Monday, December 11, 2017

Al Franken's Complex Legacy and the Credit Rating Business

Al Franken’s announcement of his pending resignation completes his descent from Progressive Saint to something of a pariah figure. But like others whose stars have fallen during this moment of reckoning for alleged sexual harassment, Franken is neither all good nor all evil. Instead, he leaves a complex legacy with both pluses and minuses. Such was his impact in the realm of financial regulation, where he correctly diagnosed an important problem but misunderstood its genesis, putting forward an ill-conceived solution.

Before being outed as a serial groper, Franken built a reputation as an entertainer, a pundit and finally a serious-minded US Senator. Although fans of the free market rarely liked his political positions, it is hard to deny that he brought a quick wit, keen intellect and passion for justice to his work.

When deliberating over the 2010 Dodd-Frank Act, a measure intended to remedy the causes of the 2008 financial crisis, Franken recognized that it didn’t adequately address credit rating agencies. He realized that these firms triggered the crisis by assigning gold-plated AAA ratings to thousands of low quality mortgage-backed securities. These rating errors attracted excess capital into the housing finance market, driving down the cost of getting a home loan and inflating the home price bubble.

Importantly, Franken understood the complex interplay in the market, recognizing that the bad ratings were a byproduct of the credit rating business model, in which the agencies are compensated by bond issuers rather than investors. In the oligopolistic rating market – dominated by three firms – bond issuers could pit rating agencies against one another, offering to hire the agency willing to apply the lowest credit standards to their bonds. Until this business practice changed, the economy would remain vulnerable to another financial crisis.

Franken’s diagnosis was buttressed by the fact that rating agencies have made many other errors. (As I discuss in a forthcoming Reason Foundation study, rating agencies also assigned inflated ratings to Enron, Worldcom, and municipal bond insurers like Ambac and MBIA, among others.)

Although Franken’s analysis was correct, his proposed solution was flawed. His idea was to break the nexus between bond issuers and rating agencies by inserting government as a middleman. Rather than select rating agencies on their own, bond issuers would have to ask a government bureau to select raters on their behalf. This so-called Franken Amendment to Dodd Frank was stripped from the bill, so we cannot be certain how this solution would have worked.  But with all likelihood, the core problem would remain, and the “selection agency” function would similarly be exposed to capture by the industry, not to mention any other number of unintended consequence. Likely, there would have been multiple unintended consequences including the eventual capture of the selection agency by industry interests. 

The issue with the rating model is that the government is involved, unnecessarily, and not in a way that advances or incentivizes accurate measurement.  The solution, then, is not to increase government involvement.

We can easily identify a better solution by understanding how the credit rating business became distorted and then removing the causes of this distortion. In the early 20th Century, Moody’s and its competitors were small firms that sold rating manuals to investors. After Depression-era bank failures and the inception of federal deposit insurance, bank regulators began using the ratings manuals to determine which companies banks could lend to. Since the 1970s, regulations based on credit ratings were extended to other financial players, and the SEC began to license and regulate rating agencies.
These interventions created barriers to entry for competitors while making the ratings themselves valuable to bond issuers – since the ratings determined whether many types of investors could buy certain bonds. As a result, credit rating agencies had been handed a powerful and exclusive tool – one they could monetize by selling ratings to bond issuers.

Instead of adding more bureaucracy as Franken proposed, a better solution is to dismantle the entire regulatory apparatus. Let’s allow anyone to issue credit ratings on a level playing field and divorce these ratings from all financial regulation. It will then become the investor’s responsibility to choose which rating agency to trust, giving credit raters – both incumbents and disruptors – the incentive to provide better ratings.

Although Franken was a smart legislator, his policy positions may have been compromised by a worship for power, just as the various groping allegations appear to have been the result of an abusive exercise of power.  Likewise, increasing financial power through regulation – as Franken proposed to do – creates opportunities for abuse. Rather than concentrate power we should be trying to disperse it – in Washington, on Wall Street and beyond.  In this way, we can prompt financial market participants to be more accountable for their own investment decisions, and more directly responsible.

Marc Joffe is a Senior Policy Analyst at the Reason Foundation and a researcher in the credit assessment field. He previously worked as a Senior Director at Moody’s Analytics. This article reflects his personal opinion, and not necessarily those of PF2 Securities.

Friday, November 17, 2017

Developments in FX and US Treasuries Litigation

An interesting week. Two developments emerged concerning possible behind-the-scenes activities in two of the largest markets – foreign exchange (FX) and U.S. Treasuries (bills, notes and bonds). 

The New York Department of Financial Services (NY DFS) fined Credit Suisse $135 million for FX wrongdoing. And plaintiffs in a class action alleging manipulation in the U.S. Treasuries market filed a new complaint with additional allegations.


