds of stocks, then no one has much incentive to gather firm-specific information. And if most firms' biggest shareholders are index funds -- who never gather any information -- then they are not exactly functioning as classic blockholders.
One theme of the recent criticism of index funds is that what is good finance for investors is not necessarily good business for companies. Diversification really is good for investors; beating the market really is hard; index funds really do charge low fees; people who invest in low-cost diversified passive funds sleep well at night knowing that they are following the most advanced wisdom of modern financial science. But, the criticism goes, companies whose shareholders are passive and diversified don't work that well as companies: Their thinking is too short-term, they do not compete with each other effectively, they care about financial engineering rather than sustainable growth. The shareholders are acting rationally and scientifically, but the result may not be what they want.
Blockchain blockchain blockchain.
The initial coin offering craze is basically, there is some service (cloud data storage, online advertising) that lots of established companies provide in exchange for money, and you start a brand-new company and propose to instead provide that same service in exchange for tokens, and then you sell the tokens to the public for tens or hundreds of millions of dollars to raise money to build the service that you promised to provide and that other people are already providing. There are skeptics:
“People say ICOs are great for ethereum because, look at the price, but it’s a ticking time-bomb,” Charles Hoskinson, who helped develop ethereum, said in an interview. “There’s an over-tokenization of things as companies are issuing tokens when the same tasks can be achieved with existing blockchains. People are blinded by fast and easy money.”
I like the term "over-tokenization," though Hoskinson might actually understate the case; I mean, you can achieve cloud data storage with no blockchains at all. Anyway though:
Regulation is the biggest risk to the sector, as it’s likely that the U.S. Securities and Exchange Commission, which has remained on the sidelines, will step in to say that digital coins are securities, he said.
The idea that "regulation is the biggest risk" is something you sometimes see from people in unregulated Wild West-y areas, but I am not so sure. Another pretty big risk to the ICO sector is if a lot of ICOs turn out to be hopeless busts or frauds, and investors realize that they have poured millions of dollars into unviable companies with half-baked ideas, and then they stop pouring money into the sector at all, and people with viable and three-quarters-baked ideas that would actually be well served by an ICO can no longer raise money to finance those ideas. Oh, sure, regulation is a risk: If the ICO sector can't self-police, then regulators will come in and police it and probably be too aggressive and shut down a lot of legitimate innovation. But a little too little fraud might be better than waaaaay too much fraud.
People are worried about bond market liquidity.
We talked yesterday about a paper finding that bond mutual funds that supply liquidity -- that accommodate dealer inventory rather than straining it -- tend to outperform, which you can read as a story about liquidity provision (liquidity is a valuable thing and funds are paid for supplying it) or about value investing (buying bonds when everyone else is selling them can get you some bargains). But here is a European Capital Markets Institute working paper by Yannick Timmer of Trinity College Dublin about "Cyclical Investment Behaviour across Financial Institutions," which finds that, overall, bond funds seem to take liquidity, buying when everyone is buying and selling when everyone is selling. I suppose this is not surprising; what is more fun is that banks -- dealers -- also seem to be liquidity takers:
Banks and investment funds respond in a pro-cyclical manner to price changes. Insurance companies and pension funds act counter-cyclically, however; they buy after price declines and sell after price increases. The heterogeneous responses can be explained by differences in their balance sheet structure.
This makes sense. Bond mutual funds have, in a sense, extremely short-term funding: All of their money comes from investors who can pull it out overnight. Banks have more capital and long-term funding than they used to, but they still rely a lot on financing sources that might run. Pension funds are in no rush; they can buy bonds and hold them for decades. So when there is a panic, you'd expect run-prone bond funds to sell their bonds quickly to redeem investors; you'd expect banks to buy those bonds as market makers but quickly offload them; and you'd expect pension funds and insurance companies, with their long-term balance sheets, to be the deep value investors who can profit by ultimately providing liquidity.
People are worried about unicorns.
Oh man, Uber Technologies Inc. sounds fun:
“I never even thought of spending the weekend not working,” said one employee. Another said it “was a problem” with management that he left work at 6:30 or 7 to be with his family.
“It’s overwhelming to be told, 'We’re the top startup, we’re killing it, we’re expanding to China,' and all this other stuff, and to be asked to work weekends and pour hours in,” said a former employee. “I feel so broken and dead.”
Would you say that you felt ... uberworked? Anyway Uber's commitment to the laws of supply and demand, and to the rigorous use of algorithms to maximize efficiency and make everyone feel like they're getting ripped off, also apply to its own engineers:
While engineers in the Bay Area are, by any standard, well-paid, Uber acknowledges that it pays less than some of its top competitors for talent. For example, a software engineer at Uber earns an average salary of about $115,000 annually, according to data from Glassdoor — about $10,000 less than those at Facebook. The Information reported that Uber uses an algorithm to estimate the lowest possible compensation employees will take in order to keep labor costs down. Asked about the algorithm, Uber declined to comment.
I feel like if I were the engineer tasked with building that algorithm, I'd put one or two bugs in it. "Weird, it says that the lowest possible compensation we can give you is $20 million." "Well, the algorithm never lies! Immutable laws of supply and demand! Surge pricing! Paying me $20 million will incentivize me to put more of me out there!"
Things happen.
Morgan Stanley Traders Top Goldman’s for Second Straight Quarter. (Earnings release, supplement.) McCormick to Buy French’s Mustard in $4.2 Billion Deal. Pimco on "Housing Finance Reform: First Things First." Goldman Sachs, BofA Reverse Roles With Core Business Disappointments. America’s Farmers Turn to Bank of John Deere. Banks are benefiting less than expected from higher rates. Wall Street Efforts to Improve Its Image Fail to Sway Americans. "The country’s going to hell, but people keep going out — there’s no alternative." Paul Tudor Jones Sells Connecticut Headquarters, Moves Locations. Sunac’s Debt Load Draws Attention After Wanda Deal. Draft rules cast doubt over eurozone securitisation reforms. This Startup Wants to Replace Your Office With 3D Holograms. The strange world of the Silicon Valley intern. Interns Today Make Less Than They Did in 2010. Americans Are Spending At Least $900,000 Per Month on Avocado Toast, According to Square. A Grand Unified Theory of Avocado Toast. Naked, all-male ‘Hamlet’ to play Prospect Park. "The private-equity investor who owns the Southampton mansion featured in the Showtime TV show 'Billions' broke a kid’s nose there during a charity fundraiser for special-needs children, The Post has learned."
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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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