Monday, May 23, 2016

Probes into Trading Executions

We've been keeping logs of valuation/pricing disputes and issues pertaining to fees charged (more regularly buy-side probes).

This new set is a little different.  Here, we're looking at investigations into whether the buyer/client/customer got a fair execution from the broker-dealer (primarily sell-side probes).

As you'll see from the following list, the regulatory heat is on...
  1. May 2016. Why Merrill Lynch and Stifel Were Fined by FINRA. "Merrill Lynch, Pierce, Fenner & Smith, a subsidiary of Bank of America (BAC), was ordered to pay $422,708 in fines and restitution by the Financial Industry Regulatory Authority for charging customers excessive markups and markdowns on municipal securities." 

  2. May 2016: State Street Nears Settlements to End Probes Into Alleged Overcharges. "The lawsuits accuse State Street of promising to execute foreign exchange trades for clients at market prices, but instead using inaccurate or fake rates that included hidden markups. The alleged overcharges occurred between 1998 and 2009, ..."

  3. May 2016: U.S. investigates market-making operations of Citadel, KCG.  "Federal authorities are ... looking into the possibility that the two giants of electronic trading are giving small investors a poor deal when executing stock transactions on their behalf." 

  4. May 2016: Lawson Financial, Its Top Officials Charged in Muni Case. "[FINRA] has filed a complaint against Phoenix-based Lawson Financial Corp. and the firm's president and chief executive officer, charging them with securities fraud in connection with the sale of millions of dollars of municipal revenue bonds to customers." 

  5. Apr. 2016: Three Firms Ordered by FINRA to Pay $115K for Muni, Other Violations. "Alton Securities Group, based in Alton, Ill., did not receive a fine for its conduct but was ordered to pay $75,000 in restitution, plus interest, to customers for taking excessive markups and markdowns in muni and corporate debt and for not making suitable recommendations on exchange traded funds. FINRA found in 104 muni trades occurring between February 2009 and June 2013, markups ranging from 3.01% to 4.53% that [] violated MSRB Rule G-30 on prices and commissions."

  6. Feb. 2016: Oppenheimer One of 7 Firms FINRA Fines Over Minimum Denominations. "Oppenheimer & Co., WFG Investments, and E*TRADE are three of seven firms that [FINRA] fined ... for trading municipal securities below the minimum denomination." 

  7. Jan. 2016: BNY Mellon faces lawsuit claiming FX transaction overcharges on ADRs

  8. Jan. 2016: The Hidden—and Outrageously High—Fees Investors Pay for Bonds

  9. Jan. 2016: Barclays, Credit Suisse Charged With Dark Pool Violations. “Dark pools have a significant role in today’s equity marketplace, and the firms that run these venues must ensure that they do not make misstatements to subscribers about their material operations,” said Andrew Ceresney, Director of the SEC’s Enforcement Division. “These largest-ever penalties imposed in SEC cases involving two of the largest ATSs show that firms pay a steep price when they mislead subscribers.” 

  10. July 2015: Banks are ripping off investors in overseas markets. "...these are the first in history by ADR shareholders against depositary banks, in this case Citibank and JPMorgan, according to Germinario. In the Citibank case, ..., the investors claim the bank docked fees from dividends and cash distributions by foreign companies without proper disclosure ..." 

  11. Mar. 2015: BNY Mellon Agrees to Pay $714 Million to Settle Forex Probes. "Federal and state officials alleged in lawsuits filed in 2011 that the bank misled investors about foreign-exchange deals by promising it would provide the best rates available when executing trades. Instead, the bank obtained the best rates for itself and gave less favorable terms to customers, pocketing the difference,..." 

  12. Jan. 2015: SEC Charges Direct Edge Exchanges With Failing to Properly Describe Order Types

  13. Aug. 2014: Edward Jones to Pay $20 Million for Overcharging Retail Customers in Municipal Bond Underwritings

  14. Mar. 2014: SEC Said Examining Hidden Electronic Bond Trading Prices. "The practice of dealers showing clients different prices for the same securities on electronic bond-trading platforms is drawing the scrutiny of the [SEC], which is concerned that smaller investors are being penalized." 

