Sinful Derivatives Have Their Uses

(Bloomberg Opinion) -- Is CDS evil?

Has the Pope been following the Hovnanian Enterprises Inc. trade? Yesterday the Vatican released a bulletin on economic issues, “Oeconomicae et pecuniariae quaestiones,” that spent multiple paragraphs criticizing derivatives in general and credit-default swaps in particular:

It is obvious that the uncertainty surrounding these products, such as the steady decline of the transparency of that which is assured, still not appearing in the original operation, makes them continuously less acceptable from the perspective of ethics respectful of the truth and the common good, because it transforms them into a ticking time bomb ready sooner or later to explode, poisoning the health of the markets. It is noted that there is an ethical void which becomes more serious as these products are negotiated on the so-called markets with less regulation (over the counter) and are exposed more to the markets regulated by chance, if not by fraud, and thus take away vital life-lines and investments to the real economy.

A similar ethical assessment can be also applied for those uses of credit default swap (CDS: they are particular insurance contracts for the risk of bankruptcy) that permit gambling at the risk of the bankruptcy of a third party, even to those who haven’t taken any such risk of credit earlier, and really to repeat such operations on the same event, which is absolutely not consented to by the normal pact or insurance.

The market of CDS, in the wake of the economic crisis of 2007, was imposing enough to represent almost the equivalent of the GDP of the entire world. The spread of such a kind of contract without proper limits has encouraged the growth of a finance of chance, and of gambling on the failure of others, which is unacceptable from the ethical point of view.

In fact, the process of acquiring these instruments, by those who do not have any risk of credit already in existence, creates a unique case in which persons start to nurture interests for the ruin of other economic entities, and can even resolve themselves to do so.

The document does not appear to be available in Latin, which is disappointing, as you cannot exactly say that it reads like English. As for its economic analysis, it feels a little old-fashioned, doesn’t it? The fact that the CDS and securitization markets were enormous and risky in 2007 is interesting as a matter of historical fact, but arguably not a reason to excommunicate them in 2018, when they are smaller and more chastened. The Vatican takes the long view, though, and there is no reason to expect it to react to financial developments in anything like real time. It will be centuries before a new Dante describes a new circle of Hell where the CDS traders go.

Something else feels old-fashioned about it. The idea that CDS buyers “start to nurture interests for the ruin of other economic entities, and can even resolve themselves to do so,” is a standard one. People worry that “empty creditors,” who own a company’s debt but are hedged with CDS, will have an incentive to force it into bankruptcy, and they worry that “naked CDS” positions give speculators an incentive to attack otherwise viable companies.

But all the recent CDS controversies look very different. In the Hovnanian trade, which we have talked about many times, an “empty creditor”—a hedge fund that owned Hovnanian debt but also owned CDS—came to the company with a solution for its money problems. Now, yes, that solution involved it defaulting on its debt, I cannot deny that, but the default was tiny and contained and allowed Hovnanian to finance itself more cheaply. It involved a transfer of money from the CDS market (specifically CDS sellers) to the company (and sure also CDS buyers). In the less-discussed but also delightful McClatchy Co. trade, meanwhile, a CDS seller came to the company with a solution to its money problems, one that happened to transfer money from CDS buyers to the company (and the sellers). In both cases, the CDS market was harnessed not to “take away vital life-lines and investments to the real economy,” but to provide those life-lines. More houses can get built, and more newspapers can get printed, because of these CDS trades.

In sneaky and upsetting ways, sure, fine, and that is part of what the Vatican is objecting to. (I think? I don’t really know how to parse “really to repeat such operations on the same event, which is absolutely not consented to by the normal pact or insurance”; again I think it might make more sense in Latin.) And it is certainly tough when the Commodity Futures Trading Commission, Goldman Sachs and the Pope all object to your CDS trade. But surely the Pope can’t object that much to CDS traders ripping each other off, since both sides of the trade were sinful anyway?

The real objection seems to be the one about the “vital life-lines,” the idea that all this frenzy of derivatives takes economic activity away from the real world and puts it instead into a wasteful zero-sum casino. That too is a standard worry, but it feels strange to derivatives people. Sure a derivative is a zero-sum side bet not directly involving the real underlying economic activity, but that is just a formal distinction. Derivatives trading works by arbitrage; if the price of a derivative and the underlying thing diverge, then someone will trade in the underlying thing to bring them back in line, meaning that derivatives markets constantly and inevitably affect the real underlying world. Mortgage securitizations made it easier to build more houses. (Too many houses, sure!) Bitcoin futures arguably affected the price of real Bitcoins. And zero-sum side bets on CDS can, it turns out, be transformed into actual loans to struggling companies. 

