Monday, February 26, 2018

Florida Shootings Require Cultural & Mindset Changes

Our failure to prevent the Florida school shooting illustrates a pervasive problem in modern societies: we often have access to ample warning signs but all-too-frequently fail to leverage this information to avoid disaster. The issue not only impacts law enforcement agencies, but our financial institutions as well. To more effectively handle all the intelligence available to them, organizations will require major structural and cultural change. 

The FBI and local law enforcement reportedly had more than enough information to legally disarm and detain confessed school shooter Nikolas Cruz before he killed 17 people at Parkland High on February 14. This is not the first such intelligence failure, and won’t be the last. Consider these examples:
  • 9/11 could have been prevented had the CIA and FBI done a better job of sharing and handling intelligence.
  • Russian intelligence warned the FBI about Tamerlan Tsarnaev long before he carried out the Boston Marathon bombing.
  • In France, authorities failed to act on multiple clues that would have enabled them to prevent the Paris bombings that claimed 130 lives in November 2015. 

In the financial industry, rating agencies and bank risk management teams failed to act in their or their clients’ best interests when they continued to create and sell residential mortgage-backed securities, despite the deterioration in mortgage lending standards, and the increasing and disturbing amount of mortgage fraud being reported by the FBI in its annual mortgage fraud reports.

A well-operating risk-management function, with a voice, would most likely have limited the potential for the cultural failures seen at the Royal Bank of Scotland, as detailed in the recently published report commissioned by the Financial Conduct Authority. The extraordinary activities of the gung-ho Global Restructuring Group at RBS in London could immediately have been stymied, as they posed reputational and business risks far outweighing the group's short-term revenue-generating interests. As the report explains: 
“GRG enjoyed an unusual independence of action for a customer-facing unit of a major bank. It saw the delivery of its own narrow commercial objectives as paramount: objectives that focused on the income GRG could generate from the charges it levied on distressed customers. In pursuing these objectives, GRG failed to take adequate account of the interests of the customers it handled and, indeed, of its own stated objective to support the turnaround of potentially viable customers.” 
These assorted failures suggest that we have a systemic problem with risk monitoring, or a failure to incorporate it appropriately within institutions. And because the problem is systemic it won’t be solved by firing a few bad apples. Instead, we need to understand and address the root cause. 

One feasible argument is that jobs involving risk monitoring and mitigation generally come with a relatively low social status and thus do not necessarily attract the most motivated applicants.

This phenomenon is epitomized by our (often unfair) stereotype of security guards: that they are ineffective and prone to sleeping on the job. Because security jobs are low paying, they don’t often attract type “A” individuals. The job itself is quite boring: most of the time nothing happens. While a more proactive security guard could find and act upon many clues during the course of his or her day, almost all of the extra effort will be for naught. At least 99 times out of 100 that suspicious backpack won’t contain an explosive device. 

Although bank risk managers and FBI call handlers undoubtedly have higher social status than security guards, they are most likely to be subordinated within their organizations. At a bank, monitoring credit risk is much less glamorous and lucrative than acquiring or merging companies, underwriting deals or trading securities. And, as with the case of the seemingly suspicious backpack, most clues won’t lead anywhere anyway: for every legitimate call law enforcement departments receive there are many that lead nowhere; a missed charge card payment, similarly, often doesn’t presage a mortgage foreclosure. 

Ideally, we should elevate the status of risk monitoring jobs and make them more exciting. More attention from senior management may help. Although most money-center banks took massive losses during the financial crisis, Goldman Sachs came out relatively unscathed. A major reason is that the bank’s Chief Financial Officer reviewed daily risk management reports and held a meeting in his office to call for immediate action once its was detected that mortgage backed securities had begun to underperform in 2006. Goldman is also an exceptional case in that it rotated fast-track talent between moneymaking and risk management roles, and it empowered risk management staff to veto certain trading activities. 

Although more high-level attention might help those charged with receiving and sifting through raw intelligence, the job is still a tedious one – akin to looking for a needle in a haystack. 

Conviction Dilemma 

In addition to the possibility that risk monitoring personnel are as a group less motivated, risk personnel tend to be a more introverted type than their front-desk colleagues. This may manifest in their being apprehensive when expressing themselves to their comparatively more aggressive colleagues, and potentially come off as being indecisive or speculative.  Leaders often like a strong, definitive opinion: “hedge this risk!” and may shun or ignore a more complex opinion coming from a more cautious analyst. 

In short, the personalities hired into risk-management roles often suffer from what we will term the “conviction dilemma,” which emanates from the work of Philip Tetlock and others, who studied predictive expertise. Tetlock's research findings informed his commentary that those whose expertise was valued and sought out, for example pundits on TV shows like The McLaughlin Group, were those who had vocal, unequivocal opinions, that could be articulated with utter conviction – but were often wrong. 