  15. Feb. 2014: Regulators Are Probing How Goldman, Citi and Others Divvied Up Bonds. "The Securities and Exchange Commission has sent requests for information about how banks allocate corporate-bond deals and how they traded those bonds after they were sold, the people said."
Visit our recent research piece on financial markets probes and litigation, here.


Thursday, May 5, 2016

How About a Real Federal Bailout for Puerto Rico?

Later this month, Congress will begin its race against a July 1st deadline to pass legislation addressing the financial mess in Puerto Rico. July 1 appears to be the date on which the Commonwealth will default on general obligation debt service payment – the first such default by a state or territory since 1933. The proposed bill, HR 4900, includes a combination of federal oversight over Puerto Rico finances and a mechanism to restructure the island’s public sector debt. Although the restructuring procedure would begin with voluntary negotiations between issuers and bondholders, the bill would authorize courts to impose cram-downs on holdout bondholders.

This last aspect has displeased hedge funds that own Puerto Rico bonds, and they have been trying to kill the legislation. The most visible part of this effort has been a spate of issue ads on TV urging voters to call their Representative to stop the so-called federal bailout. When people think of a bailout, they normally assume that taxpayer money is being spent on some objectionable purpose. In this case, the ad misleads viewers to think that Congress is trying to send more federal dollars to the island. In fact, the legislation does not provide any new funding to Puerto Rico whatsoever. Even the federal oversight board is to be funded with proceeds from new bonds that will be obligations of the Commonwealth. 

Although I like HR 4900 overall, I think it would be better if the federal government did make a financial commitment. Specifically, I suggest that Puerto Rico Commonwealth bonds be exchanged for newly issued US Treasury Bonds with similar maturities. The federal government would service these new Treasury Bonds by diverting grant monies earmarked for the Commonwealth government.

Right now, most Puerto Rico bonds carry coupons of between 5% and 8%. Treasury rates are below 3% at all maturities. Refunding Puerto Rico bonds at par with Treasuries saves bondholders from taking a haircut and saves taxpayer money viz.-a-viz. fully servicing the current bonds. The swap is thus a win/win situation.

While the debt burden would then be shifted onto the federal government’s books, there is a surefire way for federal taxpayers to be made whole. Each year, the federal government provides over $7 billion in grants to Puerto Rico’s public sector to support a variety of services. Under my proposal, any money needed to pay principal and interest on the newly issued Treasury bonds would be withheld from Puerto Rico and used instead to pay holders of the new Treasury bonds.

This concept has a rough precedent in the municipal bond market. Several states provide credit support to local school district bonds through aid intercepts. The state deducts principal and interest from money that would otherwise be apportioned to the school district borrower and remits it to bondholders. School bonds serviced this way carry ratings similar to those of the state, allowing small districts to realize substantial interest savings. (Typically the aid intercept mechanism is just a backup in case the school district fails to pay, so this is a bit different from my recommendation for Puerto Rico).

I propose this only as a solution for Commonwealth-issued bonds including General Obligations and COFINA sales tax supported debt. Debt issued by other Puerto Rico borrowers should be restructured either according to procedures laid out in HR 4900 or using the Chapter 9-like mechanism provided by the Puerto Rico Corporations Debt Enforcement and Recovery Act of 2014 now being reviewed by the Supreme Court. This non-Commonwealth debt is more akin to municipal bonds on the mainland that have been adjusted under Chapter 9, so there should be less political concern about using these mechanisms to restructure them.

* * *

I have been writing a lot about Puerto Rico lately. Here are some of my other recent commentaries on the web:

Thursday, April 28, 2016

So You Think You Can ... Run a Bank?

You’re probably not alone in thinking you could have done a better job running one of the banks.  

Now you can see if that’s true, thanks to the Banking Simulator, a creative, educational tool designed by PF2 team member Joe Pimbley.  Like a flight simulator for pilots, it will give you a chance to hone your skills in simulated, but realistic, market conditions and risk scenarios.

Bank managers and executives use models for VaR, loss distributions, economic and regulatory capital, to help with decision-making, but of course those cannot capture the human element of a manager’s decision-making process during a downturn or in reaction to a “black swan” event.
Click on the slideshow for detailed instructions
In the Banking Simulator, you'll be playing the part of the bank CEO or CFO; you'll have to make many quarterly decisions and contend with several risks to keep your bank afloat in whatever situations we throw at you... including bank runs. You decide on the level of debt and equity to issue, and the amount of risky assets to acquire. You also decide the strength of your risk management.

