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.