The NY DFS consent order presents its findings that Credit Suisse engaged in a myriad of transgressions in the FX market – including: 
  • Efforts to manipulate prices around the “fix” and improper sharing of customer information with traders at other banks, e.g.: 
    • "... Trader 1 discussed with Trader 4 an effort to “unload” ammunition. Trader 1 stated “get ready unload on nzd,” to which Trader 4 replied, “I am. Nearly hit it last time.” As the fix drew near, Trader 1, referring to an unidentified co-conspirator, remarked “if he can’t get it lower we may be in trouble.” After apparent success, Trader 1 remarked “come to poppa,” while Trader 4 retorted, “phew.” "
  • Attempts to front-run customer orders, e.g.: 
    • " In one instance in February 2013, a Credit Suisse trader, Trader 1, disclosed potentially confidential information obtained from the Credit Suisse sales desk about FX trading associated with a pending merger and acquisition: “I think there’s some lhs2 action today at the fix on the back of tht massive m+a . . . massive caveat, info is from sales desk . . . but 4 o clock. . . . 16 yrds . . . something to do with the equity leg is going thru today . . . that’s the reason they saying the spot will be done.” "
  • Collusion with other banks to maintain wide bid-offer spreads
  • Price manipulation on behalf of certain customers, e.g.: 
    • " On September 7, 2012, a Credit Suisse customer (“Customer 1”) enlisted the assistance of a Credit Suisse trader, Trader 18, in seeking to push down the price of the U.S. dollar/Turkish lira pairing. Customer 1 asked Trader 18, “can you walk down usdtry for me pls.” Trader 18 replied, “Yeah, no problem.” Customer 1 then stated, “just offer 1 at like 72 . . . just walk it brotha,” to which Trader 18 replied, “No sweat.” Customer 1 cheered on Trader 18, saying “come on . . . just walk it,” to which Trader 18 replied, “Collapsado.” Apparently upon achieving success, Customer 1 stated, “thks [Trader 18] for walking it down . . . great job . . . you really shellacked it.” Trader 18 quickly replied, “pleasure.” "
  • Abuse of last look via its electronic platform
  • Deliberately triggering (and front-running) customer stop-loss orders
This last item is particularly noteworthy – not because Credit Suisse is the first to be accused of intentionally triggering stop-loss orders (it’s not), but because the bank apparently wrote an algorithm to calculate the likelihood of successfully triggering stop-loss orders that were potentially ripe for targeting.  In so doing, the bank seems to have systematically developed a system for deciding which stop-loss orders to target.

The penalty imposed by the NY DFS is the first FX-related regulatory fine imposed against Credit Suisse. In contrast, Swiss competitor UBS has settled with the CFTC, Federal Reserve, FINMA (Swiss regulator) and FCA (UK regulator), as well as class action plaintiffs in the U.S. and Canada, for a total of nearly $1.3 billion. 

U.S. Treasuries 

In the consolidated complaint, styled In Re Treasuries Securities Auction Antitrust Litigation (1:15-md-02673), plaintiffs indicate that they have evidence in hand, such as chats and emails, which shows bank traders sharing customer order information with traders at other banks (but by our reading they don't seem to have produced said evidence). 

According to the complaint: 
“Plaintiffs have obtained documents relating to the DOJ’s ongoing investigation, which confirm that such trader communications occurred. These materials include online chat transcripts in which the Auction Defendants shared the identities (often using code phrases) of their indirect bidder customers, the details of those customers’ order flow, and other private customer information.” 
Interestingly, plaintiffs have broadened the scope of the complaint, to include wrongdoing in the secondary market.  Plaintiffs allege, anew, that dealer banks have conspired to boycott trading platforms that would enable market participants to trade with each other on anonymous all-to-all platforms, such as eSpeed and Direct Match: the theory being that all-to-all trading platforms could be a threat to the status quo of dealer dominance of the secondary trading market, potentially putting dealer trading revenues at risk. 

The boycotting allegations are similar to those made against interest rate swap and credit default swap dealers in cases such as In Re Interest Rate Swaps Antitrust Litigation (1:16-md-02704) and Tera Group, Inc. et al v. Citigroup, Inc. et al (1:17-cv-04302).

For more detailed coverage of these matters, visit our piece here.

Monday, October 30, 2017

The Cost of NOT Investing

Asset price bubbles are a tricky thing. 

Recognizing a bubble may be tough enough.  Predicting its bursting is another story altogether.  Like earthquakes, both the timing and magnitude of a pop is difficult, if not impossible, to measure.  And then there are the after-shocks, similarly difficult to quantify, although we may think we know a thing or two about them.

Now once you think you're seeing a bubble -- after all, a bubble is a bubble -- does that mean you should not invest?

Welcome to the Land Down Under

We're not going to take a position on whether the Australian housing market is in a bubble or not.  But we'll tell you that its an ongoing debate.  And this debate has been, err, ongoing for well over 15 years.

Earlier this month, the Economist put out an interesting article that included this diagram.  Wow, or booya, it sure looks like a housing bubble, doesn't it?

But, on deeper investigation, the blue line was also disconnected from population growth or per-person-GDP way back in 1990.  Wouldn't that mean it was a bubble already in 1990, or certainly 2003.  Well...

In May 2003, the Economist magazine put out a story called House of cards, in which their economics editor explained that:
"Over the past few years, house prices have been booming almost everywhere except Germany and Japan. Since the mid-1990s, house prices in Australia, Britain, Ireland, the Netherlands, Spain and Sweden have all risen by more than 50% in real terms. American
house prices are up a more modest 30%, but that is still the biggest real gain over any such period in recorded history. Commercial-property prices in some big cities have also been looking rather frothy."   
... and ...  
"This survey will conclude that the latest housing boom has inflated bubbles in several countries, notably America, Australia, Britain, Ireland, the Netherlands and Spain. Within the next year or so those bubbles are likely to burst, leading to falls in average real house prices of 15-20% in America and 30% or more elsewhere over the next few years, in line with average price declines during past housing-market busts."

Looking back at this now ... more than 14 years later, it has been one-way traffic in Australia.  Had you invested a dollar in Australian housing in May 2003, it would be worth over $2.1 dollars today.  You would have more than doubled your money.  And the biggest one-year dip in house prices, according to an index that weights the eight largest Australian cities, was approximately at the 1% mark.  Hardly a 30%+ correction.

In June 2005, the Economist would continue with an article called In come the waves explaining that "America's housing market heated up later than those in other countries, such as Britain and Australia, but it is now looking more and more similar."  In this article, the Economist would not quite call Australia a bubble, but worse, would allow that inference based on a diagram and some "compelling evidence" and also would misdiagnose a correction in Australia.

"The most compelling evidence that home prices are over-valued in many countries is the diverging relationship between house prices and rents. The ratio of prices to rents is a sort of price/earnings ratio for the housing market. Just as the price of a share should equal the discounted present value of future dividends, so the price of a house should reflect the future benefits of ownership, either as rental income for an investor or the rent saved by an owner-occupier."