There is nothing unexpected about that. It is the central magic of the financial system: Derivatives make it easier to find the right price for something, and finding the right price for a thing allows real resources to flow into it. If you are a believer in that magic, the entire world can seem suffused with the power of derivatives, and those derivatives can be harnessed to do real good in the world. You just have to have some faith.

CBS v. Redstone.

We have talked all week about the weird drama at CBS Corp., where the board of directors is trying to get rid of its controlling shareholder, Shari Redstone’s National Amusements Inc., because it claims Redstone wants to force through a merger with Viacom Inc. Somehow the situation got even weirder yesterday, with a Schrödinger weirdness whereby the board has voted to get rid of Redstone, while Redstone has voted to make that impossible, and each of those results is contingent and hypothetical and awaits ultimate resolution by a Delaware chancellor. Eventually, probably months from now, we will find out that the board got rid of Redstone yesterday, or it didn’t, but meanwhile they will have to live together in quantum superposition and also extreme awkwardness.

What happened? Well, first of all, on Wednesday, Redstone amended CBS’s bylaws to, “among other things, require approval by 90% of the directors then in office at two separate meetings held at least twenty business days apart in order to declare a dividend,” which would prevent the board from carrying out its plan to declare a voting-stock dividend that would dilute Redstone’s voting power from 79.6 percent down to 17 percent. (Three of CBS’s 14 directors are NAI designees, including Redstone, so that would practically kill the dilution-by-stock-dividend plan. NAI’s economic interest in CBS is about 10.3 percent, but it owns most of the voting stock.)

Then, on Thursday, Delaware Chancellor Andre Bouchard ruled against CBS’s request for a temporary restraining order to prevent Redstone from doing, um, the thing she had just done. The board had asked Bouchard to order Redstone and NAI not to interfere with the board meeting intended to dilute her, and he said no: “No precedent has been identified, however, in which the court has ever entertained, much less sanctioned, the type of request for relief that plaintiffs make here.” He added that the board’s worries are overblown: Its stated reason for diluting Redstone was to prevent her from forcing through a Viacom merger that would be bad for CBS shareholders, and Bouchard pointed out that there are lots of less drastic ways for him to do that. “To the contrary, the court has extensive power to provide redress if Ms. Redstone takes action(s) inconsistent with the fiduciary obligations owed by a controlling stockholder.”

He was less dismissive than I was, though:

On the other hand, there is a line of authority emanating from Mendel v. Carroll, where Chancellor Allen expressed an openness to “the possibility that a situation might arise in which a board could, consistently with its fiduciary duties, issue a dilutive option in order to protect the corporation or its minority shareholders from exploitation by a controlling shareholder who was in the process of threatening to violate his fiduciary duties to the corporation.” It could be argued that, implicit in this reasoning, it would be reasonable in an appropriate circumstance to afford a board “breathing space” to deliberate over such options free from the preemptive power of a controller by affording temporary relief of the type plaintiffs seek here. 

And then later on Thursday the board held its meeting to dilute Redstone (which she attended), and voted 11 to 3 to do it. Well, not exactly to do it, but to do it if it turns out to be legal:

The payment of the dividend is conditioned on a final determination by the Delaware courts, including a final decision on or the exhaustion of time for any appeals, that the dividend is permissible. The record date for the dividend will be 10 days following such final determination by the Delaware courts or on the next business day after the end of such 10-day period. 

It probably isn’t legal, both because it is ridiculous in itself (directors can’t really get rid of a controlling shareholder just to prevent her from firing them, can they?) and also because it violates Redstone’s new bylaws. But I guess it is in the queue now anyway, and if the Delaware courts eventually rule that it worked, then it will have worked. 

