High Frequency Hiccups

This week has been an interesting one in the world of HFT worries...

Citigroup, somewhat surprisingly, announced the closure of its premier alternative trading system, or ATS, called LavaFlow.  LavaFlow had been the subject of regulatory scrutiny, leading up to a small settlement with the SEC back in July.

Citigroup maintains at least two other ATSs or ECNs, much smaller in size than LavaFlow.  LavaFlow, despite some negative press associated with the July settlement, had gained significant traction recently -- see the table of weekly flow, below -- which makes its closure all the more intriguing.

Citigroup reportedly explained that "Following a recent review of the LavaFlow ECN, we have decided that our capital, resources and efforts would be better redeployed to other areas within Citi’s Equities Division, ..."

Citi had previously spent heavily to get into the game.  We dug up a couple of their multi-million dollar purchases from 2007 and before that, including the $680mm purchase of Automated Trading Desk LLC.  The newly shut down LavaFlow likely took over the reins from Lava Trading, a division bought from Knight Capital back in July 2004, purportedly to "catapult [Citigroup] to a leading position in the electronic-execution arena."

Barclay's dark pool, the subject of one of our earlier posts, continues to grow, although it remains a fair share away from its lofty heights of early June.

Meanwhile the SEC is purportedly nearing the end of a lengthy investigation into the way BATS Global's Direct Edge Holdings LLC exchanges handled customer orders.  Among the concerns are whether all parties were allowed access to the same information about how the order types worked (or would be executed) and the order of execution among various open orders -- and whether they were indeed executed as they were advertised to be executed.  

We'll blog more on this issue in the coming months, as order types are an area of significant regulatory investigation, in addition to the focus on how or where brokers choose to execute their trades, as we covered previously.

California Municipal Default Probabilities and a Reply to Lumesis

Earlier this month, we published default probability scores for 490 California cities and counties using a municipal scoring model I developed during previous research. The scores and a description of the model can be found on the California Policy Center’s website. The methodology – which relies solely on financial statement data – is further justified in this academic paper.

The accompanying CPC study identified thirteen cities that had heightened risk of default or bankruptcy. The median city in the universe had a one year default probability of 0.11%, while cities in this highly distressed category had default probabilities of 0.74% and up.

Our findings were reported in the Los Angeles Times and produced rebuttals from two of the cities on the distressed list – Compton and San Fernando.

We also received a rebuttal from an unexpected source: a municipal bond analytics provider named Lumesis. In a November 10th commentary, they compared our county default probabilities to their Geo Scores, which measure relative economic health. Finding little correlation between the two sets of results, Lumesis concluded that our model “needs improvement”.

But this conclusion begs a fundamental question: are municipal bond investors better served by socioeconomic metrics like those provided by Lumesis or by metrics that rely upon financial statement data? Even our colleagues at Lumesis appear to recognize that economic health is not conclusive, noting the “ability of bad management to create a mediocre credit from a strong economy.”

Fortunately, we have some empirical evidence at hand to assess the relative strength of fiscal and economic predictors. Back in December 1994, Orange County California filed for bankruptcy. Thanks to the magic of the MSRB’s EMMA system, I was able to locate the County’s 1993 and 1994 financial statements –as appendices to old offering documents.

For the reader’s convenience, I have posted the statements here and here. Next I input relevant numbers from the statements into my fiscal scoring tool which you can see here and in the screenshot below.

The result was a default probability of 0.85%, well above the current median and comparable to the worst performing entities in the current universe. As of June 30, 1994, the County had a negative general fund balance and had experienced declining year-on-year governmental fund revenues – two harbingers of trouble we have seen in other default and bankruptcy cases.

Would the Geo score have singled out Orange County in this way? Perhaps Lumesis can run the numbers for us and report back. Short of that, I note that according to 1990 Census figures, Orange County had the 5th highest per capita income among California’s 58 counties. So it would seem that a methodology based solely on economic health (like the Geo score) would have missed this particular calamity.

Broker Order Routing, in a High Frequency Trading World

The brokers/dealers have had their fair share of scrutiny among the recent revelations in the high-frequency trading (HFT) saga.

Among the questions being asked are whether Brokers are routing orders to whichever venues pay them most handsomely for the flow ... and potentially not to whichever venue provides best execution for their clientele.

We previously covered the discount brokerage world in which TD Ameritrade is being sued

(see for example Gerald J. Klein, on behalf of himself and all similarly situated v. TD Ameritrade et al, 14-cv-05738) for their order routing decisions.

You may recall that shortly after New York's AG filed a complaint against Broker Barclays in June 2014 for issues relating to its dark pool, Broker Barclays saw a precipitous decline (of roughly 66%) in trading within its own dark pool.   Some of that has returned, but while the tide has turned and the "true" nature of trading activity in some of the dark pools has been revealed, others like Wells Fargo have had to shut their dark pools: each venue requires a certain amount of trading activity to be relevant, or advantageous.

Brokers' Routing Decisions - Where to Send the Trades

Today we're covering a little of what we've found in the brokerage world itself: the changing nature of Brokers' routing orders to their own dark pools. We're spent some time digging through order broker routing information in their quarterly Rule 606 reports, and found some interesting changes in the regularity with which some of the large brokers are routing "non-directed" orders -- orders for which the client hasn't specified a specific execution venue.