"Calculations by The Economist show that house prices have hit record levels in relation to rents in America, Britain, Australia, New Zealand, France, Spain, the Netherlands, Ireland and Belgium. This suggests that homes are even more over-valued than at previous peaks, from which prices typically fell in real terms. House prices are also at record levels in relation to incomes in these nine countries."

"The rapid house-price inflation of recent years is clearly unsustainable, yet most economists in most countries (even in Britain and Australia, where prices are already falling) still cling to the hope that house prices will flatten rather than collapse."

Looking back at this one now ... had you invested a dollar in Australian housing in June 2005, it would be worth over $2.0 dollars today.  Doubled your money.  And no flattening and certainly no collapse.


Our point is that, sometimes you can decide a bubble is a bubble, but if you don't invest you might protect against a chance of losing 30% (if the economists are right, which they more regularly are not), but you've also lost the chance of making 100% in this example. 

Australia is an unusual case: they have had 26 years of pretty much unabated growth without a recession, although they have come close.  The story Australia helps tell, though, is important. 

It's easy to constantly call a bubble, and maybe one day you'll eventually be right.  But in the meanwhile ... is losing 30% by investing any worse than missing out on making 30% by not investing?

Wednesday, August 30, 2017

A Three Hour Trading Day ... or Two

The equity markets are open from 9:30 am to 4:00 pm Eastern.  Trading does occur after-hours, but it's really a 9:30 to 4:00 pm job, or trip, or whatever we want to call it.

It used to be 10 am - 4 pm, until 1985, when NYSE voted to start half an hour earlier to accommodate overseas buyers.  Californians weren't happy: they would now start trading at 6:30 am local time.

But the game is a-changing.  Markets are different to what they once were, and a good portion of trading is done electronically, and often by automated "bots."    And nowadays, many traders sit idle during long stretches between market opens and market closes, during which there is a typical flurry of activity (40% at market close, on average, last week).

Which leaves us to propose two alternatives. 

 A shorter trading day, say 1 pm - 4 pm.  Or splitting the trading day into two trading windows, say 9:30 - 10:30 am and 2 pm - 4 pm.

Here are the many advantages, including several social benefits.
  1. The markets would be more liquid.  Always. (Reducing costs, adding efficiency.)
  2. There would be more "off-trading" hours for companies to release earnings reports and any other news items that might "shock" markets.  (Traders wouldn't have to stick around till 6 or 7 pm to watch Apple release its earnings reports.)
  3. Traders could spend more time on research & strategy, and less time glued to their ever-changing screens.
  4. Some traders, if they're only performing a pure trading function, would become cheaper for firms, creating an efficiency.  They could take part-time work outside of trading hours, or walk their kids to school.
  5. Traders could leave the office for lunch with their colleagues without worrying about the market moving on them, promoting healthier working relationships, and driving business to nearby restaurants.  Or they could go to gym midday, lowering healthcare costs.
  6. The west coast traders would no longer have to wake up before the sun rises to start trading, creating more stable family relationships out west.  (We acknowledge we're making several conclusory assertions here!)
There would be some losers, like the exchanges (perhaps, although arguable) and those overseas traders.  But they can work from home these days, and keep trading after dinner, or set up their robots to take care of things!  

We welcome any pros or cons to be added to our list: we're know we're missing many ideas.  

Friday, June 30, 2017

You Can’t Do That On Chat!

Since the global financial crisis, all sorts of investigations have gone on in the financial markets, and some very interesting chats have been made public. We're collecting some of the more saucy IMs and phone calls here, in their original form (with spelling errors retained):

UBS [Trader A]: and if u have stops….
UBS [Trader A]: oh boy
Deutsche Bank [Trader B]: HAHA
Deutsche Bank [Trader B]: who ya gonna call!
Deutsche Bank [Trader B]: STOP BUSTERS
Deutsche Bank [Trader B]: deh deh deh deh dehdehdeh deh deh deh deh dehdehdeh
Deutsche Bank [Trader B]: haha16 
June 2011 | electronic chat (likely) | Product: Silver Futures | Deutsche Bank & UBS
In re London Silver Fixing Ltd Antitrust Litigation Proposed 3rd Amended Consolidated Complaint

Trader to prospective cartel member: “mess this up and sleep with one eye open at night.”
2011 | electronic chat | Product: FX (one month trial to join "cartel") | Barclays | Link

(Future) Co-Head of UK FX Hedge Fund Sales: “markup is making sure you make the right decision on price . . . which is whats the worst price i can put on this where the customers decision to trade with me or give me future business doesn’t change . . . if you aint cheating, you aint trying.”
Nov. 2010 | electronic chat | Product: FX | Barclays | Link

Broker-B (non-UBS) to Trader-1: “mate yur getting bloody good at this libor game . . . think of me when yur on yur yacht in monaco wont yu”
June 2009 | electronic chat | Product: LIBOR | UBS | Link

Employee 1 to Employee 2: “[We] can’t mark any of our positions [to market price], and obviously that’s what saves us having this enormous mark to market. If we start buying the physical bonds back then any accountant is going to turn around and say, well, John, you know you traded at 90, you must be able to mark your bonds then.”
June 2007 | telephone chat | Product: RMBS/CDOs | AIG | Link 

Analyst #1: Btw (by the way) that deal is ridiculous. 
Analyst #2: I know right…model def (definitely) does not capture half the risk. 
Analyst #1: We should not be rating it. 
Analyst #2: We rate every deal. It could be structured by cows and we would rate it.
April 2007 | electronic chat | Product: RMBS/CDOs | S&P | Link

Trader-10: “Good morning [Submitter-4], [Trader-10] here.. could we please ask you to put in low 1m fixing pls”
Submitter-4: “Difficlt, think [Senior Manager-6] wnarts it [] on the high side”
Trader-10: “Oh no!! But ladies first no ;))?”
Submitter-4: “First come first serve.”
Trader-10: “Exctly.. And we have been begging you for last two month!!”
Submitter-4: “But u dont sign my bonus right?”
Trader-10: “Hahah hmmm.. Unfortunately not...”
Oct. 2005 | electronic chat | Product: EURIBOR | Deutsche Bank  | Link

