(Bloomberg View) -- Corporate equity derivatives.
Here is a Bloomberg story with the headline "An Opaque $3.5 Billion Business Gives Wall Street a Hangover," and I clicked it, thinking, oh, you know, opaque businesses, can never get enough of opaque businesses, and it turned out that the opaque business is my old business: It is corporate equity derivatives, the business where I was employed on Wall Street for four years. Specifically it is about financing transactions -- margin loans and funded collars -- for large equity stakes owned by rich corporate insiders, private-equity funds, sovereign debt funds, etc.; more specifically it is about the margin loans to the former chairman of Steinhoff International Holdings NV that a bunch of banks did, secured by his stock in Steinhoff, and how those loans lost more than $1 billion for the banks. We have discussed those loans a few times around here.
I would like to use this article as an excuse to reminisce about my old job, and about how dumb and naïve I used to be. For instance: At some point during my time doing corporate equity derivatives, my desk did a margin loan, and I was surprised to learn that a margin loan is a corporate equity derivative. It doesn't sound like one! It has the word "loan" right there in the name, for one thing, rather than a good derivatives-y word like "option" or "swap" or whatever. For another thing, I had heard of margin loans before. They're just loans that your broker gives you so you can buy more stock. Every discount brokerage firm -- even Robinhood -- offers margin loans to retail customers. It is strange to think of that basic brokerage service as an "equity derivative."
I suppose I was about half-right. There are two ways to think about a margin loan:
- As a far-out-of-the-money put option with some odd features, or
- As a margin loan.
Approach 1 starts from the recognition that, if your client owns a bunch of stock in a company, and you lend her a bunch of money secured by that stock, and that stock loses most of its value overnight, then all of a sudden you own the stock, and it's worth a lot less than you paid for it. That description sounds like you sold her a put option: Your payoff profile is that you get back a little bit of money in most states of the world (where the stock is up or flat or down a bit), but you lose a ton of money in a few very bad states of the world (where the stock craters). It's not quite a put option -- this ignores important issues like margin calls and recourse -- but you can kind of think of it that way. And if you do, when you give a client a margin loan, you treat it like any other equity derivative sold off your corporate equity derivatives desk. In particular, you hedge it. You might use some of the money that the client is paying you to buy put options to offset the put option that you effectively sold to her.
Approach 2 is like, well, I don't know, all the discount brokers give their retail clients margin loans, surely we should extend the same courtesy to our big billionaire/sovereign-wealth-fund/whatever clients. Also we should give them better rates than the discount brokers give their clients, because our clients are bigger and more lucrative. Basically we'll charge them our cost of funds plus a bit of profit margin; we're certainly not going to charge them enough premium to buy put options to hedge. Why would we buy put options? Robinhood probably doesn't.
Approach 1 is why big margin loans are mostly done off corporate equity derivatives desks, but Approach 2 is mostly how they are done. It's pretty clear that the banks that did the Steinhoff margin loan treated it like a margin loan, not a put option. You can tell, first of all, because they lost a billion dollars: If they'd been hedging more, they'd probably have lost less. You can tell, second, because "the debt had an interest rate of about 125 basis points above the London interbank offered rate," which is "lower than the 1.87 percent average cost of borrowing for corporations around the time of Sept. 2016." That's a loan-secured-by-good-collateral rate, not a we-need-to-pay-to-hedge-this-equity-risk rate.
The problem is that a corporate equity derivatives desk lending to the chairman of a public company against his stock in that company is in a bit of a different situation from a retail brokerage lending against its customers' stock portfolios. For one thing, that retail brokerage will have a lot of margin loans secured by a lot of different stocks. Some of those stocks will crater and wipe out some of those margin loans, but it will be a manageable and more-or-less predictable small percentage. But a corporate equity derivatives desk will do just a few giant margin loans secured by concentrated stock positions that are hard to sell. The diversification effect that helps retail brokers doesn't work in this business; it is necessarily lumpy:
“The products have good profitability, but they have difficult profit profiles,” said Daniel Fields, head of global markets at Societe Generale SA until 2016. “They generally make reasonable returns over time, but they will create occasional large losses and that is difficult to manage.”
