The Crisis Was in the System

(Bloomberg Opinion) -- Crisis retro. 

We are only two days from the 10-year anniversary of Lehman Brothers Holdings Inc.’s bankruptcy, and there is too much crisis reminiscence to keep up with. So let’s talk about something else. Here is a series of tweets from Julia Carrie Wong about a recent profile of Facebook Inc. Chief Executive Officer Mark Zuckerberg:

I think one of my takeaways from the New Yorker profile of Zuck is that it’s time for tech journalism to move away from the idea that we can understand this industry by understanding the great men who built it.

Founder stories are much more interesting than product specs, and this profile is legitimately interesting, but what does it matter that we understand Zuck when Zuck himself so clearly doesn’t even understand Facebook.

“Zuck himself so clearly doesn’t even understand Facebook” strikes me as a completely fair and not even controversial position. Mark Zuckerberg built an online facebook for Harvard students. It became popular, and he turned it into a company with a vision “to make the world more open and connected,” and now it is enabling mob violence in India and ethnic cleansing in Myanmar and election interference in the U.S. and corporate emotional manipulation and the transformation of the news media and also probably just making people sad a lot. That list is sort of random, which is the point; no one at Facebook sat down to build an election interference function. They sat down to build a system for purposes that they thought were good, and are happy to brag to you about: sharing baby pictures, connecting the world, making piles of money by showing you ads, that sort of thing. All — most, anyway — of the bad effects of Facebook are emergent features of the system that they built for the good effects; that system itself, and its messy interactions with billions of people out in the real world, creates the bad effects.

I don’t mean to claim that Zuckerberg, or anyone else at Facebook, is or is not responsible in some moral or legal sense for the bad effects of Facebook, or that those effects could or could not or should or should not have been predicted, or that they can or can’t be fixed, or whatever. I just mean to endorse Wong’s claim that if you want to understand Facebook, the main thing you have to understand is Facebook, the product and architecture and algorithms and effects and interactions, the system of it. Understanding the people who built it is not a substitute for that, because the system has moved beyond their conscious control. Facebook does things in the world that are not directly willed by the people who built it; to understand and predict those things, you don’t interview its founder, you examine its workings.

These are good things to think about on the anniversary of the financial crisis. Business and financial journalism has always had a bias toward the great-man theory of business and finance, because colorful quotes from larger-than-life CEOs about their personal rivalries and triumphs and failures and goals and values and extracurricular activities tend to be more conventionally interesting (and easier to explain) than, say, the cash waterfall of a synthetic collateralized debt obligation on residential mortgage-backed securities. And certainly since the financial crisis there have been lots of efforts to find villains, and to find heroes, and to show that the heroes were really villains or vice versa, and to understand and dramatize the human desires and failings that motivated them.

But for the most part people now understand that the financial crisis was a crisis of systems, that understanding it and preventing the next one is about system design rather than personal morality. What brought down the global economy was the instability of a set of complicated interlocking architectures — mortgage securitization, credit derivatives, short-term wholesale bank funding, the bank/shadow-bank nexus, etc. — that in many cases the bank CEOs themselves barely understood. The actual workings of those things — how repo funds flowed, what collateral-call rights existed in credit-derivative agreements, what correlation assumptions ratings agencies made in assigning ratings to CDO-squareds — are what mattered, not the charisma or intent of the CEOs. The thing to understand is the thing itself, not what the people who (supervised the people who supervised the people who supervised the people who) built it thought or felt about it. 

Anyway, here’s a collection of Bloomberg Opinion articles on the Lehman anniversary, including an editorial about how “We Never Learned From Lehman” and columns from Brian ChappattaMohamed El-Erian, Edward Evans, Nir KaissarAndy Mukherjee and Matthew Winkler. And elsewhere:

  • DealBook has a special edition on the Lehman anniversary, which includes Jamie Dimon telling people in the JPMorgan Chase & Co. executive dining room on Saturday, Sept. 13, that things were bad, “So you might as well enjoy the champagne and caviar!” 
  • Neil Irwin defends “the engineers of the American crisis response” on economic terms but argues that “the response to the crisis was in many ways the high-water mark for a mold of centrist, technocratic policymaking that seeks to tweak and nudge existing institutions toward better outcomes” and “undermined any widespread popular support for that mode of governing for the foreseeable future.”
  • Laura Noonan and Patrick Jenkins write about how JPMorgan has thrived since the financial crisis, with a particular focus on the personal influence of its charismatic larger-than-life CEO. (To be fair, if there’s one person in the financial world who has built a large and complicated edifice and managed to stay on top of all of it, it’s probably Jamie Dimon.)
  • “Bernanke Admits Fed Made Mistakes Combating Crisis 10 Years Ago.”
  • “The Epicenter of the Housing Bust Is Booming Again. (That’s a Warning Sign.)”
  • Here’s a song called “Who Killed the Lehman Bro?” 