The data are sparse, and the time periods short, but it seems like Credit Suisse (which has the largest dark pool) is generally substantially increasing its order routing to its internal dark pool, while Goldies and Broker Barclays are generally decreasing their self-routing decisions.

Minimum Authorized Denominations: A Truly MAD Restriction Now Enforced by the SEC

Last week, the SEC sanctioned thirteen brokerage firms for selling individual investors Puerto Rico General Obligation bonds in denominations less than $100,000.  The action is part of a wider SEC effort to protect municipal bond investors, which has also included pressuring issuers to post their continuing disclosures on EMMA and censuring issuers that have improperly reported their pension obligations.

While the SEC’s efforts to enforce transparency are welcome, the enforcement of minimum denominations is, in my view, counterproductive. Before I explain why, I should begin with the necessary disclosure:  I am an owner of Puerto Rico General Obligations, so I clearly have a financial interest in taking the view I am advocating.  However, it is not a very large financial interest – probably not large enough to justify the time spent writing this piece.

You see, I own an “odd lot” of Puerto Rico GOs.  In fact, my purchase of $25,000 face value Puerto Rico bonds was legal in January 2014 when I made it, and would still be legal today. The $100,000 Minimum Authorized Denomination (MAD) restriction only applies to bonds issued in 2014 (and probably thereafter).  An individual investor can still purchase smaller amounts of PR GOs that were issued prior to 2014.  Many of these bonds mature in the 2030s, thus presenting risk characteristics very similar to the March 2014 MAD bonds, which mature in July 2035.

The reason for this discontinuity is that the SEC is enforcing a restriction in the Commonwealth’s bond resolution that authorized the issuance of the 2014 securities.  That resolution includes the following:

The Bonds … shall be issuable … in the minimum denomination of $100,000, with integral multiples of $5,000 in excess thereof; provided, however, that upon receipt by the Registrar from the Secretary of written evidence from any of Fitch Ratings, Moody’s Investors Service, or Standard & Poor’s Rating Services that the Bonds have been rated “BBB-,” “Baa3,” or “BBB-,” or higher, respectively, then the minimum authorized denomination of the Bonds shall be reduced to $5,000.

Prior to 2014, Puerto Rico carried investment grade ratings from the big three credit rating agencies, so earlier resolutions apparently did not need to incorporate the $100,000 denomination floor. Thus, investors can and do continue to trade these securities in smaller pieces as anyone can see on EMMA.

Buying older PR bonds is not the only way for an individual investor to evade the new MAD requirement. Since many municipal bond funds own PR GOs, one can gain exposure to this asset by purchasing shares in any one of these funds. Not only can the investment be less than $100,000 in most cases, but the exposure to PR will only be a small fraction of the fund’s overall exposure.

But why should investors have to pay mutual fund overheads to add Puerto Rico exposure to their portfolios?  It should be possible to simply buy a small amount of PR bonds directly as part of a diverse municipal bond portfolio or multiple asset class portfolio.

The MAD restriction begins to foreclose that option to all but the wealthiest investors. Imagine, for example, an accredited investor with $5 million in investable funds.  Let’s say that, after reading all of Puerto Rico’s voluminous disclosures, she decides to take some risk on Puerto Rico, but to limit this risk to 1% of her portfolio.  If worst comes to worst, and Puerto Rico repudiates its bonds, she will still have $4.95 million – enough to survive. But, since 1% of $5,000,000 is only $50,000, that investment choice is not available for the 2014 and future bonds.

Many hedge funds and other institutional investors thought Puerto Rico’s March 2014 bonds to be a sensible investment, concluding that the 8.7% yield more than compensated them for the Commonwealth’s heightened risk. That issue was five times oversubscribed, with hedge funds being major participants.  The question is why anyone else who shares this view must be compelled to pay a hedge fund “two and 20” to express this conviction.

Besides being discriminatory and easily circumvented, the MAD restriction is just bad public policy. Investors can buy small denominations of penny stocks which frequently become worthless, so why single out PR General Obligations as something from which the “little guy” must be protected? It furthers the false narrative that municipal bonds are an especially risky asset class, when, in fact, quite the opposite is true.  No US city, county, state or territory filed for bankruptcy in the last year.  How does that compare to the corporate sector?

Municipal bonds were recently proscribed by regulators from the list of high quality liquid assets that banks could hold.  The major justification for excluding munis was their lack of liquidity. Regulatory actions that scare investors away from municipal bonds and impose floors on trade sizes simply reinforce the lack of liquidity in the market.  This, at a time when we hear that Republicans and Democrats agree on the need for greater infrastructure investment – investment that could be partially financed by municipal bonds.

Finally, the MAD restriction uses credit rating agency assessments to determine whether the bonds are “junk” and thus subject to the denomination floor. Using bond ratings to distinguish between investment grade and non-investment grade securities goes against the spirit of Dodd Frank, which sought to cleanse regulations of their reliance on credit ratings. This aspect of Dodd Frank is one of the few parts of the controversial law that seems to have elicited bipartisan support.

While it is gratifying that the SEC is trying to protect municipal bond investors, we need to be sure that the rules being enforced actually contribute to investor welfare. Puerto Rico’s MAD requirement is a restriction that is easily circumvented, that penalizes individual investors, that reduces municipal bond market liquidity and that reinforces the credit rating oligopoly.  For these reasons, it fails the test of being a rule worthy of commanding enforcement resources.