You must make quarterly decisions to: 
  • buy and sell risky assets
  • issue deposits
  • issue, redeem, and repurchase debt
  • issue and repurchase equity
  • pay dividends  


The simulator will show you your bank’s net income and stock price at the end of every quarter. You'll be encouraged to monitor and manage your asset-to-debt and reserve ratios, and you'll need to buffer against asset-liability or maturity mismatches.

Can you run a profitable bank, and at the same time maintain your reserve ratio, satisfy regulatory stress tests? 


Take your chances.  Let's see how resilient you can be, under changing market conditions.  Will you survive a run on the bank?

Monday, April 25, 2016

Rogue Bonds

We received a couple of calls late last week about the securitization structure (or catastrophe or "cat" bond) deal that Credit Suisse is preparing.

We haven't seen the deal docs, but from what we understand and have read, the concept is interesting:

Credit Suisse would free up some capital by insuring itself (by way of the bond sale) against certain operational risks, like fraudulent transactions, trade processing errors, regulatory or compliance shortcomings ... or the all-important concern of rogue trading, which caused JPMorgan and SocGen a pretty penny (just look up London Whale or Jérôme Kerviel).

We understand that CS would issue a two-tranche securitization, reportedly backed by a 700 million franc policy from Zurich Insurance Group.  Zurich would retain the first 10% of the risk, with the senior notes being sold off by way of a Bermuda vehicle.  From the reports we've seen, the senior notes would attach at losses of $3.6 billion and detach at losses of $4.3 bn. It's not immediately clear to us whether Credit Suisse would stomach losses above $4.3 billion, but that would seem unlikely ... we assume there's more to it than is publicly known at this time. 

Operational Risk, or What Credit Suisse Will

There are some serious questions.

It would seem Credit Suisse would have a massive informational advantage over the other side: they would know their operational strengths and weaknesses better than anybody else.   That's okay, as long as it's well understood.  

But the real questions start when there is a loss, 

Can one always put a value on the operational portion of the cost, easily separating out all of the factors?   Suppose for example that a loss is magnified as the market turns against a bank while it was slowly extricating itself from a large, unauthorized trade -- as happened in the case of JPM's London Whale?  Is that additional writedown the fault of the bank or the operational shortcoming?  How much of the supposedly unauthorized trade would have been "okay" and how much was "unauthorized"?  One issue here is that the party that knows best if probably Credit Suisse ... but it may often be a conflicted party, benefiting directly or indirectly through the decisions in makes in quantifying the losses.  

Next, the category of operational risk can be difficult to define, and items may fall in the grey zone. Might CS, knowing it has insurance, be more likely to categorize the marginal loss as operational?

And might it change Credit Suisse's approach to fixing up an issue to the extent it knows of certain insurance providers' interests or exposure?  At worst, knowing that they're insured, might they be less particular about buffering against the risk?  Could that create an adverse incentive from a cultural perspective? 

Banks might not need a second invitation!

If this all goes wrong ... we're insured!  Double down!  Lock and load!


Thursday, April 14, 2016

Goldies Sampling, and the Silver Settlement

This week has brought with it some significant disclosure on some of the forms of pre-crisis misconduct at the banks, and the first settlement of post-crisis alleged manipulation of the silver markets.

Allegations into silver and gold markets manipulation are among a string of claims made against the big banks for post-crisis benchmark manipulation -- the other well-known cases being the three exchange rate and interest rate manipulation allegations: LIBOR, FX, and ISDAFIX, the last of which survived a motion to dismiss, just two weeks ago.

Deutsche Bank has settled with the class In re: London Silver Fixing Ltd., Antitrust Litigation, 1:14-md-02573, U.S. District Court, Southern District of New York (Manhattan), but those terms have not been disclosed.

Statistical Sampling Techniques ... Gone Wrong

But the Goldman Sachs settlement (a headline settlement amount of $5.06 billion) for what the Justice Department calls "serious misconduct," provides some real insight into the artful approach taken to mortgage sampling for residential mortgage-backed securities (RMBS).