Short and distort.

You know, just yesterday I went and made some nice generalizations about short sellers. I asserted that they often believe their own patter, that they work to “make markets more efficient, deflate bubbles, root out fraud and delusion, and generally make the world better with their unpopular and negative activity,” that they’re mostly not going around dishonestly sabotaging perfectly good companies. And then, for my troubles, the Securities and Exchange Commission brought a fraud case against Gregory Lemelson, a hedge fund manager who is also a Greek Orthodox priest, accusing him of running a “short-and-distort scheme” in which he shorted the stock of Ligand Pharmaceuticals Inc. and “made a series of false statements to shake investor confidence in Ligand, lower its stock price, and increase the value of his position.” 

Well I mean obviously you are not supposed to do that! (Lemelson denies the charges and says that “The commission chose to bring this case based upon its enforcement staff’s personal feelings and facts be damned, win-at-any cost ambitions.”) The SEC’s case is based on five negative reports that Lemelson published in 2014 for his $15 million hedge fund the Amvona Fund LP, distributing them to newswires and places like Seeking Alpha, Benzinga and Value Walk.

Honestly I am a little underwhelmed by them? From the SEC’s summary, they sound silly, and certainly unduly alarmist — one was titled “Institutional Holders waste no time dumping stock in response to Insolvency and bankruptcy risk,” and Ligand is fine and a $5 billion company now — but, I don’t know, if you hang around on stock message boards I feel like you become inured to this sort of thing? The SEC quotes them saying things like “Ligand’s fair value is roughly $0 per share, or 100 percent below the current stock price,” and “the intrinsic value of Ligand shares must be reaffirmed as $0 with downside risk justifiably calculated at 100%,” and after reading those sentences I was utterly unable to take the rest of it seriously. If someone bothers to do the math to tell you that $0 is 100 percent below today’s price, and to dress it up with that much verbiage, he is playing at seriousness, dressing up in his Big Hedge Fund costume to disguise a lack of substance. 

Lemelson allegedly asserted that Ligand’s main drug, Promacta, would soon be obsolete (in fact, Promacta revenues have increased each year since 2014), mischaracterized a conversation with a Ligand investor-relations person to claim that the IR person agreed with that assessment, quoted a doctor saying the same thing without disclosing that the doctor was also an Amvona investor, and claimed that Ligand was “indirectly creating a shell company … to generate paper profits to stuff its own balance sheet.” There are no allegations here of elaborate schemes to cleverly trick sophisticated investors into believing that a legitimate company was going bankrupt, no devastating revelations based on clearly false factual claims. It was just a guy spreading some breathless worries. 

Frankly the alarming thing is that it could work so easily. “A major financial news organization noted that Ligand’s stock price ‘fell more than 7 percent’ after Lemelson published his report claiming that demand for Promacta was rapidly declining,” says the SEC. (Disclosure: That was Bloomberg, in a report about the SEC’s investigation of Lemelson; also, “Lemelson unsuccessfully sued Bloomberg” for that report.) This was a billion-dollar company moving dramatically on just some guy typing stuff on some message boards. I am not generally sympathetic to corporate managers who complain about dishonest short sellers undermining their companies. “If your company is actually good,” I wrote recently, “then it just doesn’t matter that much if some hedge funds say that it is bad. Just do the work and let your results speak for themselves.” I still mostly believe that — Ligand, after all, is fine! — but it does seem weirdly easy for short sellers to shout over results.

Also here’s a hilarious Wall Street Journal profile of Lemelson from 2015 in which he says this:

He recalled the moment when he became serious about investing.

“I said, ‘They are going to have to bar me from the securities markets, because I would make too much money,’” he said.

The Lord, I think it is fair to say, works in mysterious ways. 

The Problem of Twelve.

Here is a recent paper by John Coates of Harvard Law School with the imposing title “The Future of Corporate Governance Part I: The Problem of Twelve.” The “problem of twelve” is his name for “the likelihood that in the near future roughly twelve individuals will have practical power over the majority of U.S. public companies”: 

We are rapidly moving into a world in which the bulk of equity capital of large companies with dispersed ownership will be owned by a small number of institutions. Those institutions, in turn, are ultimately controlled by a small number of individuals. For any given portfolio company, the ownership rights – most importantly the right to vote in election of directors – will be controlled by a small number of individuals working for those institutions. It is not an exaggeration to say that even if this mega-trend begins to taper off, the majority of the 1,000 largest U.S. companies will be controlled by a dozen or fewer people over the next ten to twenty years.