San Francisco Mortgage Eminent Domain Plan - A Look at the Target Properties

On October 28, San Francisco Supervisors will consider forming a Homeownership Stabilization Authority with the city of Richmond. The Authority would have the ability to condemn residential mortgages as a way of keeping financially distressed owners in their homes. The focus would be on underwater properties with mortgages held in private loan securitizations; federally owned or guaranteed mortgages would be excluded.

I was surprised to learn that San Francisco has a problem with underwater mortgages. According to Zillow, the median home price in the City by the Bay peaked at $822,000 in 2007, bottomed out at $667,000 in late 2011, and has now reached $979,000 - 19% above the pre-recession high.

The Board of Supervisors' resolution states that San Francisco has approximately 300 underwater mortgages in private loan securitizations and that these are concentrated in "historically Black, Latino and Asian working class communities." 

Supporting documentation in the Supervisor's agenda packet includes a memo from ACCE Action stating that 279 San Francisco mortgages have LTV (loan-to-value) ratios of 107% or more. The memo breaks these mortgages down by zip code - with the highest concentrations in 94112 and 94124.

These two zip codes are in less affluent sections of the city where real estate prices have not performed as well as they have in the "hottest" neighborhoods.  That said, property in these zip codes is not seriously depressed by historical standards. In 94124 - which has seen the worst price performance - Zillow shows a median home value of $609,000 compared to a pre-recession peak of $635,000. Further, Zillow forecasts that within a year, the median will reach $636,000 - roughly equaling its previous peak. In 94112, Zillow only reports selling prices per square foot, and these have fully recovered from the recession.

Looking Beneath the Cover - Examining the Data

To learn more about San Francisco's underwater mortgages, I filed a public records request with the Mayor's Office of Housing and Community Development.  They provided the 279 mortgages in an Excel file along with other lists and correspondence.  There is a lot of material to work through, but I thought I would share some initial findings.

First, unlike in the case of Richmond, there are no property addresses, so it will not be possible to map the properties unless and until the list is matched against a public records database. CoreLogic and some other companies perform this sort of matching, but normally charge substantial fees for doing so.

Still, the file does contain information that should raise some eyebrows. For example, 47 of the 279 properties have current estimated values in excess of $1 million. Many of these are 2-4 unit properties, but there are 18 condominiums and single family houses in the million dollar-plus category. One home has an estimated value of $8.65 million after being originally appraised at $12 million.

Perhaps the biggest surprise is the number of loans that have been modified. According to the Board's resolution, homeowners whose loans were sold into private label securitizations "are unable to access many of the foreclosure prevention programs available to other struggling homeowners". Yet the data tell a different story:  129 of the 279 mortgages have had some kind of modification, such as principal reduction, interest rate reduction or additional time allowed for repayment. In many cases, multiple features of the mortgage were modified.

The resolution also notes that the vast majority of private label securitizations have "predatory" features. The features identified as predatory include negative amortization, interest only, balloon payments and adjustable rates. While I agree that negative amortization loans can be objectionable, I don't consider all these attributes to be necessarily predatory. Like many financial professionals, I have taken out ARMs on multiple occasions, and I never felt exploited. Indeed, since base interest rates are sharply lower than they were in 2007, it is likely that most ARM borrowers are paying little more than the original interest rates they incurred at origination. Of the 279 underwater San Francisco mortgages, 203 bear current interest rates of 4% or less - hardly predatory. Half of the universe consists of ARMs and another 49 are fixed rate.

Finally, it is worth noting that the vast majority of the underwater homes have multiple liens. In 244 of the 279 cases, the Combined LTV Ratio is different from the LTV Ratio, suggesting the presence of second and third mortgages. If one of the other liens is federally backed, the Authority may be challenged to liquidate the private mortgage while leaving the government mortgage intact. 

Undoubtedly, some San Francisco homeowners were sold predatory mortgage products by unscrupulous financial institutions. In some cases, these individuals may still be underwater because their homes were aggressively appraised or they live in neighborhoods with less robust price appreciation.

That said, we have yet to see a pool of mortgages that reliably falls into these categories. If the City cannot identify a set of mortgages that is fit for condemnation, the joint powers authority might benefit some undeserving homeowners - like the one with the $8.65 million house mentioned earlier. Further, if only a few dozen mortgages really do need to be liquidated, it is likely the City can find more cost effective means of doing so than through the use of eminent domain.

Ocwen Letter Spooks the Market

Ocwen just can't seem to get a break.

After a rough first 9 months to the year -- stock was down 53.5% YTD as of Monday's close -- the release of NY State Fin. Dept. Superintendent Benjamin Lawsky's letter to Ocwen's general counsel sent the stock tumbling again. 

Our last coverage was back in February, after Ocwen had agreed to a settlement fee, with the CFPB, of $2.2 billion, for its missteps from 2009-2012.  We showed the potential for this litigation expense to grow, as there were even more complaints in 2013 against Ocwen than in 2012.

The stock is now down 24.8% from Monday's close: Lawsky's letter included some powerful language, some of which could have repercussions to Ocwen beyond the immediate scope of the letter.

Lawsky's previous letter to Ocwen, dated April 2014, brought to the fore what Lawsky's office saw to be a "particularly troubling issue" - "the relationship between Ocwen and Altisource Portfolio’s subsidiary, Hubzu, which Ocwen uses as its principal online auction site for the sale of its borrowers’ homes facing foreclosure, as well as investor-owned properties following foreclosure." 