Also the retail brokerage's business will be kind of random: Its margin-loan portfolio will look like the stock portfolio of its customers, which in turn will look like the stock market. On the corporate side, the margin loans will be to a handful of people who have some particular reason to want to margin their stocks. That is ... worrying. Like, if I told you that the chief executive officer of Company X owns a billion dollars' worth of Company X stock and borrows as much as he can against it to spend on yachts and more stock, while the CEO of Company Y owns a billion dollars' worth of Company Y stock and never touches it and lives frugally off his salary, which company would you think is riskier? Which CEO has more of an appetite for adventure? Also:
Banks are particularly spooked by margin loans that have “wrongway risk,” executives said. This is when a borrower’s financial health is too closely linked to that of the shares pledged as collateral and they both decline at the same time, as was the case with Steinhoff, they said.
Here's another story about how dumb I used to be. I worked on a corporate equity derivatives desk when the Volcker Rule was being debated and passed in Congress. The Volcker Rule, most notably, forbids banks from doing "proprietary trading," which is usually described as making big bets in the securities markets with their own money. I walked around for weeks, probably, in a state of hidden anxiety, before I mustered the nerve to ask a lawyer: Wait, are we doing proprietary trading? Will the Volcker Rule shut us down? The lawyer laughed delightedly and patted me on the head. (I mean this was probably over the phone but let's pretend he did.) No of course we were not proprietary traders. We were the very definition of a client-facilitation business: All of our trades were designed to satisfy a client's needs, not to take a proprietary position.
You can understand my confusion. I spent all day targeting and pitching and getting on planes to try to get clients to do trades. It sure felt like we wanted to do the trades more than they did, like we were looking for the trades rather than just waiting for the clients to show up. And when we did get clients in the door, we didn't just match them up with someone on the other side; we took a big position with the bank's own money, a position that could lose lots of money if things went wrong.
But of course the lawyer was right and I am embarrassed now at my naïveté. Banks are in the business of doing trades for clients, and the way they conduct that business is by dreaming up trades for the clients to do and then pitching those trades to the clients. But they're still client trades. They still -- in the words of the Volcker Rule -- reflect "the reasonably expected near term demands of clients." They are designed to make money because clients pay for them, not because the underlying securities will go up. That difference -- where the profit expectation comes from -- is what distinguishes proprietary trading from customer-facilitation trading. But of course they are still ideas dreamed up by the banks, and pitched by the banks, and designed to make the banks money, and that can lose the banks money if the underlying securities go down.
Anyway the point is that if someone says to you "huh a bunch of banks did a derivatives trade that lost them a billion dollars? Isn't the Volcker Rule supposed to stop that?" you should laugh and pat them on the head and say no, of course not, of course not, the Volcker Rule is about proprietary trading, and this is not that at all. This is just about the banks having a billion dollars of exposure with their own money to the stock of Steinhoff, but it's totally different.
SEC vs. investors.
A well-known oddity about securities fraud lawsuits is that they tend to consist of investors suing themselves. If you are a shareholder of a public company, and you think that company lied to you to trick you into buying the shares, you can sue, and if you win then the company will pay you money. But you are a shareholder, which means that you are a part-owner of the company, which means that the money the company pays you will be your money. You'll just have to give a big chunk of it to your lawyers. It seems a little pointless. Of course there are mitigating factors: The class of aggrieved shareholders may not perfectly overlap with the current shareholders, and they may be able to recover some money from the company's insurers, or from its directors and officers personally. Still it is an uncomfortable system.
But it could be worse! For instance, the Securities and Exchange Commission sometimes sues a company for securities fraud, and wins (or settles), and takes a bunch of money from the company as a penalty. In a sense this is fine: The company did a bad thing, and the SEC is in charge of punishing it, and the monetary penalty is the punishment. But in another sense it is frustrating for shareholders: The specific bad thing that the company did was defraud shareholders, and the SEC's punishment is to take more money away from the shareholders. As a vindication of the public policy against securities fraud it is okay I guess; as a vindication of the rights of shareholders not to be defrauded it is kind of backwards.
Anyway here's a story about some shareholders who are suing Theranos Inc., which is not a public company but which did commit a whole bunch of securities fraud and settled with the SEC this month. In that settlement the SEC was actually quite considerate of the defrauded shareholders: It didn't fine Theranos, and punished founder Elizabeth Holmes mostly by making her give her Theranos shares back to the company, meaning that whatever value is left in the company still belongs to those shareholders. But the SEC is also pursuing Theranos's former president, Sunny Balwani, who has not settled, and who might actually have some money. The investors want that money too, putting them in conflict with the SEC that is supposed to be protecting them:
The investors’ lawyer, Reed Kathrein, said that while he doesn’t think Holmes has much left since the SEC settlement, which also required her to give up control of the company, he believes Balwani -- who is fighting the SEC’s claims and denies any wrongdoing -- has assets that they can pursue, pointing to a recent report by STAT that put his wealth at almost $100 million.