Trader 3: “LOWER MATE LOWER !!”
Submitter 1: “will see what i can do but it’ll be tough as the cash is pretty well bid,”
Submitter 1: “ok, let’s see if we can hurt them a little bit more then.”
Sept. 2005 | electronic chat | Product: LIBOR | Deutsche Bank | Link

Trader: “I was front running EVERY single offer in usdjpy and eurjpy.”
Trader: “call me a legend! Front run legend.”
Trader: “jamming some stops in eurusd here at 0515”
Trader: “the day of intervention, i was front running EVERY SINGLE ODA and I mean EVERY haha” 
Dates unknown (multiple) | electronic chats | Product: FX | UBS | Link

Wednesday, June 21, 2017

The Electronification of Consumer Pricing

Would it be interesting if we told you that owners of Apple products often pay more for the same product when purchasing it online?  What about if we told you that airlines might jack up the price of their products based on your level of enthusiasm for buying a ticket?  

A version of this is occurring in the United States.  We're going to explain some of the beauty of this process, from an efficient markets perspective, but we'll also try to home in on the ways in which it can be jarring, if you're the user/customer/client/consumer, that is.

Briefly, companies like,, or Home Depot or Walmart might "collect" data from you or your computer when you search for a product or a flight or a hotel -- or "make a request."  A user's request often brings with it information such as the user's browser, operating system, IP address and other information being maintained in what are called tracking cookies.  Of course, if you're logged in, the company may already have some of this information about you (your purchase preferences) or other information it cannot get via the cookies or IP address.

Based on your information, companies often personalize their results for you.  

There are at least two forms.  They might steer you, say, to relatively more expensive hotels if you're using an Apple product, as they might infer that you're relatively wealthy.  Or they might customize the pricing of the product based on your perceived level of interest.  A person who regularly flies home for Christmas may be a prime suspect for an increased price, or if a prospective buyer has already checked on the price of a flight twice previously, it might indicate that he's relatively more desperate to buy a specific ticket.

Image licensed by PF2 Securities from Condé Nast (New Yorker)
Different from typical supply and demand economics, the new age presents a form of dynamic pricing that measures a person's capacity and motivation for purchasing.  

Here, it's not just a demand of one unit or one ticket: it's a relatively enthusiastic or relatively needy and able buyer, as opposed to a marginal buyer, who may go elsewhere if the price is too costly.

From a company's perspective, they are using your information to price their product accordingly for you, and if they optimize this process, they can make a lot more money than store sales allow, with store sales typically requiring them to fix a single price per good.

One way to think of dynamic pricing is that it adjusts to you.  If you're regularly checking the price, it may just go up because you're checking it.

This seems in many ways to perfectly capture the idea of capitalism.  It may also be agreeable to consumers in perfectly competitive markets.  But absent perfect competition (e.g., the presence of some monopolies)  or when market players dynamically calibrate their models in a way that they seem to work in concert (even if it's not collusion), consumer-customers might feel they are being squeezed.

This graphic shows the results of ticket searches on Kayak's website and Google Flights on different days.
Several airlines are perfectly matching one another, to the dollar, on certain tickets (for better or worse).

Some jurisdictions take issue with price customization, which is often called price discrimination, although that term brings with it negative connotations.   While many jurisdictions have (or should have) legal concerns if price discrimination is gender or race based, some already have difficulties if the pricing is not objectively justifiable relative to the seller, for example, based on the specifics of the order (e.g., company's cost of producing it for a specific user, delivery location or quantity).  But many jurisdictions feel it is in the seller's power to adjust the price as he or she see fits, outside of, say, race and gender-based discriminatory issues.

The problem is magnified in the following example:

Suppose you want to buy a rare and expensive item -- maybe an sought-after watch or antique furniture or a Stradivarius -- and you call to ascertain its price and availability.  You drive 200 miles to buy it and, on arriving at the destination, the seller tells you that, since you asked after it, he realized that demand was high and he lifted the price in the intervening hours.  As a prospective purchaser, you might rightly feel that your eagerness to purchase the product was used against you (and you are now committed to purchasing at the newly higher price, given you have just driven 200 miles).

You were, in concept, taken advantage of.  But legally, is there anything wrong with that?  This is a question for the new age of online, inter-day price re-calibration.  Companies can publicly access or otherwise purchase information about your spending habits, even the price you paid for your home, and this data may help them fit their pricing algorithm, uniquely tailored for you.  This is happening.  This is the new world of e-commerce and we should try to understand and discuss the issues involved.  We welcome your feedback.


For further reading on dynamic pricing on e-commerce websites, see here.

For issues on pricing/valuation concerns in the financial markets, click here.

Monday, June 12, 2017

Disrupting our Antiquated Fixed-Income Markets

“A talent for following the ways of yesterday,” declared King Wu-ling of Zhao in northeastern China, in 307 BC, “is not sufficient to improve the world of today.”

Much is being written about bringing our debt markets into the electronic age.  (The FX and swap markets too, but that's a story for another day.)

The Economist recently called the corporate debt markets "astonishingly archaic" and also "shockingly archaic," for additional emphasis.  Despite the US debt markets dwarfing the equity markets (by a factor of about 7-to-1 in 2016) the magazine notes that basic price data are sometimes hard to come by, and the trading of bonds often requires a call to a bank's trading desk.  

The criticism is not ill-founded.  In the bond market, even to the degree some of the trading goes through electronic platforms, the dealers still hold the cards ... which is great if you're a dealer, and frustrating if you're not.  