Hubzu appears to be charging auction fees on Ocwen-serviced properties that are up to three times the fees charged to non-Ocwen customers. In other words, when Ocwen selects its affiliate Hubzu to host foreclosure or short sale auctions on behalf of mortgage investors and borrowers, the Hubzu auction fee is 4.5%; when Hubzu is competing for auction business on the open market, its fee is as low as 1.5%. These higher fees, of course, ultimately get passed on to the investors and struggling borrowers who are typically trying to mitigate their losses and are not involved in the selection of Hubzu as the host site.

In August, Moody's downgraded Ocwen's primary servicer and special servicer ratings - and left both assessments on watch for further downgrade.  The shareholder class action complaints started to trickle in in August, and by September 2014 a handful of shareholder complaints had been filed.  (See for example NORBERT TUSEO, Individually and on Behalf of All Others Similarly Situated v. OCWEN FINANCIAL CORPORATION, RONALD M. FARIS, JOHN V. BRITTI and WILLIAM C. ERBEY)

The recent information about Ocwen's potentially backdating thousands of foreclosure documents is relevant not just insofar as it affects the nature of all current shareholder litigation, but insofar as Ocwen is being sued by mortgage borrowers, directly, and by mortgage market players and investors.  Crucially, Ocwen's servicing performance can be critical to the performance of RMBS securities.

For example, at least five third-party complaints have recently been filed by Nomura Credit & Capital, Inc. against, among other co-defendants, Ocwen as the servicer of the RMBS trusts. The complaints argue that Ocwen's underperformance has harmed the plaintiff, or that the breaches ought alternatively to relieve Nomura of certain of its duties to the trust.  The following excerpt comes from Nomura Credit & Capital, Inc. v Wells Fargo Bank, N.A., and Ocwen Loan Servicing, LLC, filed 8/11/14.

This public embarrassment can make it more difficult for Ocwen to defend itself in the existing and future litigation as it will inevitable have suffered a deterioration in reputation capital.  Last but not least, it will likely further hinder any near-term hopes Ocwen may have had of buying additional mortgage servicing rights (MSRs), and expanding its business.

Chicago’s Swap Contracts, Unfair Credit Ratings and a Way Out

In 2002, Warren Buffet called them financial weapons of mass destruction. In 2008, they triggered a severe national recession. And now, in 2014, they are jeopardizing the financial position of the City of Chicago. Like zombies who just won’t die, financial derivatives – put in place many years ago – now threaten to take a major bite out of the city’s reserves. Fortunately, new SEC rules may give Chicago the weapons it needs to ward off this financial Frankenstein.

Between 1999 and 2007, Chicago entered into a series of interest rate swap contracts with financial titans such as Goldman Sachs, Morgan Stanley and Bank of America. These swap contracts allowed the city to issue floating rate bonds while locking in a fixed interest rate - but they also locked the city into binding, long-term contracts, with the financial behemoths, that came with some unexpected risks.

The idea behind the swap contracts was appealing: the city treasury was protected from rising interest rates. At the time, no one knew that interest rates would fall to zero and stay there, obligating Chicago to pay hundreds of millions of swap payments to the major banks.

But there was a simpler alternative to issuing variable rate bonds and then offsetting the interest rate risk with swaps. The city could simply have issued more fixed rate debt. Traditional, fixed coupon bonds remain common in municipal finance and provide a straightforward way to lock in an interest rate.

The problem with simple solutions like fixed rate bonds is that they don’t generate a lot of income for financial intermediaries. In a 2011 testimony at an SEC hearing, financial expert Dr. Andrew Kalotay observed that swap advisers, pricing agents and attorneys all charge substantial fees for their efforts, while banks typically charge a 2% markup on swap transactions. In Alabama, $120 million in swap fees contributed to that Jefferson County’s 2011 municipal bankruptcy filing. Kalotay went on to observe that corporations never finance themselves with a combination of floating rate bonds and interest rate swaps. They apparently realize that this combination is a good deal for Wall Street banks – and not for them.

But excessive fees are not the only downside of these swaps contracts, as Chicago is now learning. Because swap contracts require cities to make payments to banks, they contain provisions that protect the banks in case a city becomes insolvent – as Detroit did.

In Chicago’s case, banks are protected by a clause that allows them to terminate the swap contract if the city is downgraded by Moody’s to a rating of Baa2. If the banks terminate their swap contracts under this provision, the city would have to immediately pay all the rest of the money it owes under the agreements – about $173 million according to Bloomberg.

Recently, Moody’s downgraded the city to Baa1 - one step above the accelerated termination threshold - while maintaining a negative watch. Thus Chicago is in real jeopardy of suddenly being obliged to pay a lump sum of almost $200 million to the major banks.

It is almost surreal when you think about it:  banks and credit rating agencies widely blamed for a financial crisis that happened six years ago still hold the power to seriously compromise the city’s finances.

But reforms enacted in the wake of the financial meltdown may be used to protect Chicago. Dodd Frank contained a provision requiring rating agencies to consistently apply their rating symbols. This “universal rating symbol” requirement was recently included in new SEC rule 17g-8.

There is ample evidence that rating agencies have discriminated against government bond issuers vis-a-vis other types of borrowers, including corporations and structured finance vehicles.  For example, thousands of AAA-rated mortgage backed securities failed to make complete and timely debt service payments in recent years, while no city or county rated single-A or above has experienced such a payment failure. Evidence of this discrimination was surveyed in a March 2014 comment letter from the Consumer Federation of America to the SEC.