We talk about this problem from time to time under another name, “should index funds be illegal?” The concentration of control over most public companies into a small group of large institutional investors has attracted a lot of attention, and much of it is focused on the worry that those institutional investors replicate some of the features of the “trusts” that were busted, a century ago, by antitrust law. If all the companies in an industry — in every industry — are owned by Vanguard and BlackRock, won’t they work together to reduce competition, drive up prices, and earn monopoly profits for their common owners? Shouldn’t antitrust law concern itself with shared ownership of competing firms by large institutional investors? Or that is the worry.

But Coates’s worry is broader, and his proposals are less specific and more conceptual; it is not so much that concentrated ownership is anticompetitive and ought to be broken up, but that concentrated ownership is weird and new and ought to be thought about. What does it mean for a dozen people to control the U.S. economy? Do the rules that we have now — rules of corporate governance and securities regulation and fiduciary duty and antitrust and all the rest — make sense in a world of such concentrated institutional ownership? Does this new structure of power call for new rules to control it?

One inspiration may be administrative law, which has to grapple with similar problems of legitimacy and accountability for agents of the state. Another model is corporate law, including the array of governance features that institutional investors have pressed upon public companies. Conflicts of interest, for example, could be more extensively regulated or more intensively policed with public or private enforcement. Index fund agents could be banned from taking political or corporate office after retiring from the index funds. Disclosure of potential conflicts could be coupled with active management of conflicts by independent agents accountable to the investors in the index funds. Why is it important, after all, to insist upon independent directors of public companies but then permit the index fund agents overseeing those directors to not be independent as well?

“Institutional investors demand good-governance practices from corporations that they do not follow themselves” is sort of a commonplace these days, but the idea of administrative law for index funds is fascinating. If an index provider decides to exclude companies with dual share classes from its indexes, or if an index fund decides to vote with management in a proxy fight, should it have some sort of public accountability process? Should it give notice and hold hearings and allow interested parties to comment? Should it create a record of its deliberations? Should courts be able to review its decisions for arbitrariness? I don’t know, it seems like a hassle. But it also seems wrong to think of these institutions as purely private actors with the same modest fiduciary responsibility to their investors that any small hedge fund would have. They’re a bit more than that; their size gives them power and public importance. Should it also give them more responsibilities? 

Market structure.

“IEX Group, the two-year-old stock exchange known for putting a ‘speed bump’ on trading, now has its first stock listing, as Interactive Brokers announces plans to move there from Nasdaq,” so congrats everyone. I was bullish on IEX listings for a long time, on the theory that IEX appealed not only to people who were really into the details of market structure but to people who liked general notions of fairness, transparency and sticking it to high-frequency traders. I had assumed that that described lots of corporate chief financial officers: “An anti-HFT stock exchange? Sign us up!” I seem to have overestimated that effect. It is interesting that the actual first firm to list on IEX turns out to be a retail brokerage that is very concerned, in its actual business, with the routing and execution of stock orders. There are only so many firms like that! Ideally your listings business will appeal to people who don’t care professionally about market structure.

Elsewhere, here is a somewhat speculative Seeking Alpha post by Logan Kane arguing that Robinhood Markets Inc., which lets you trade stocks for free on your phone, collects higher payments for order flow from electronic market makers than other retail brokerages do. (Robinhood and the other brokers do not report payments for order flow on a comparable basis, and so Kane makes some assumptions about average stock price to compare them.) I don’t have any particularly strong views about this, but one thing I will say is that “Robinhood sounds good because it is free but it is actually bad because it takes payments for order flow” seems like a less intuitive take than “payment for order flow sounds bad because it is a disguised kickback, but is actually good because it allows you to trade stocks for free.” Yes, sure, when electronic market makers pay for phone-based order flow from retail millennial day-traders, that segments markets and might make it harder for big investors to get tight spreads and good executions on public markets. But on the other hand those retail day-traders get execution at prices that are at least as good as those on public markets, and they get to trade for free. For them, what’s not to like?

Things happen.

Jamie Dimon Quickly Backtracks on Bragging He Could Beat Trump. “At one point, Equifax grew so worried it began building a way to monitor the computer activity of all of its ethnic-Chinese employees.” EY hits back at calls to break up Big Four accounting firms. “Tobacco stocks are rallying the most in a decade following the U.S. Food and Drug Administration’s announcement that it’s cracking down on e-cigarettes in an effort to combat youth vaping.” In Activist’s Quest to Remake Campbell Soup’s Board, Heirs Hold the Key. Tesla investor says SEC asked it about 'funding secured' tweet. Boring Company approved to build a tunnel entrance inside a residential garage. Bill Gross’s Losses Mounted in First Half After Loading Up on Futures. “It's a tourist city. They have a famous cathedral there, Salisbury Cathedral. It's famous throughout Europe and, in fact, throughout the world, I think. It's famous for its 123-meter spire.” Author of 'How to Murder Your Husband' arrested for allegedly killing her husband

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Matt Levine is a Bloomberg Opinion columnist covering finance. 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 3rd Circuit.

©2018 Bloomberg L.P.