There are some downsides, to the economy, of dealers commanding such a presence in the market.  One issue is price uncertainty, with investors only really knowing what the dealers (often their counterparties) tell them about pricing, supply and demand.  And with uncertainty, comes the potential for panic, warranted or not.  (For our European readers, some of this may be mitigated under MiFID II.)   

Another concern is that when dealers play the role of intermediary or market-maker, and investors get accustomed to this framework, the market can seize up quickly when the dealers suddenly withdraw.  When they stop supporting trading, or putting principal at risk, the market dries up... and with less liquidity, prices can drop suddenly, and we all know what that's like.

There are advantages to this system, too .... if you're a Silicon Valley-style "disrupter."  For disrupters, an antiquated system is a prime target for your energies.  Not that it's easy, but the recent flurry of news stories about the antiquated model being gamed, won't make it any more difficult to get some backers motivated to influence change.  (The FinTech revolution was arguably fueled by the financial crisis, and the diminished faith in the financial institutions.)   

We have pulled together some of the recent stories circulating about "bogus" dealer quotes and investor reliance (sometimes over-reliance) on dealer marks and representations.  Meanwhile, traders from Nomura are currently on trial (jury is deliberating) and a Jefferies trader has been convicted for misrepresenting prices.  We don't see that in the market for Apple stocks.  There's an agreed-upon price. 

The problem, to a degree, is that there's a financial motivation to lie and it's just so easy to get away with lying or fibbing or bluffing: the market is opaque, and there is a high degree of subjectivity brought to the pricing/trading process, making it ever more difficult to separate true from false, without the evergreen trader chats, that is.    

Click here to read about the (endless) ongoing investigations into pricing/valuation issues (and broker quotes).

Click here to read about a dude at JPMorgan who is enticing Silicon Valley and Silicon Beach to get a move-on in disrupting this market, or else he'll do it faster himself.  That's his job, and he has a sizable budget to work with.  The red flag has been raised, but this time by the bull.


The Economist's articles can be found here and here (subscription required on your second click).

Monday, April 24, 2017

Defending the Barrier

It’s been almost two years since the Federal Reserve fined six banks a total of $1.85 billion for misconduct in the FX markets.  Last week, Deutsche Bank joined the list, with the Fed fining DB $137 million. 

In this latest order, the Fed added a new form of misconduct, by DB, to its prior summaries of transgressions by the other banks – barrier running.  

Barrier running had never been part of the Fed's previous settlements, but the OCC did cite barrier in its settlements.  Here though, the Fed's language includes a new detail: not just the triggering of barriers, but also the defending of FX barriers.

Thus, not only might DB have regularly acted to trigger a market level that would hurt its trade counterparty (or client), but it may have actively worked to stop a level being hit to the degree that a movement in the FX pair would be harmful to the bank's pre-existing contractual exposures.

Barrier-running (and defending) by dealers is problematic: akin in some ways to front-running, dealers here would be taking advantage of their knowledge of (confidential) customer information, generally pursuant to private contracts the customer would have entered with the dealer: with barrier-running, dealers attempt to “knock out” customers from their FX exotic options positions; or in defending barriers, dealers would “knock in” and activate customers’ options.  

Importantly, dealers would be engaging in a form of market manipulation, steering the market for their peripheral benefit (here to take advantage of derivative contract exposures) as distinct from, say, simply trying to profit from a specific underlying instrument being mispriced. 
“Deutsche Bank’s deficient policies and procedures prevented it from detecting and addressing unsafe and unsound conduct by certain of its FX traders, including in communications by traders in multibank chatrooms, consisting of: ... discussions on trading in a manner to trigger or defend certain FX barrier options within Deutsche Bank, in order to benefit Deutsche Bank….” (per the Fed's C&D order, with emphasis added) 
The following table updates fines and settlements for FX misconduct pertaining to benchmark fixings (i.e. excluding “Standing Instruction” and “Last Look” settlements).  The total now exceeds $12.3 billion.

Friday, April 7, 2017

All the Equity Research Analysts in the House say "ABB, ABB"

Alec Baldwin instructed his henchmen in Glengarry Glen Ross (1992) to "ABC."  Always Be Closing.

If he were a research analyst at a bank, he would have told his client-customers to "ABB."  Always Be Buying.  He would also have told them that he's, you know, objective and conflict-free, and maybe just a little bit optimistic.  So cummon, buy.  And trust me, I'm conflict-free.

This all sounds a little bit ridiculous of course, but it is the world of equity research.  It pays big bucks to say Buy.  It sours relationships just a bit to say Stay Neutral.  It really sours relationships to say Sell.  And so the banks and their analysts generally say Buy.  You say Buy to almost everything, and every now again, thinking you're a genius and praying for your Meredith-Whitney moment, you say Sell and hope that the market will prove you right very very soon ... or who knows when you may find yourself out of a job.

We're exaggerating a little, but generally banks tend to rate something like 40-50% of the universe a Buy, 40-50% Neutral, and the small remainder Sell.  Here's an example of one bank's global distribution as of sometime in 2014.

And here's one of the reasons why.

6 months ago, JPMorgan announced it was downgrading Indonesian equities to “underweight.”  That's basically a call to Sell.  Booya!  Well, what happened next was that the market showed JPMorgan analysts to have been some sort of geniuses ... but the Indonesian government wasn't quite as enthusiastic.

2 months later, the Indonesian government terminated its business partnerships with JPM, including its status as a primary dealer and a panelist for dollar-bond offerings. Argh. According to reports, Indonesian Finance Minister Sri Mulyani Indrawati would explain, when asked to comment on the termination of the JPMorgan relationship, that banks should take responsibility for economic reports that "could influence [market] fundamentals and [investment/investor] psychology".  Other reports have an Indonesian official explaining that JPMorgan's downgrade action could destabilize Indonesia’s financial system.  In short, "Show People the Optimism" ... or else No More Business for You!