In 2008, the state of Connecticut sued all three credit rating agencies for this discriminatory practice.  The case was eventually settled, with two of the three agencies agreeing to rescale their ratings in 2010. But this adjustment failed to fully address the ratings discrepancy and has been fully offset by subsequent downgrades attributed to pension underfunding.

Despite the many scare stories about public employee pensions, they have not played a major role in triggering municipal bankruptcies to date. In fact, since Detroit filed last July, no American city or county has initiated a Chapter 9 bankruptcy process. Moreover, most of the cities that previously filed – including Vallejo, Stockton, San Bernardino, Harrisburg and Detroit – did so because they faced some combination of declining revenue and deficient or negative general fund reserves. Pension obligations were, at most, a secondary issue.

Consequently, it is fair to argue that Chicago’s pension obligations do not justify its low ratings. Moody’s and other credit rating agencies should review Chicago’s ratings to ensure that they reflect the city’s real risk of defaulting over the next few years – which is miniscule. If Chicago’s ratings were properly rescaled, the city would no longer be on the verge of making $173 million in termination fees to the big banks.

Unlike today, the City of Chicago faced the real possibility of default in 1932. At that time, a large principal payment was coming due and the Depression-wracked city lacked the revenue needed to make it.  Back then, civic-minded bankers teamed up and worked overtime to find buyers for a new bond issue that allowed Chicago to roll over its debt and avoid bankruptcy. Eighty years ago, financial leaders believed they had a role to play in helping their cities survive financial turmoil; today it seems that the financial industry regards municipalities as just another lucrative source of fee income.  

Securities Price Shopping

We've all heard about how Michael Lewis' book (Flash Boys) has brought a flurry of attention to the (real) movements of stocks, but his work seems also to have spurred on a host of other initiatives that were already in the works.

Importantly, the "authorities" have been paying attention to the all-important consideration of pricing (of securities).  In short, we think it's problematic that each party (fund, company, investor) gets to price its own assets. Two different banks can hold the same amount of the same investment, have the same auditor and the same regulator, and price the investment yards apart -- based on the application of different assumptions. We have a number of solutions to this problem, but have been arguing for pricing transparency (where are these prices coming from, and upon what assumptions are they based) for many years.

The SEC had previously found troubling pricing practices ("violations of law or material weaknesses in controls") in the world of private equity.  Now it has announced it found serious deficiencies in valuation processes used by hedge funds:

...regulators have discovered some funds engaging in what he called "flip-flopping," boosting valuations by changing the way they measure holdings several times a year. In some instances, the funds chose the measurement with the highest value or intentionally classified certain assets in a way that gave the fund manager more flexibility to inflate the price of the fund's holdings. (Source WSJ)

FINRA recently fined Citi upon finding that "one of Citigroup's trading desks employed a manual pricing methodology for non-convertible preferred securities that did not appropriately incorporate the National Best Bid and Offer (NBBO) for those securities." According to FINRA, "Citigroup priced more than 14,800 customer transactions inferior to the NBBO." FINRA also notes, as if it comes straight out of Flash Boys which focuses on exchange execution and the NBBO, that...

"Citigroup priced more than 7,200 customer transactions inferior to the NBBO because the firm's proprietary BondsDirect order execution system (BondsDirect) used a faulty pricing logic that only incorporated the primary listing exchange's quotation for each non-convertible preferred security."

For a list of pricing "issues" and disagreements, click here. For our other coverage on high frequency trading (HFTs), click here.

Meanwhile, we've been tracking dark pool trading flow after the recent investigations.  In an earlier blog we tabulated recent trading levels, showing the reported, dramatic, drop in trading at Barclays' dark pool.  Since then, the flow within Barclays' has stabilized and gone up just a touch in August, while overall ATS trading levels have stabilized somewhat.  This is despite any seasonality component, with general trading levels on exchanges down roughly 9.5% since June (i.e., comparing August to June).

The Trading's Trailing Off

There's been some generally miserable news floating about about big bank trading levels.

In a Forbes article, the team at Trefis put lower trading revenues down to "an overall reduction in trading activity over the period (a temporary factor) and a reduction in total market size as a direct result of stricter regulations (a permanent factor)."

Meanwhile, a number of media outlets were quick to cover the fact that trading levels within Barclays' dark pool has declined an incredible 66% during the week ending June 30th, versus the prior week.

We investigated this a little further and found that the week ending June 30th was not a good one for any of the alternative trading systems (ATSs).  It's not necessarily (or only) that Barclays' former clients may have been aggrieved at certain claims or findings made public in the NY Attorney General's complaint filing against Barclays, as could be inferred from a strict reading of some of the coverage -- but that trading levels at ATSs declined generally, with overall trading levels off 25% across the board, and by a median of roughly 20% across all ATSs.  The numbers are still in the same region even if we control for smaller ATSs, by only looking at the 15 largest ATSs as measured by share-trading volume for the week ending June 9.

Banking pundits will be hoping this is only midsummer madness, or maybe due to interim distractions from the Football World Cup.  The week ending June 30th coincided with the final week of group games.

Anyhow, here are the numbers from our extraction of aggregated trade data reported by ATSs to FINRA pursuant to Rule 4552.

We'll Promise You Best Execution -- For Us (That Is)

The high-frequency investigations just heated up a notch this week, with some choice testimony coming from the grillings on Capitol Hill.