Imagine you wanted to get an idea of the quality of teachers at a school you're considering for your kids.  The school chooses a sample of 100 teachers, removes the 90 worst ones, and presents to you the 10 most credible, as if they were randomly selected to fairly represent the whole group of teachers.

Well that's pretty much what several of the big banks did.  They sampled the mortgage loans under consideration for inclusion in RMBS transactions.  They kicked out some (or perhaps all) of the non-compliant ones in the sample, and then they presented the cleaned-sample as if it represented the entire pool.  

Among the problems was that the samples were not very big.  So if half of the loans are non-complaint (say 50 out of 100), and you sample only ten percent (say 10 out of a 100) ... and then you kick out 5 from those 10, well, there are still 45 non-compliant loans (half of the unsampled 90 loans) going into the pool!

We wrote about this revelation/absurdity back in 2011, just after the Financial Crisis Inquiry Commission released documents showing this incredible pattern.  (You can read our report here, or below.)

The language in Monday's Statement of Facts is additive, and confirms some of the worst suspicions that come from documents provide by Clayton to the FCIC.  Here are some choice snippets: 
"Even when the percentage of loans graded as EV3s and dropped by Goldman from the due diligence samples indicated that the unsampled portions of the pools likely contained additional loans with credit exceptions, Goldman typically did not increase the size of the sample or review the unsampled portions of the pools to identify and eliminate any additional loans with credit exceptions."
"The Mortgage Capital Committee also asked “How do we know that we caught everything?” In response to that question, the Goldman due diligence employee who oversaw the due diligence for one pool of loans purchased from SunTrust Mortgage wrote “we don’t[,] it was sampled w[ith] max at 20%- the drops were a result of timing not systemic issues with SunTrust.” Another Goldman due diligence employee who oversaw the review of a pool of Countrywide loans that Goldman had purchased on March 29, 2006 responded to the same question: “Depends on what you mean by everything? Because of the limited sampling on CW 10-15% we don’t catch everything and the way they [Countrywide] deliver the files we have little chance to upsize. This trade had issues with aged loans and we tried to get pay histories and were told they would not provide them.” In response to the Mortgage Capital Committee’s question “Are these results systemic,” the same employee wrote: “Every trade varies, but typically CW have a very high credit 3 drops on the first review of DD 60% and then clear the docs, so one can assume that the files we are not reviewing would have the same issues.”"
"In April 2006, the Mortgage Capital Committee received a memorandum with a highlevel summary of Goldman’s due diligence results in connection with a proposed Alt-A RMBS offering. The memorandum included aggregate due diligence results for three Countrywide loan pools that Goldman had purchased on March 30, 2006 and indicated that 34.38 percent of the loans in the proposed offering had been drawn from certain of those Countrywide loan pools. The memorandum reflected that Goldman had conducted credit and compliance due diligence on a total of 15.44 percent of the loans in the three March 30 Countrywide pools. ... The memorandum also stated that Goldman had dropped a total of 6.07 percent of the loans in the three Countrywide pools (not the samples) for credit or compliance reasons. Across the three Countrywide pools, Goldman dropped nearly 40 percent of the loans in the credit and compliance due diligence samples for credit and compliance reasons. The memorandum referred to this as an “exceptional drop amount” and stated that “in the case of [Countrywide], an unusually high drop rate for missing or deficient documents resulted in an above average total drop percentage (approximately 33% of the credit drops were due to missing appraisals).” Contemporaneous records reflect that Goldman closed on six Countrywide loan pools on March 29 and 30, 2006, and that Countrywide was struggling with staffing and workload issues that affected its ability to deliver missing documents requested by Goldman for the loans in those six pools."
"Although Goldman dropped 25 percent of the loans in the due diligence sample because they were graded as EV3s, including all the loans graded as EV3s for unreasonable stated income, which comprised at least 2.5 percent of the loans in the due diligence sample, Goldman did not review the portion of the pool not sampled for credit or compliance due diligence, which comprised approximately 70 percent of the total pool, to determine whether there were similar exceptions in the unsampled portion. Goldman subsequently securitized thousands of loans from this pool into one GSAMP transaction. The Mortgage Capital Committee approved the issuance of this offering."