2 weeks later, JPM had switched Indonesian equities back to Neutral.  This may not have been nefarious.  Sure, money speaks, but just look at how "right" the JPMorgan analysts have been!  They almost could not have hit the nail any straighter.  (Since the original downgrade, Indonesian stocks have underperformed the Emerging Market index by 4.6%; since the reversal to neutral, they have been on par just about perfectly neutral, with the difference being less than 0.1%.  Not bad for equity analysts!)

Bigger picture, however, is that we may never know to what degree business interests impacted any specific decisions.  But the bullishness of equity analysts, and the known conflicts, certain leave the analysis anything but objective and conflict-free.  (One solution is simply to disclose that the analysis is conflicted, rather than to constantly try to pretend it is objective.)

The broken-model of (bank) equity research is being revisited with the ongoing saga that is the Snap IPO, which priced in March at around a $24 billion valuation, only to move up to about $34 billion that day (roughly $25 per share).  A Bloomberg columnist found that:
  • Analysts of 13 banks that were underwriters on Snapchat’s IPO have issued recommendations on the company’s shares. Among those analysts, 69 percent issued "buy" recommendations or the equivalent, with a median price target of $27, according to an analysis of Bloomberg data. (Meanwhile, without drinking the Kool-Aid ....)
  • Of the 14 analysts whose firms didn’t work on the Snapchat IPO, only two (14 percent) said the company's stock was worth buying. The median price target among those unaffiliated analysts is $21 a share. 
Things became a little more embarrassing when it was reported that:
  • On March 27, Morgan Stanley published an equity research note on Snap, the social media company it helped take public, putting a $28 price target on the stock. 
  • Almost a day later, the bank issued a correction, changing a range of important metrics in its financial model but not the $28 price target. 
Apparently, the bank has found counter-balancing errors that allowed it to maintain the same price despite significant downward adjustments to projections.

One market commentator posed a novel theory that the market knows the price, and so the back-solving or reverse-engineering to obtain the known price doesn't make the research wrong.  But it makes us wonder ... if the goal of the research is simply to create some fancy model to justify a price that's pre-conceived, errr, what's the point?  And isn't the justification of a pre-conceived valuation misleading to the degree some of the customer-client-prospects thought is was an objective effort to analyze, you know, Snap's real and inherent value?  Of course, if it were a contest for American's Next Top Pricing Model, we would be all for producing the Sexiest Equity Pricing Solution ("SEPS").

The answer is known, of course.

The objective of equity research is to make money elsewhere in the bank, not to be smart and right, but to win (and maintain) banking business.  Equity research doesn't, alone, make money: it is given out freely to certain clients and prospects, with the expectation of revenues to be generated elsewhere, like in commissions on trades.  But if it's a free product, and its goal is to make money elsewhere, then as soon as it jeopardizes the external prospects, it becomes a burden. And the research analysts know when they're being a burden.  So they say Buy when they need to, and they say, sure, $28 dollars, the Price is Right, and boy do we have a super-model for you.  But independent and conflict-free analysis it is not.

Regulation AC tells us, essentially, that when research analysts tell clients to buy or sell a particular security, they must actually mean what they say.  But the product is sweetener.  It is quite helpful in selling the coffee.  And the coffee can't sell with a salt or pepper alternative. 

Thursday, March 23, 2017

The Art of (Illiquid) Securities Pricing

As you all know, the financial meltdown was caused by some part faulty-product (mortgages, RMBS, CDOs) and some part market-panic itself and its influence on certain other products (auction rate securities, SIVs) and market mechanics (pricing, rating).

Faulty products are not new: the world is awash with faulty products.  But we need buyers for them, and to encourage buyers we need forums (e.g. securitization) and mechanisms (e.g. ratings) that would induce buyers and give them comfort that the faulty products weren't, err, all that bad.

Well that's a long and old story.  But where we're going today is that many of the mechanics that went awry, and needn't have, have not been fixed.

Back in 2008, we had majestic moments of illiquidity, which spurred quotes like this one, from a conversation among AIG employees:
“we can’t mark any of our positions [to market price], and obviously that’s what saves us having this enormous mark to market. If we start buying the physical bonds back then any accountant is going to turn around and say, well, John, you know you traded at 90, you must be able to mark your bonds then.”
Since the crisis, the SEC has ramped up its investigations into pricing issues, and in 2013 set in motion three initiatives (the Financial Reporting and Audit Task Force; the Microcap Fraud Task Force; and the Center for Risk and Quantitative Analytics).  There has been a steady and growing stream of findings of asset valuation mismanagement.  Some hedge funds have been shut down. (A list of issues here.)

But there is much to be done, if the recent dispute between a Canadian pension fund and a US hedge fund is anything to go by.

We have written about that dispute in detail here and here, but a transcript was released as part of discovery in the matter that depicts just how tricky and error-prone our pricing systems are as soon as there is any level of illiquidity.  Before we get to the transcript, here's a brief picture of the issue at play, per the pension fund's (original) allegations.

  • Pension fund requested a full redemption of its investment in Saba’s hedge fund 
  • Prior to redemption, Saba marked down its valuation of one issuer’s corporate bonds (a relatively illiquid issuer), lowering the fund’s NAV and the amount to be returned to redeeming investors
  • Saba altered its valuation methodology to mark down the bonds issued by The McClatchy Company (“MNI”): it applied a bids-wanted-in-competition (BWIC) approach instead of relying, as usual, on its external pricing sources 

    • Saba had made sales of MNI bonds in March 2015 at prices from 58% to 60% (of par)
    • 3/31/15 mark used for redemption, based on all-or-none $50 mm BWIC: 31% 
    •  Saba later made sales of MNI bonds in April 2015 at prices from 53.75% to 55.75%
  • After the redemption was completed, Saba resumed its prior valuation methodology for MNI bonds, marking them back up

With that background, here is a concise depiction (provided here by Bloomberg columnist Matt Levine) of the hedge fund's chats with its pricing providers in 2015, demonstrating just how much the pricing process is based on art, rather than science.