We previously had investigations (SEC, FBI, DOJ, NY AG) into the activities within dark pools, and they were mostly concerned with whether information about some parties was being disclosed to other parties, when it might have been expected to be hidden.  There were also more general concern about whether the game had changed in such a way as to make it easy for the high frequency trading firms (the HFTs) to game the "ordinary" investor. 

The recent hearings, held by the Permanent Subcommittee on Investigations, have now honed in on the all-important question of whether online or discount brokers are appropriately routing their customers' order flow in the best interests of the customer.

As highlighted in a WSJ article, there seems to be an indication that, at least for TD Ameritrade, the flow went to the exchange that was most likely to produce the highest refund (or revenue gain) to TD.

We haven't as yet been able to track down the transcript of the hearing (aside from the written statements, that is) but the snippet on the right seems to corroborate the WSJ's coverage:

"Mr. Levin asked [TD Ameritrade's] Mr. Quirk whether the firm's routing decisions "virtually always led you to route orders to the markets that paid you the most."

"Virtually, yeah," Mr. Quirk replied.

TD Ameritrade had already been feeling the heat from some clients who recently learned how much TD made from selling order flow to Citadel and Knight Capital. This testimony, we imagine, won't help any!

Are "Dark Pool" Probes Pending?

Banks' so-called "dark pool" trading venues are all the rage these days.

The media jumped when dark pools were cited in federal authorities' and investor class action complaints against SAC Capital and its executives. The focus was on how the anonymity associated with dark pools, and the levels of secrecy they provide, allowed SAC and/or its members to avoid detection and potential losses on its sale of stock. (See also Gazing into 'dark pools,' the tool that enables anonymous insider trading)

One quote from a complaint reads:

“We executed a sale of over 10.5 million ELN for [various portfolios at CR Intrinsic and SAC LP] at an avg price of 34.21. This was executed quietly and efficiently over a 4 day period through algos and darkpools and booked into two firm accounts that have very limited viewing access.”

Next Goldies brought its dark pool, Sigma X, to the fore.  Having discovered pricing errors within the opaque pool, Goldman reportedly decided to send refund checks to customers to compensate them for the mistakes.

Michael Lewis didn't make matters any easier for Goldman or dark pools, giving them a hard time in his new book, Flash Boys.  Among other things, he casts doubt on whether investors got "best execution" through the dark pools:

“A broker was expected to find the best possible price in the market for his customer. The Goldman Sachs dark pool—to take one example—was less than 2 percent of the entire market. So why did nearly 50 percent of the customer orders routed into Goldman’s dark pool end up being executed inside that pool—rather than out in the wider market.”

That quote, alone, might not be altogether convincing: it's not clear whether he's looking at scenarios in which Goldman's clients have requested execution through the Sigma X, or whether Goldman's clients, requesting best execution, were oddly quite regularly executed through Sigma X, despite the potential for sub-optimal execution through that platform.  It's probably fair to say that those requesting execution through the dark pool would agree that they were foregoing "best execution" in the market - which is something one typically foregoes even with "hidden" orders submitted to an (open) exchange.

But now Goldies is back in the spotlight.  According to today's WSJ, they're considering shutting down their dark pool.

But why?

According to the Journal article, Goldman executives are weighing the benefits of the revenues it produces, against the burdens dealing with trading glitches and negative press.  Some burdens those must be, given Sigma X is purportedly one of the largest bank dark pools, and is likely producing significant flow.

Perhaps there's another theory...

Consider these stories:

In January 2014 Barclays decided to shut down its retail / margin Foreign Exchange business, Barclays Margin FX; in February, NY regulator Lawsky opened a currency markets probe.

In January 2014 Deutsche Bank AG (DBK) announced that it will withdraw from participating in setting gold and silver benchmarks in London;  in March, the CFTC announced that it is looking at issues including whether the setting of prices for gold—and the smaller silver market—is transparent. 

In July 2013, the CFTC put metals warehouses on notice of a possible probe. By November 2013 Goldman was resuming talks to sell its metals warehouses and seeking a buyer for its uranium trading unit; and by March 2014 we had various notices of JP Morgan's intent to sell its physical commodities divisions.

Probe and Sale

We could go on and on, but ultimately these are all anecdotal and we aren't wanting or looking to prove statistical significance at this stage.  We're also not too concerned about what comes first: the probe or the sale.  There's certainly no one-to-one mapping.  Not every regulatory probe is followed by a sale, or vice-versa.  We're only wondering if there's a pattern. And if there's a pattern, could there be an explanation as to why there's a pattern?

Here's one theory.  (We welcome yours.)  Might it be that, pending a likely or imminent (and embarrassing or expensive) enforcement action, banks may take preemptive action in selling "problematic" divisions ... to enable the negotiation of a more lenient settlement as they're (now) less likely to be repeat offenders of whatever activity was the subject of the probe?

In other words, is a dark pool probe pending?

High Frequency (Non) Trading

This week's release of Michael Lewis' new book, Flash Boys, has renewed focus on a little understood area of the market, an area that has garnered the recent attentions of market regulators, New York's Attorney General, and more recently the FBI -- but never as much attention as it garnered from Michael Lewis' interview on 60 Minutes on Sunday, with his book pending release the following day.

Without going into too many specifics, one of the central themes that Lewis discusses is the potential for high frequency traders (or HFTs) to take advantage of certain market information -- like bids and offers -- that are unknown to many other market players.

