Not Stressing the Stress Tests

(Bloomberg Opinion) -- Programming note: Money Stuff will be off tomorrow for U.S. Independence Day, back on Thursday.

Stress tests.

Here is a weird story about how Goldman Sachs Group Inc. and Morgan Stanley managed to pass the Federal Reserve’s stress tests without actually getting a passing score. Goldman and Morgan had asked to return about $16 billion to shareholders between them, but that would take their stressed capital levels below the minimum requirements on the stress test. So the Fed called them and said that if they cut those requests in half—to about $8 billion—then they’d get passing grades. But it also offered them another choice:

But Fed officials gave the banks an unprecedented option: If they agreed to freeze their payouts at recent levels, they would get a “conditional non-objection” grade and avoid the black eye of failure. That meant the banks could pay out a combined $13 billion, or about $5 billion more than what they would have given back to investors if they had decided to retake the test and get a passing grade.

One thing that’s weird about it is just, you know, it’s weird for the Fed to cut banks slack on the stress tests. But the other thing that’s weird about it is how the Fed chose that $13 billion number. With a capital return of $8 billion, they’d pass the tests. With a capital return of $16 billion, or $13 billion, or $11 billion or $29 billion for that matter, they’d fail. Obviously they’d fail by less at $13 billion than they would at $16 billion, but why is that particular level the new phantom cutoff? Well, because that’s the level that matches their recent level of capital return. (They got to choose how recent. “The two banks could peg their shareholder payouts to one of two levels: either the amount they paid out over the past year, or an annualized average of its payouts over the past two years,” and each bank chose a different option to maximize its respective payout.)

It’s a bit of an odd message, suggesting that whatever you did last year is presumptively fine this year, even if technically it causes you to fail the stress tests. It creates a sense of a one-way ratchet, that each time a bank gets permission to give back a certain amount of capital then that becomes its normal capital return, and that future stress tests are mostly about whether it can increase that amount, not whether it must decrease it. 

Elsewhere, Lauren LaCapra pointed out an amusing fact about the stress tests and Wells Fargo & Co. The basic rule of bank capital regulation—and the stress test is just a complicated form of capital regulation—is that you need to have equity capital equal to at least X percent of your assets (risk-weighted assets, stressed assets, etc.). Most bankers want to have as many assets as possible (because running a big important bank makes them feel big and important), with as little equity as possible (to maximize return on equity, etc.). Capital regulation constrains those desires, and forces bankers to make tradeoffs: If they want more assets they need more equity; if they want to reduce equity they need to reduce assets. In an environment of moderate lending growth and robust bank profits that choice is fairly straightforward: You have all the equity you need to support all the assets you’re likely to get, so you just return more or less all of your profits to shareholders. 

But Wells Fargo has an additional constraint: Because it did bad things involving fake accounts, etc., the Fed punished it by forbidding it from increasing its assets. It is subject to capital regulation and stress testing like everyone else, but when it passes the stress tests there is only one knob it can turn:

The Fed, as punishment for a string of scandals, has told Wells Fargo that it cannot increase the size of its balance sheet until the Fed is satisfied that the bank has rectified its problems. As a result, Wells Fargo appears to be paying out capital it might otherwise have used to finance a greater amount of loans. Its payout ratio in 2017 was 99 percent, according to Barclays.

So it will pay out 141 percent of its expected earnings over the next year, well above the payout ratios that most other big banks have planned.

“The most interesting and perverse stress test story is how the Fed effectively prodded Wells to return capital to shareholders rather than make loans,” tweeted LaCapra, and while I agree that it’s interesting I am not sure it's perverse. The Fed didn’t prod Wells to return capital rather than grow its balance sheet: It literally exactly mandated that. It told Wells Fargo that it couldn’t increase its assets (the denominator of its capital ratios), and so Wells Fargo will optimize capital the only other way it can, by decreasing its equity (the numerator).

One way to think of this is as a conflict between giving money to shareholders (which people tend to think is bad), or lending it to customers (which people tend to think is good). Given that opposition, the Fed’s choice looks perverse.

But the way I usually think about stock buybacks is as a simple question of corporate finance, which is: Given a dollar of profits, is it better that a company’s management keep that dollar, or that the shareholders have it? Who will make better use of that dollar? And the Fed’s position on that is really clear! Its position is: Wells Fargo, we have quite as much of you as we want. No additional Wells Fargo, please, until its problems are fixed. At this point, a bigger Wells Fargo would be bad for society, is the Fed’s clear implication. And so if Wells Fargo comes into any money, it should give it to someone else. And given the way corporations work, that someone else is its shareholders.

Everything is securities fraud.