  • Saba Capital's Weinstein: Z, where would you bid a few mm of the 29s with or without 5yr cds? ... 
  • Trader: most likely below where you care. 50- 2mm 
  • Weinstein: Yes, that is low I think. 
  • Trader: where would u bid? 
  • Weinstein: Who knows. See it quoted much higher. Actually you should change your 65/66 quote I guess. 
  • Trader: im happy to reflect any market you would like me to make 
  • Trader: i have no position 
  • Trader: and quote it only 
  • Trader: but thats the discount i would bid to go at risk 
  • Weinstein: Yeah, the quote seems wrong I guess. 
  • Trader: given how illiquid it is 
  • Trader: sure do u have a two sided market? 
  • Trader: or what is an appropriate quote? 
  • Weinstein: I guess if you only care at 50 on 2mm then probably 65/ for any size is wrong. 

So we have reliance, for pricing purposes, on information produced by traders who are not really willing to meet their quotes, and whose quotes may differ depending on the size of the investment, and are therefore not well-tailored to depict the hedge fund's specific investment size. The quotes are just that, quotes.  Nothing more.

The concern, then, is that the next softening in the market will also be magnified by our pre-existing market's structural deficiencies: the issues of illiquidity, and our ability to cater appropriately for them in our pricing procedures, could again magnify the uncertainties at play and exacerbate the downturn.

Right now, the price is just not right for illiquid assets, and prices are not consistently applied across firms.  We are ill-advised to think that the prices presented are in any way reliable, given the clumsy (antiquated?) nature with which those prices are derived.

More on this topic soon.

Wednesday, March 15, 2017

Can Deregulation and Open Data Solve the Credit Ratings Problem?

This blog is provided by guest contributor Marc Joffe.  The following views are his own, and do not necessarily reflect those of PF2.
Credit rating agency scandals, widely blamed for the 2008 financial crisis, now seem to be a distant memory. We have gone several years without another major ratings failure, so casual observers may be forgiven for thinking that the underlying problem has been solved. But as a new Brookings study shows, the defective rating agency market structure that triggered the crisis remains in place. Further reforms would seem unlikely under unified Republican government, but bipartisan support for open financial data may offer a way forward.
Since 2008, the government has taken several steps to address credit rating agency problems. In the waning days of the Obama Administration, the Department of Justice and State Attorneys General settled complaints against Moody’s for $864 million. This followed a larger settlement with S&P and a series of regulatory changes spurred by the 2010 passage of Dodd Frank. That law mandated the removal of credit ratings from regulations, tighter control of SEC-licensed Nationally Recognized Statistical Ratings Organizations (NRSROs) and an SEC study of possible changes to the way investment banks choose rating agencies to rate newly-issued structured finance securities.  
Writing for Brookings, former CBO Director Alice Rivlin and researcher John Soroushian criticize the SEC for failing to execute its Dodd Frank mandate to change the rating agency business model. By not acting, the SEC has left in place a regime under which rating agencies have an incentive to competitively dumb down their standards so that they can sell more ratings to bond issuers. Rivlin and Soroushian recommend that the SEC implement a process under which new structured finance issues are randomly assigned to rating agencies.
Joe Pimbley, a risk analyst who  - like me - used to work at a credit rating agency, goes even further, calling for an outright prohibition of issuer payments for credit ratings. This change would oblige rating agencies to serve investors first, as they did in the years before the transition to the “issuer pays model” around 1970. (Pimbley and I both have consulted for PF2 Securities, which publishes this blog).
Such interventions would seem unlikely under a Republican-led government. If anything, President Trump and Congressional Republicans have expressed the desire to roll back many aspects of Dodd Frank. But, led by Congressman Darrell Issa, Congressional Republicans have shown an interest in more open financial data – and this could be a way forward toward further reform.
To understand the relevance of open data, we must first realize that the credit rating business is not a standalone industry. Instead, the rating agencies are part of a larger industry: the business of credit risk assessment.  This field includes in-house credit analysts at banks, independent credit advisors, and analytics firms, as well as the NRSROs.
By mandating the elimination of credit ratings from federal regulation, Dodd Frank has helped to level the playing field between rating agencies and alternate credit assessment providers. (But, as Rivlin and Soroushian remind us, this process of removing credit ratings from regulations is incomplete.)
Deregulators can go further by pursuing Pimbley’s suggestion of removing credit rating agencies from the list of entities that can receive non-public disclosures from securities issuers, as provided under Regulation FD. Such a reform would allow credit analysts not employed by rating agencies to receive all of the same data at the same time as their agency counterparts.
Indeed, Republicans could completely eliminate the special status of credit rating agencies by scrapping the NRSRO certification entirely, as recommended by NYU’s Lawrence J. White. If ratings are not required by regulation and all credit consultants and analytics firms have equal data access, there would seem to be little benefit to NRSRO status anyway.
But even without regulatory-conferred privileges, rating agencies would still have an advantage over upstart providers of credit analysis. The incumbents’ size allows them to invest in systems and manual procedures to assimilate the large volume of issuer and security data needed to rate and review a large number of debt issues.
Reforms that lower the costs of collecting this data would enable new analytic firms to compete against incumbent rating agencies despite their relatively small size. Representative Issa’s new bill, the Financial Transparency Act of 2017 (HR 1530), would make all financial regulatory data available in machine readable form. Right now, much of this data is only available in PDFs which are costly to process. By instead providing financial filings in the form of structured text, new credit data sets will become more readily available at little or no cost.
One regulator affected by the Act is the Municipal Securities Rulemaking Board (MSRB) which oversees the municipal bond market. Right now, offering materials and continuing disclosures such as annual financial reports are published as PDFs. Anyone hoping to analyze them must either mine the PDFs for relevant data or buy data sets from third parties, usually at high costs and with tight restrictions on redistribution (effectively preventing smaller firms from showing how their opinions are driven by issuer fundamentals). If the MSRB switches to structured text, the cost of analyzing municipal securities would drop, making it easier for municipal analytics startups such as MuniTrend to provide insight across a broad range of instruments.
The MSRB is one of ten regulators affected by the proposed act.  If passed and implemented, the bill would trigger a wave of free and low cost data sets that could help analysts outside of the credit rating agencies keep up with these powerful incumbents. When combined with reforms that remove the special privileges now enjoyed by licensed NRSROs, open financial data could usher in a new era of competition and innovation in the field of credit assessment.