Defenders of HFTs have come out aggressively, with claims that HFTs increase market activity and liquidity, and have lowered trading costs.  The WSJ published an extensive opinion editorial by hedge fund guru Cliff Asness and his colleague Michael Mendelson of AQR, which energetically claims that much of what HFTs do is "make markets" and that they do it best because "their computers are much cheaper than expensive Wall Street traders, and competition forces them to pass most of the savings on to us investors."

Of course this sounds altogether too convincing.  Unfortunately, Asness and Mendelson provide little or no evidence (although their business as long term traders relies heavily on evidence, and they claim in the article to spend considerable energies looking into their trading costs) and they admit that they actually don't have too much conviction in the premise of their exposition:

"We think it helps us. It seems to have reduced our costs and may enable us to manage more investment dollars. We can't be 100% sure. Maybe something other than HFT is responsible for the reduction in costs we've seen since HFT has risen to prominence, like maybe even our own efforts to improve." (emphasis ours)

But this aside, no doubt all forms of HFTs bring liquidity.  They're a good thing.  Let's focus our attention elsewhere.  

Or not?

Might there be another type of HFT, that doesn't always bring liquidity for the greater good of the market ...  perhaps a type that uses obscure mechanisms to change the look and feel of the market -- to make people think there is a bid, think there is an offer, without there being one?  

This is what Flash Boys, and the interest it has invigorated in HFTs, really concerns itself with -- understanding market maneuvers like spoofing or pinging: the submission of phantom orders, immediately cancellable, that have the potential to create a false impression of market levels.

Are we creating a whole lot of (potentially fictitious) orders, but not a whole lot of activity?  Are there high-frequency non-traders?  Are we mis-marking our portfolios as a result? We continue to investigate.  But we couldn't help but bring you back to a 2013 chart from Mother Jones, which highlights the growing contrast between actual trades (in orange) and quotes/orders (in red).

Government Credit Crisis is Over - So Where are the Ratings Upgrades?

The sovereign and municipal debt crisis of the early 2010s is finished. Overblown predictions of a credit meltdown among European sovereigns, US states and cities, and other advanced economy governments have not been realized. Yes, there have been a few high profile defaults - Greece, Detroit, Harrisburg, Stockton and San Bernardino all come readily to mind because their insolvencies received so much coverage. But many other predicted defaults – Italy, Spain, California, Illinois, San Jose – failed to materialize and the overall default rate among government issuers has been only a few basis points annually. Meredith Whitney’s 2010 forecast of dozens of major municipal defaults is now fully beyond resuscitation – even by Michael Lewis.

Muni bond market shorts set their 2014 hopes on Puerto Rico, but this month’s successful $3.5 billion bond sale makes the odds of a near term default or restructuring remote. Last year, both major pension systems received major overhauls with many current employees taking reduced benefits. Most of Puerto Rico’s debt is long term and annual deficits are relatively low, so the Commonwealth’s intermediate term financing needs are modest. 

The end of the default “wave” and its limited magnitude leave credit rating agencies in an awkward position. Having repeatedly downgraded government credits, their current ratings are inconsistent with those that prevailed at the beginning of the apparent crisis. Also, their government credit ratings are now even more inconsistent with their ratings for corporate and structured – asset classes that have more underlying risk because issuers cannot levy taxes.

In 2013, Fitch announced that it downgraded twice as many US public finance credits as it upgraded in 2013. Moody’s 2013 transition report has yet to appear, but weekly accounts of its upgrades and downgrades at MunicipalBonds.com suggest a similar pattern. This preponderance of downgrades is occurring despite the overall improvement in state and local government finance. Renewed economic growth is yielding more income and sales tax revenue, rising home prices are swelling property tax receipts and a buoyant stock market is shrinking unfunded pension liabilities. But because Moody’s decided to use a lower rate of return assumption for pension fund assets, it has created the perception of increased credit risk, despite the absence of such. The blizzard of downgrades has largely offset the (upgrading) effects associated with the 2010 reconfiguration of the municipal ratings scale that had been undertaken in the wake of a lawsuit by Connecticut’s attorney general.

Meanwhile, the high profile states of California and Illinois remain at single-A despite the marked improvement in their prospects. Since Moody’s last downgraded California, the state has swung from deficit to surplus and seen a substantial decrease in its unemployment rate. Illinois, downgraded in mid-2013 due to a temporary failure to pass pension reform, has yet to see a compensatory upgrade now that the reform has been enacted. My own view was that neither state had material default risk in the medium term, given their low debt service requirements relative to projected revenue.

Markets appear to be rejecting the drumbeat of dire rating actions. In the same week that Puerto Rico successfully sold its non-investment grade issue, Chicago placed $884 million in securities on the heels of two Moody’s downgrades (a three notch reduction from Aa3 to A3 in July 2013 followed by a further one notch cut to Baa1 this month).

Perhaps markets have started to ignore ratings because they have become so rudderless. Ratings have inconsistent meanings because they are products of human discretion. If, instead, they were the outcome of stable, empirically-based algorithms, ratings would more likely have the same meaning across time and between categories. Unlike human analysts, computer models don’t have to worry about criticism that they are being soft on politicians or inadequately mindful of unfunded pension liabilities – which are rarely associated with actual bond defaults anyway.

Finally, it is worth noting that inconsistent, incoherent ratings are not merely a sin of US rating agencies. Dagong, which commanded respect for issuing a sub-AAA rating to the US back in 2010, has not covered itself in glory since. After the end of the October 2013 government shutdown it inexplicably downgraded the US rating to A-.