  1. If you are a public company that runs a social networking site, and you give your users’ data to shady people without their permission, and then when you’re caught you just endlessly make false public statements about it, then that is, arguably, bad.
  2. Specifically it is arguably bad for those users—I mean, I guess; they liked their data, wanted to control what happened to it, etc., I don’t know—and, perhaps, in certain cases, it is bad for democracy and social cohesion and so forth.
  3. The U.S. regulatory regime governing what social networks have to disclose to their users and how they can use user data, and setting penalties for misleading disclosures or misuse of information, is sort of unclear and fragmented and untested; social networks haven’t even been around for that long.
  4. The U.S. regulatory regime governing social networks’ obligations to democracy is basically nonexistent, though there are plenty of congressional hearings about it.
  5. But the U.S. regulatory regime governing what happens when public companies make misleading disclosures to their shareholders is really really clear, and has been clear for decades, and there is a large and specialized enforcement apparatus that is solely focused on it.

The upshot is that when you tell users “we are not using your data nefariously” and then it turns out that you are, or when you tell the public “we are not doing nefarious things to democracy” and then it turns out that you are, you will get in trouble, but not for doing the nefarious things, and not for lying to users, and not for lying to the public. (I mean, you might get in trouble for those things, but it’s novel and complicated.) But you will get in trouble for lying to your shareholders—who are, after all, part of the public, so if you lie publicly you are lying to them—at least if your stock goes down.

As a regulatory regime this is:

  • intellectually kind of a mess, but
  • convenient.

I mean, it’s convenient for the generic governmental purposes of Punishing People Who Do Bad Things, even if not quite punishing them for the bad things they did. (It’s not convenient for the companies, exactly, though it does at least provide clarity: You know that publicly lying is going to get you in trouble, without having to analyze specific regulatory regimes governing specific types of lies.)

A federal investigation into Facebook’s sharing of data with political consultancy Cambridge Analytica has broadened to focus on the actions and statements of the tech giant and now involves multiple agencies, including the Securities and Exchange Commission, according to people familiar with the official inquiries. …

Facebook discovered in 2015 that Cambridge Analytica, which later worked for the Trump campaign, had obtained Facebook data to create voter profiles. Yet Facebook didn’t disclose that information to the public until March, on the eve of the publication of news reports about the matter.

The questioning from federal investigators centers on what Facebook knew three years ago and why the company didn’t reveal it at the time to its users or investors, as well as any discrepancies in more recent accounts, among other issues, according to these people. The Capitol Hill testimony of Facebook officials, including Chief Executive Mark Zuckerberg, also is being scrutinized as part of the probe, said people familiar with the federal inquiries.

The maximalist version of the Cambridge Analytica story is something like “Facebook has the power to install or remove governments across the world, and allowed the wrong people to use that power.” If you believe that version of the story, then it is odd to think that the people harmed by it were Facebook shareholders. Arguably being the world’s kingmaker is good for the shareholders! The stock is up since Donald Trump was elected.

Blockchain offerings.

JA Energy was a public company that “claimed that it was in the business of ‘designing a suite of modular, self-contained, fully automated, climate controlled units for distributed production of energy,’ although it never sold any products.” Instead it became an empty shell that waited around on the public markets until it could fulfill its destiny of becoming a blockchain company. And so it did: It was acquired by a Hong Kong investor, changed its name to UBI Blockchain Internet Ltd, and in February 2017 “disclosed an entirely new and vaguely defined business plan focusing on ‘the research and application of blockchain technology with a focus on the Internet of things covering areas of food, drugs and healthcare.’” (These quotes, needless to say, are from a Securities and Exchange Commission complaint.)

UBI Blockchain then set about monetizing its name change and blockchain pivot by selling stock to the public. It filed a registration statement saying that its selling shareholders would sell stock “at market prices prevailing at the time of the sale, at prices related to such prevailing market prices, at negotiated prices or at fixed prices, which maybe changed.” The SEC said, no dice:

On June 5, 2017, staff from Corp Fin issued a comment letter to UBIA stating that the registration statement must include a fixed price at which the selling shareholders would sell their shares in the offering. …

UBIA was not eligible to conduct a primary "at the market offering" pursuant to Securities Act Rule 415(a)(1)(x) and Rule 415(a)(4) because it was not eligible to use Form S-3 to register a primary "at the market offering." The company was not eligible to use Form S-3 in part because it did not have an aggregate market value of voting and non-voting common equity held by non-affiliates, also known as a public float, of $75 million or more. …

The reason for the requirement that a company must have a minimum public float to do an "at the market offering" is the concern that, without a sufficiently large float, the market cannot efficiently absorb information about the company and reflect it in the price. … In addition, the Commission has observed that "the securities of smaller public companies are comparatively more vulnerable to price manipulation than the securities of larger public companies, and may also be more prone to financial reporting error and abuses."

The SEC’s worry is that if a tiny public company with limited float and not much of a trading market oh, say, I don’t know, announces vague plans to pivot to the blockchain, then the stock might shoot up for no good reason, and unscrupulous insiders might be able to unload their stock at ridiculously inflated prices before the market wised up. And so UBI Blockchain went and added a fixed price for its shares of $3.70.

But it gave some shares—a total of about 2.5 percent of its stock—to two guys, T.J. Jesky and Mark DeStefano, who did some legal work for UBI Blockchain. It registered those shares for them so they could sell in the offering. At $3.70. And they ignored that and sold about 50,000 shares for prices between $21.12 and $48.40, because in fact the SEC’s fears came true and the stock shot up for no good reason before trading was halted. And yesterday the SEC sued Jesky and DeStefano, who settled by agreeing to pay back the $1.4 million they made and another $188,682 in penalties. 