Tuesday, January 17, 2017

Moody's Settlement and Its Wider Implications for Finance and Beyond

This blog is provided by guest contributor Marc Joffe.  Marc also studies and writes extensively on debt issues in sovereign and sub-sovereign markets.  His recent commentary on the relative strength of US cities can be found here.  The following views are his own, and do not necessarily reflect those of PF2.


On Friday afternoon, Moody’s settled DOJ and state attorneys general charges that it inflated ratings on toxic securities in the run-up to the financial crisis. Moody’s paid $864 million to resolve certain pending (and potential) civil claims, considerably less than S&P's settlement of $1.35 billion. While the settlement appears to close the book on federal investigations of rating agency malfeasance, the episode deserves consideration because it has something to teach us all about broader institutional failures, and their implications for both the economy and news coverage.

Moody's received better treatment than S&P despite the fact that its malpractice was painstakingly documented in 2010 by the Financial Crisis Inquiry Commission. I suspect that Moody's achieved a better outcome than S&P for some combination of three reasons: (1) employees were more disciplined about what they committed to email, so DOJ lacked some of the smoking guns S&P analysts handed it (including the infamous message sent by one S&p analyst to another "We rate every deal. It could be structured by cows and we would rate it."); (2) senior management and corporate counsel took a less confrontational approach to prosecutors; and (3) Moody's carried the water for Democrats at critical times during the Obama administration. Moody's Analytics economist Mark Zandi was a vocal proponent of the 2009 stimulus bill and other Obama policies. Meanwhile, the rating agency declined to follow S&P in downgrading US debt from AAA in 2011. 

Having worked at Moody’s structured finance in 2006 and 2007 – but not in a ratings role – I recall that most rating analysts didn’t think they were doing anything wrong (although it is also true that some left exasperated). I believe this was the case because the corruption of the rating process occurred gradually. In the 1990s, ratings techniques were primitive, but appear to have been motivated by an intention to objectively assess then novel mortgage backed securities and collateralized debt obligations. After the company went public in 2001, quarterly earnings became a concern for the many Moody’s professionals who were now eligible for equity-based compensation.

As the structured finance market soared during the early part of the last decade, the pressure to dumb down ratings standards increased. As portrayed in The Big Short, analysts at S&P and Moody’s understood that the failure to give investment banks AAA ratings for the junk bonds they were assembling from poorly underwritten mortgages would place their companies at a competitive disadvantage. 

The collapse of rating agency standards is one case of a much larger set of problems that are threatening our economy and social fabric: professionals who we expect to provide objective information prove to be biased. It’s like a baseball umpire calling a strike when a batter lays off a wild pitch. While that type of behavior could ruin a ball game, the loss of integrity by financial umpires has more earth-shaking implications.

Aside from rating agency bias, the financial crisis was also triggered by a spate of dodgy appraisals. Inflated home appraisals, made at the behest of originators trying to qualify new mortgages, also contributed to the 1980s Savings and Loan crisis.

Malpractice by supposedly unbiased professionals also exacerbated the 2001-2002 recession. The values of dot com stocks were inflated when securities analysts issued misleading reports exaggerating the companies’ earnings potential. The analysts’ judgment was clouded by incentives at their investment banks, which profited from underwriting stocks issued by these overrated companies. Meanwhile, Arthur Andersen’s shortcomings in auditing Enron's books magnified the impact of that firm’s spectacular 2001 crash.

So the credit rating agency problem is part of a more generalized issue that encompasses appraisers, auditors and security analysts. It can occur whenever professionals are asked to provide objective evaluations: they can succumb to their own biases or pressure from those who have a vested interest in the outcome of the review. Because the judges usually receive less compensation and have lower social status than those who are judged, they are especially vulnerable to temptation.

And the problem is not limited to finance. Journalistic institutions which have built stellar reputations for objective, fact-based news reporting have let their standards slip, especially during the contentious 2016 election and its aftermath.  For example, the Washington Post recently embarrassed itself by hastily reporting that the Russians had hacked a Vermont power utility. Ultimately, it turned out that a computer virus created in Russia was found on a laptop at the utility’s offices. The laptop was not connected to the power system, and the virus was typical of Eastern European computer worms that proliferate across the internet. Adding insult to injury, the newspaper failed to issue a proper retraction when the story collapsed.

Like those working at Moody’s, I suspect that most WaPo reporters didn’t imagine that they were doing anything wrong. They may have been guided by a belief that the public needed to be more wary of the Russians, especially now that they appear to have influence within the Trump administration.  Some mainstream media reporters may honestly believe that protecting America from the Russians and from Donald Trump is more important than living up to the ideal of objectivity that had been the gold standard of 20th century news coverage. It is also possible that reporters are influenced by pundits, government sources and political power brokers: there have been many cases of journalists cycling in and out of government roles, so a victory by one’s favored party can offer career benefits.

But whether it’s Moody’s and S&P or a major news outlet, we all suffer when systemically important providers of allegedly objective information lose their bearings. Even the most primitive organisms need facts to survive. Prey that deny knowledge of the position and trajectory of predator movements become dinner. Today’s most complex social organism, American society, needs institutions that provide just the facts in a dispassionate manner. The rot destroying the foundations of these organizations should worry all of us regardless of our position in the financial hierarchy or on the political spectrum.