The Chinese rating agency, apparently unaware that partial shutdowns are a familiar part of the US political scene, suggested that the October incident reflected an unprecedented level of risk. Contrary to political and media hyperbole, there was never a serious risk of a Treasury default arising from either a shutdown or a delay in raising the debt ceiling. While I agree that an issuer that engages in kabuki theatre over its credit obligations cannot warrant a top rating, it is absurd to place the world’s most powerful government a few notches above junk amidst declining deficits and accelerating economic growth. Further, we should all take pause from the fact that the Fed has proven capable of buying the lion’s share of new Treasury issuance with freshly printed money and without triggering price inflation.

Dagong’s goal appears to be to convince the world that the US is a worse credit than China. That’s a hard case to make given the latter’s relatively short history as a market participant, its lack of transparency and the risk that its single party political system cannot be sustained over the long term.

But regardless of the ratings themselves, Dagong’s process is disturbingly similar to that of the Western incumbents – discretionary ratings subject to political pressure and human biases. This is unfortunate for a rating agency that hopes to displace the ruling ratings triumvirate. By declining to offer a superior analytical product, Dagong leaves investors little choice but to stay with the incumbents.

Mortgage Servicers, Underserving?

There's been a lot of news coverage in the last few months on the changing nature of the mortgage servicing industry, and consumer and regulatory difficulties with status quo. (See for example, here and here.) 

Among other things, late last year mortgage servicer Ocwen Financial (OCN) paid roughly $2.2bn to settle claims made against it by the Consumer Financial Protection Bureau (CFPB) that it, according to bureau director Richard Cordray, had "violated federal consumer financial laws at every stage of the mortgage servicing process." 

According to the NY Times, the $2.2bn settlement covers activities from 2009 to 2012 by Ocwen and two companies it recently acquired.

But what about "activities" since 2012?

We did some digging into the number of CFPB complaints being filed by borrowers against mortgage servicers in 2013.  Looking at only those complaints pertaining to (1)    loan servicing, payments, escrow account or (2)    loan modification, collection, foreclosure, we found an increase of over 20% from 2012 to 2013, broken down as follows:

Puerto Rico Rating Downgrades: Enron Redux?

On November 28, 2001 Enron lost its investment grade credit rating. Four days later, the company filed for bankruptcy. Those awaiting a similar collapse after Puerto Rico’s descent into junk bond territory last week will have to wait a lot longer to see the Commonwealth’s financial denouement.

The relatively slow motion nature of Puerto Rico’s fiscal collapse – if, in fact, one is occurring – underscores the differences between various classes of public sector and private sector debt. It also speaks to changes in market conditions.

As with the 2011 S&P downgrade of the US, rating agency actions had little impact on Commonwealth yields. The New York Times reported last Wednesday that the investors had shrugged off the S&P action. On Friday, the Wall Street Journal reported that Puerto Rico General Obligation debt traded at a lower yield after the Moody’s follow-on downgrade than it had earlier in the week.

The limited impact of the ratings downgrades might be attributed to market discounting – since the rating agency actions were widely anticipated. It could also speak to the greatly reduced reputation rating agencies enjoy in the aftermath of the Enron/Worldcom scandals of the early “aughts” and the subprime fiasco of 2008.

Unlike Enron, Puerto Rico can operate for some time without capital markets access. The Commonwealth can get by without financing because its fiscal deficits are relatively low and its debt is predominantly long term. It thus does not need that much new cash to finance ongoing operations or to roll over previous bond issues.

But, sooner or later, Puerto Rico will have to bring new issues to market, and many doubt whether investors will be around when it does. Commonwealth-related debt accounts for about 2% of overall US municipal bonds outstanding and its fall from investment grade leaves many traditional investors out of the running. So it would appear that there is a lot of debt and not much appetite.

In my view, this analysis misses some key institutional developments. Hedge funds and certain other classes of investors can traverse multiple markets. Further, Asian investors have accumulated billions of savings and remain on the lookout for alternatives to low yielding US Treasuries. So the constituency for Puerto Rico debt is not merely the $3.7 trillion municipal market, but a much larger audience especially if the price is right. 

Puerto Rico debt is now trading at yields much higher than that of Italy, Spain and Portugal - and is roughly on a par with Greece. In contrast to Greece, Puerto Rico is not a serial defaulter. In fact, it is part of an asset class – US state and territorial bonds – that has not seen a default in over 80 years. Further, the last default – of Arkansas in 1933 – ended in a full recovery for investors. So, from an international perspective, Puerto Rico bonds appear to offer good relative value.

Thus if new Puerto Rico bonds are offered at 8% or 9%, I expect that they will find a bid. While coupons at that level are not fiscally sustainable, the fact that most Puerto Rico government debt is long dated means that Commonwealth interest expenses as a proportion of revenue will remain low relative to previous default cases.

Unlike Enron or another private company, a US sub sovereign like Puerto Rico has secure revenue sources in the form of taxes and federal assistance. As Detroit has shown, insolvency is ultimately possible, but the path to ruin for a public sector debt issuer is usually a long one.

Notes: I purchased a small number of Puerto Rico GO bonds last month. Any opinions provided herein are my own. PF2 is an independent third party and does not provide investment advice. For my previous commentary on Puerto Rico's lack of fiscal transparency, click here.