Our report from 2011 can be viewed here:


For an update on the current status of alleged benchmark-rigging antitrust cases, see Alison Frankel's blog, here.

Monday, April 4, 2016

Sydney, Australia

We're thrilled to have launched an office Australia, and to welcome Chris Coleman-Fenn to the team.

Chris is a math whiz, and we look forward to entertaining blogs coming out of him in the near future.


If you're in Australia, give us a shout.  ~ PF2

Thursday, March 31, 2016

Ratings Arbitunities — A Tale of 5 Bonds

Moody's, Fitch, S&P and all often get bundled together under the same umbrella as "credit rating agencies," and it's quite possible that we're among those guilty of treating them as if they're all pretty much alike.

Of course, each rating agency is different, and even within each rating agency, arguments can be made that across different departments or product types, their ratings don't exactly mean the same thing.  So, naturally, different rating agencies might well rate things differently.

Moreover, each rating agency has its own (different) ratings scale.  And applying a similar result to different scales can mean that one rating agency's BB may be another's BB+.  Or might the differences be much larger yet?

We've investigated thousands of seasoned RMBS securities, issued pre-crisis, and our findings were ... interesting.  

Below, we're going to show some bonds for which three credit rating agencies have different opinions.  Err, very different opinions.  For some traders and risk-managers, large ratings differentials can create real money-making opportunities, even if it's just by way of risk-allocation or strategic re-allocation benefits. Importantly, in the world of OTC debt instruments, ratings arbitrages don't exactly disappear overnight.  They can exist for ... years.

We hope you enjoy some of the following: current ratings of the same bonds, per 3 different rating agencies.  Screenshots are courtesy of Bloomberg LP.  






Thursday, March 24, 2016

While the Shorts are Getting High on Valeant...

The last ten days have been miserable for shareholders of Valeant (VRX), investors in its debt, or believers in (insurers of, or "sellers of protection" on) its creditworthiness.  

The stock is down >50% over the last ten days.  Accounting statements are said to be unreliable; the CEO and CFO are no longer there, with the CFO having been accused by the company of improper conduct. The list goes on.  Investor Bill Ackman has been recently appointed to the board (arguably a credit positive).

Just about a year ago in March 2015, Valeant raised millions of dollars from debt investors, with ratings of B and B1 being provided to their debt by S&P and Moody's, respectively.

Already denoted as being of somewhat high risk, it was interesting to visit the responses of market participants (traders), and compare them to those of the rating agencies, on receiving the never-ending slew of incoming bad news.

Credit default swap (CDS) spreads widened dramatically on Valeant (reference obligation US91911KAE29) in the last 10 days. See the spike on the right of the following Bloomberg graph. 


At a 40% recovery, CDS-implied default probabilities more than doubled from 5.7% to 13.2% on the 1-year, and cumulative default probabilities jumped from 37.3% to 55.2% on the 5-year trades.

Meanwhile, the rating agencies were less alarmed, and their response more tepid: Moody's downgraded Valeant bonds one rating subcategory from B1 (watch negative) to B2 (watch negative); S&P simply placed the bonds (downgraded to B- from B in October) on downgrade watch.


To put the difference into perspective, we wanted to draw a relationship between the CDS-implied default probabilities and rating agency-implied default probabilities.  

We'll do this for Moody's, by way of their idealized default rate tables.

Valeant Starting to Look Like a Triple C Basket Case

In the 1-year CDS, now at 13.2% from 5.7%, the market is now no longer seeing this as a B1/B2 risk  (close to Moody's rating) as it did on March 14, bur rather closer to a B3/Caa1 credit as of March 24.

The pattern is even more dramatic for the lengthier term 5-year CDS: at the 55.2% CDS-implied cumulative default probability, the market is seeing the credit risk as closer to the Caa2/Caa3 range.


Right now, the market is saying that there's chaos at Valeant.  Moody's and S&P aren't so sure.

Monday, March 21, 2016

Was Information Fed Pre-Fed?

Last Wednesday the Fed concluded its two-day Federal Open Market Committee (FOMC) meeting and issued its statement, deciding to hold the Fed Funds rate between 0.25% and 0.50%, as expected. The accompanying economic projections show that Fed policy-makers currently expect to raise rates only twice this year, down from their December median projection of 4 rate hikes in 2016. Markets responded in kind to the Fed’s more accommodating monetary stance, with 2-year yields falling, the dollar weakening, and gold rallying. 