But in any case it hasn’t worked yet; even if the dividend does turn out to be valid then it won’t be distributed for ages. Which means that Redstone still controls about 80 percent of CBS’s stock, and can easily vote the directors out. There is an argument for her not to do that—basically, the nicer and more conciliatory she is, the less justified the board’s concerns look, and the more likely the court is to side with her—but I have to say, if I were her, I’d fire them all today. I guess I would make that firing also contingent on a Delaware court’s approval. And so you’d end up with two parallel CBSes, one with Redstone as a controlling shareholder and a brand-new board, and another with the old board and no controlling shareholder, and they’d both go along making their own decisions for months until a court sorted out which was the real CBS. 

Crypto scammo.

“In a review of documents produced for 1,450 digital coin offerings, The Wall Street Journal has found 271 with red flags that include plagiarized investor documents, promises of guaranteed returns and missing or fake executive teams,” which … seems … low? Perhaps my sample is biased because people send me the worst ones, but if you had asked me “what percentage of initial coin offerings are transparent nonsense,” I would have guessed somewhere north of 50? But the Journal found obvious red flags in only 18.7 percent of deals. Great!? The red flags are pretty bad though:

The Journal found lawyers in California, an escrow agent based in Ukraine and the co-owner of a media company whose identities had been hijacked in order to lend credibility to a range of cryptocurrency projects involving education, e-commerce and crypto mining.

“I’m a little creeped out by the whole thing,” said Amanda Gavin, co-owner of a media production company in San Francisco, whose image and name were taken from her LinkedIn page and used for a coin offering she had never heard of called Pixiu.

I tell you what, if you come across an ICO that uses my picture, (1) it is fake and (2) please do send it my way. Unless I have specifically advertised it on Money Stuff. I feel like I am constantly coming up with great ideas for ICOs— ExcelCoin, CoinNameCoin—and eventually the temptation to actually raise money will become too great. Especially given how easy it apparently is to plagiarize a white paper, guarantee some returns, and watch the money roll in.

People are worried about unicorns.

We talked last month about the weirdly common Silicon Valley business model of “rapidly growing a business by selling its products below cost, subsidized by huge venture-capital investments, in the hopes of one day flipping to profitability once you’ve achieved scale.” One way to think about that model is as a cold-blooded rational economic calculation: The financial benefits of entrenching your company into everyone’s digital lives are so big that losing even billions of dollars to get there can be worth it.

But there are other ways to think about it, and they are much more fun. For instance, I like to think of it as a sort of venture-capitalist false consciousness. An important story of the modern technology industry is its contribution to inequality, as entrepreneurs and venture capitalists become fabulously wealthy with scalable digital products that do not create lots of middle-class jobs to match the wealth they build for their tiny elite class of owners. In the limit, robots will do all the work, and the people who invent and own the robots will have all the wealth, and everyone else will … what? Starve? Revolt? Maybe they will live off subsidies thrown off by venture capitalists who want to achieve scale. I wrote:

It is pleasing to imagine that the VCs might give away their products because they are (1) rapacious growth-hungry capitalists and (2) confused. “Please give me free food so that you can grow your daily active user base,” you’d say to the robot-farm monopoly, and its owners would reply “yes, scale, we must scale, here is your food,” and you’d be pleased to have put one over on capitalism.

The fun view of the venture-capital-subsidized perpetual-loss-leading user-growth-at-any-cost economy is that it represents socialism as the transcendent end state of capitalism, a capitalism that is so refined that it consists of just giving people free stuff in exchange only for their willingness to take it. 

Kevin Roose at the New York Times wrote about this model the other day, with the headline “The Entire Economy Is MoviePass Now,” referencing MoviePass’s particularly silly approach in which you can see unlimited movies for less than the price of one movie ticket, with MoviePass eating the difference. (Though MoviePass is part of a public company, so it is not venture money.) He wrote:

I’ve got a great idea for a start-up. Want to hear the pitch?

It’s called the 75 Cent Dollar Store. We’re going to sell dollar bills for 75 cents — no service charges, no hidden fees, just crisp $1 bills for the price of three quarters. It’ll be huge.

Look he hasn’t gotten funding yet but give him time.

I will do him one better though. My startup will be an online subscription service in which we mail people checks, or Venmo them money maybe, or ugh send them Bitcoins who cares. They don’t have to give us quarters or anything. It’s just free; all they have to do is sign up. I expect that my monthly-active-user growth rate will be more than sufficient to support a $50 billion valuation; who’s in?  I call it the Silicon Valley Universal Basic Income Project.

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