With the rise of crypto currencies and blockchain, you sometimes see people complaining that securities regulation is outdated, that this new paradigm has fundamentally changed how people invest and finance new businesses, and that the SEC can’t keep up. At the high end of the market—where people are trying to pursue genuinely new methods of financing unowned decentralized projects that are hard to fit into existing categories—there might be some truth to that. (Though the SEC actually seems to be open to innovation there.)

But at the low end of the market, where I sit, reading about frauds and pump-and-dump schemes and vague pivots to blockchain that bring in millions of dollars, it is impressive how well the SEC’s rules and categories and enforcement fit the new world. The rule against at-the-market offerings for small new public companies, for instance, sounds in the abstract like the sort of arcane rule that would be outdated in a new world of crowdfunding and tokenization and instantaneous peer-to-peer trading. But it was exactly tailored to UBI’s situation: This was a company whose stock soared on pure hype, and whose insiders tried to cash out on that hype, and the SEC stopped them because it had just the right rules to deal with the problem.

Of course this is not because the people writing the securities laws in the 1930s somehow foresaw the blockchain. It’s because, at the low end of crypto innovation, the new tricks are exactly the same as the old tricks. The buzzwords are new, the particular things being hyped are new, but the mechanisms of how they are hyped and how the promoters profit from that hype are at least a century old. 

Should ETFs be illegal?

One of the more amusing critiques of the rise of index funds and exchange-traded funds is that, as Inigo Fraser-Jenkins at Sanford C. Bernstein & Co. memorably put it, they are “Worse Than Marxism.” What that means is that in a communist planned economy, decisions about investment and capital allocation are made by central planners, and those decisions have a reputation (at least among U.S. equity analysts) of being less efficient than the decisions made by the invisible hand of the stock market. But in an economy ruled by index funds, decisions about investment and capital allocation simply aren’t made: Investors buy stocks because they are in the index, not because they like the companies’ prospects, and so the price signal of the stock market, which tells companies what ideas are worth pursuing and where they should invest their resources, is attenuated. It’s even worse than central planning; it’s no planning.

In its strongest form this thesis sounds pretty funny, but here are a blog post and related paper on “ETF Ownership and Corporate Investment” by Constantinos Antoniou and Onur Tosun of the University of Warwick and  Avanidhar Subrahmanyam of the University of California at Los Angeles.

We hypothesize that, since ETF ownership makes stock prices more volatile and less informative, it adversely affects the ability of managers to learn about the prospects of their firms from stock prices. Therefore, for firms highly owned by ETFs, the positive relationship between investments and stock prices should be weakened.

We test this hypothesis using three different corporate investment measures: capital expenditure, capital expenditure plus R&D, and change in assets. In our models we use Q as a measure of normalized price (calculated as the market value of equity plus the book value of total assets minus book value of equity scaled by book value of total assets), where higher Q values indicate better growth opportunities. The variable of interest for our hypothesis is the interaction between ETF ownership and Q, which we expect to be negative, so that for high ETF owned firms, real investment is less sensitive to stock prices.

The results strongly confirm our hypothesis. Using data on a sample of U.S. firms from 2000 to 2014, and models that include several firm level controls as well as firm and time fixed effects, we find that the coefficient on the interaction between ETF and is negative and statistically significant, for all three investment policy measures. …

We find that the negative relationship between Q and ETF is more pronounced among larger, older and less volatile firms, with better governance systems, operating in high competition industries, and managed by CEOs with longer tenure. Collectively these results suggest that the adverse effect of ETF ownership on the ability of managers to learn from prices is concentrated in cases where managers are more likely to rely on prices for information.

If you run a wild disruptive unicorn, you are making your own visionary decisions about what projects to pursue. If you run a big stable old public company, you are more likely to be pursuing “shareholder value” by pursuing the projects that the stock market tells you to pursue. If the stock market has stopped talking to you, then you might be a bit adrift.

Things happen.

Former Malaysia Prime Minister Najib Arrested in 1MDB Probe. Judge Rules PricewaterhouseCoopers Must Pay $625.3 Million in Damages. KPMG Was Key Witness as Investment Firm Abraaj Unraveled. Glencore Slumps as U.S. Orders Documents in Corruption Probe. How Michael Dell’s financial engineering created a fortune. IPO Market Posts Blistering First Half. Payday-Loan Mogul Indicted for Masterminding Phantom Debt Scheme. Millennials’ favourite gadgets dragged into trade war. Vanguard Will Let Investors Trade Its Rivals’ Funds Online for Free. Tech Elites Recreate Burning Man Inside Their Living Rooms. “Within two hours of joining the agent team, I was on the phone with the Vatican, sorting out the logistics of having the pope marry an interfaith couple on their elopement-cum-honeymoon.” Wallace the mule refused permission to compete in dressage.

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