One of our readers passed along a chart showing an 890,000 share spike in volume in GLD (the SPDR Gold Shares ETF) about 20 minutes before the 2:00 FOMC statement release — a volume spike which doesn’t create any noticeable spike in the market. We dug into Bloomberg’s “Trade/Quote Recap” data and found that there was a single execution of 825,000 shares. 

Source: Bloomberg 

Our reader was suspicious of the timing, suggesting that perhaps the statement and updated projections had been leaked. 

We certainly would not dismiss the possibility of information leakage and the timing of the block trade certainly is curious, but it’s worth being skeptical in this instance: there are plenty of innocent explanations for a block trade in GLD — even one so close to the release of the FOMC statement: 

First up, is a trade of 825,000 shares of GLD all that unusual? According to Bloomberg, and not counting opening and closing crosses, there were 36 trades of 500,000 shares or more (ranging up to 1.8 million shares per trade) in the previous 30 trading days. So while trades of half a million shares or more of GLD are not exactly an hourly occurrence, they do occur slightly more than once per day. 

Next, we cannot ignore the (albeit remote) possibilities that (1) investors (or traders) weren’t targeting the vanilla GLD, as much as delta-hedging a large options position or (2) that the GLD transaction was part of an arbitrage strategy in which a trader bought or sold GLD shares against a short or long position in gold futures. (If we assume a delta of .50 for an at-the-money option, then an 825k share cash position suggests the options position would be around 1.65 million shares, or 16,500 contracts.) 

Finally, we can’t be sure that this trade was initiated by a buyer — there are, of course, two sides to every trade.[1] Perhaps the customer initiating the trade was a seller and the broker-dealer bought the block (or found the other side of the trade) in order to facilitate a customer sell order.  In other words, maybe it was a large seller, looking to get out of a long position before the Fed decision. We have no way of knowing which side of the trade the customer was on, nor whether the broker-dealer took principal risk or found the other side of the trade. (FINRA would, however, be able to dig further, if so inclined, via the OATS system, which enables them to monitor the detailed history and execution of orders.)

--------------------------------------
[1] We do know, per Bloomberg, that the trade was reported via FINRA’s ADF, which means that the execution did not occur on an exchange. So, it could have occurred in a dark pool or other Alternative Trading System (ATS) venue, but more likely it was done through an institutional broker. 

Thursday, February 18, 2016

Servicing Complaints are Down, Yay, Now Close to 2012 Levels

It's mid-February already, and now that the numbers are out it's time for our annual update on mortgage servicing complaints – which are handsomely down for the second year running: the number of complaints to the CFPB for the calendar year 2015 declined 6% from 2014 levels (vs. 12% decline from 2013 to 2014).

Ocwen, the mortgage servicer that's perhaps been most regularly under the microscope, saw its number of customer complaints decrease by a mammoth 1292, the largest absolute improvement.  However, by our calculations in 2015 Ocwen sold roughly $89 billion in mortgage servicing rights (MSRs), reducing the size of its MSR portfolio by 22%, in terms of unpaid principal balance (UPB), notwithstanding any runoff.  So, Ocwen’s decrease in complaints appears to be roughly in line with its more modestly sized servicing assets.

Within 2015’s top 10 (complaints-wise), only Ditech Financial/Green Tree and Seterus experienced an increase in complaints.  Ditech Financial LLC merged with Green Tree Servicing last year (data in table reflect combined totals); both were subsidiaries of Walter Investment Management Corp. and the combined entity still is.  Seterus is an IBM subsidiary – it is unclear to us whether it enjoyed an improvement in market share that might explain its 69% increase in complaints. 


For the top 5, we also looked at complaints relative to total loans serviced, by UPB. We would prefer to consider the number of loans serviced instead of UPB but, alas, only Ocwen and BofA provide those numbers, and only as of 4Q14. Ocwen outpaces the group at 12 complaints per billion dollars of UPB serviced. It is possible that these five servicers have widely varying average loan servicing balances, although Ocwen’s and BofA’s are fairly similar ($160,387 and $162,617 per loan, respectively, as of 4Q14).