“We may be in competition with the SEC over those assets,” Kathrein said.
I keep saying that this is an oddity, but actually in this particular case it feels kind of right? Really, you should not defraud investors, and if you do you should have to pay a lot of money. But the opposite is not quite as true: If you are an investor, you should not be defrauded, but if you are you should ... not ... necessarily get your money back? Like, you probably should, most of the time. But there ought to be some incentives for due diligence too. You could imagine the SEC occasionally coming into a situation and thinking, look, this company defrauded these investors, but the investors kind of deserved it, so why don't we keep the money.
Stack That Money.
One of my biggest worries these days is that finance has gotten boring, a development that might be good for society but that would definitely be bad for my career. I can think of few more troubling signs that that is true than the fact that Zeke Faux, Bloomberg's great bard of penny-stock and pump-and-dump and payday-lending scams, has now turned his attention to Facebook advertising scams. Here is his story about a conference (a "Stack That Money" conference) for "affiliate marketers," who are a lot like pump-and-dump scammers except that they use fake stories to market "miracle diet pills, instant muscle builders, brain boosters, male enhancers" on Facebook rather than to market penny stocks on the pink sheets. Because it is lucrative and also because it is easy:
Affiliates once had to guess what kind of person might fall for their unsophisticated cons, targeting ads by age, geography, or interests. Now Facebook does that work for them. The social network tracks who clicks on the ad and who buys the pills, then starts targeting others whom its algorithm thinks are likely to buy. Affiliates describe watching their ad campaigns lose money for a few days as Facebook gathers data through trial and error, then seeing the sales take off exponentially. “They go out and find the morons for me,” I was told by an affiliate who sells deceptively priced skin-care creams with fake endorsements from Chelsea Clinton.
It is a cliché at this point that ambitious young people are shunning the financial industry for the tech industry, where they have a chance to make a difference and change the world and do good and so forth. I am always a bit skeptical of that cliché, because so much of the tech industry actually seems to be about optimizing ad targeting. It might be true of ambitious young scammers, though, anyway. For them, the ad targeting is the draw.
Here is a story from Bloomberg's Zachary Mider about "Robert Mercer's Secret Adventure as a New Mexico Cop," the basic point of which is that Mercer -- the former Renaissance Technologies co-CEO -- seems to have spent about six days a year patrolling Lake Arthur, New Mexico, as a volunteer policeman, which gave him the right to carry a concealed weapon anywhere in the U.S.
Lake Arthur has a population of 433, "no stores," and a crime blotter that includes "stolen pecans." We have talked a few times before about my dream for a sitcom in which a character based on Steven A. Cohen, banned from the securities industry for insider-trading-adjacent troubles, moves to a charming small town and gets into trivial disputes with his quirky neighbors, but the Mercer-in-Lake-Arthur story -- right-wing hedge-fund billionaire flies in to patrol tiny New Mexico town in order to get a concealed-carry license -- is crying out to be turned into a romantic comedy, or perhaps a David Lynch series.
The only problem is that the truth, with Mercer, is stranger than anything anyone could make up. "There seems to be an inexhaustible supply of incredible-but-true Mercer stories," writes Mider, "including his pioneering research that begat Google Translate, his funding of a stockpile of human urine in the Oregon mountains, his million-dollar model train set, and his habit of whistling constantly, even during work meetings." And then there is his daughter Heather Sue, a football player, baker and high-stakes poker player who married the Mercer family bodyguard who "once had a sideline making concealed-carry holsters out of elephant and ostrich skin" and who is Mercer's partner in many of his gun-related ventures. No one would believe any of these characters.
Will New York City "pass a law making it illegal for employers to require employees to check work email outside regular work hours"? No, no it will not, but wouldn't it be fascinating if it did? How would the financial industry respond? Ignore the law? Leave New York for Greenwich or Jersey City? Or decide to be kinder and gentler and stop worrying about responding to client demands at all hours? We talked a couple of weeks ago about efforts by Goldman Sachs Group Inc. and other banks to improve work-life balance; I argued that they are addressing real issues in banking culture, but that the harder problem is to rein in constant client demands. There is a coordination problem with that: If Goldman stops responding to a company's emails at 6 p.m., JPMorgan Chase & Co. would be happy to have that company as a client, and the company wants what it wants when it wants it. But if the law required every bank to stop responding to emails at 6 p.m., then that would be a real change for banking culture. Probably the change would be "moving to Jersey City," but you can imagine other outcomes.
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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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