Altogether, even strong and motivated risk experts may be introverted and may be indecisive when expressing themselves. Playing a function that is considered as subordinated in management’s eye, they might struggle to make convincing and resolute “do this!” arguments, and management might therefore be less likely to take them seriously, and act on them expeditiously. 

Applying Technology 

In the 21st century, we have learned to assign boring or laborious jobs to computers. We can identify potential attackers earlier by entering all the clues law enforcement receives into shared databases, and we have state-of-the-art data science tools built for analyzing this mass of information. This approach need not violate privacy: social media posts, calls from tipsters and prior arrests are all legitimately available to law enforcement today. 

Palantir is among the most prominent of companies offering software that enables intelligence agencies to find needles in the haystacks of raw data they receive. Unfortunately, Palantir is not an inexpensive solution, and may thus be beyond the budgets of smaller law enforcement agencies. 

Governments and NGOs may wish to invest in the development of free, open source data analysis. Aleph is an open source tool that can analyze large volumes of unstructured data. Although designed for investigative journalists, it could be customized for use by law enforcement of for counterparty tracking. Whether they use licensed or open-source solutions, law enforcement and intelligence agencies should establish and apply technical standards for data sharing. Because financial firms are overtly competitive, data sharing of financial intelligence may be less appropriate between competing firms, but may be more prevalent within institutions. 

Often the information needed to prevent mass killings is hiding in plain sight. By improving organizational structures and leveraging technology, financial firms and law enforcement agencies can harvest more actionable data from legally available information. Armed with this data, they can prevent certain future acts of carnage. While no single policy solution – VaR levels or gun control included – can ever guarantee endless success, we need to be thoughtful and dynamic in going about limiting the frequency or even the magnitude of these catastrophes, and we would do well to use our tools effectively in pursuing the goal not only of making money, winning clients and awards, but also of limiting the downside.


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This piece was co-written by Marc Joffe, who consults for PF2, and members of PF2’s staff. For more on this topic, visit our 2016 piece on the detrimental impact of short-term thinking patterns on conduct with financial firms. Among other things, we recommend a re-thinking of the design of incentive structures: “The approach we put forward here is the studious linking of profit-sharing to successful and honest risk-taking and business practices.”

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. 

Tuesday, February 20, 2018

Apple or the United States: Which is the Stronger Credit?

In blogs like this, we sometimes like to begin discussions. 

Today, we're going to present an interesting situation. Moody's holds that the US is a Aaa credit, while Apple Inc. is rated Aa1 (both its debt and its corporate family ratings are Aa1). 

Aside from some recent hiccups, Apple is a growing company (see the chart). Its debt level sits at 44% of its annual revenues, and the expense of its debt is somewhat moderate, at 1.2% of its annual revenues. The US is growing its revenues too, albeit at a modest clip. The expense of its debt, however, is approaching 8% of annual revenues. 

Recent developments make us wonder whether the US is truly the stronger credit. This blog takes you through some of the bigger picture here, including elements of the credit rating processes that might be supportive of the rating agency's stance, despite the numbers perhaps telling a different story. We don't take a position here, as much as pose the question.  And we look forward to your thoughts.

Comparing Apples & Oranges? 

Recent fiscal developments have us thinking again about the US's credit rating.

February 9th’s budget and spending caps agreement tipped next year’s budget deficit over $1 trillion, according to the Committee for a Responsible Federal Budget, despite the fact that we are almost nine years into the current economic expansion and with the official (U3) unemployment rate at just 4.1%.  That bipartisan debt binge, in the wake of last year’s $1.5 trillion tax cut (over ten years), has some prudent budget-watchers scratching their heads. 

Last month, Reuters reported that “China’s Dagong Global Credit Rating Co, one of the country’s most prominent ratings firms, on Tuesday cut the local and foreign currency sovereign ratings of the United States, citing an increasing reliance on debt in the world’s largest economy.” Dagong cut the US’s sovereign rating to BBB+ (from A-), with a negative outlook. 
“Deficiencies in the current U.S. political ecology make it difficult for the efficient administration of the federal government, so the national economic development derails from the right track,” Dagong said. “Massive tax cuts directly reduce the federal government’s sources of debt repayment, therefore further weakens the base of government’s debt repayment.”
Looking at the numbers as of fiscal year-end 2016 (the most recent year with complete figures), Apple’s debt as a percentage of revenue and its interest expense as a percentage of revenue are much lower than the US’s corresponding levels.

Strictly based on the debt/revenue and interest expense/revenue ratios, an entity with US’s metrics would likely garner a below-investment-grade rating: according to Moody’s' ratings methodology for diversified technology companies, a negative EBIT/Interest Expense equates to a rating of Ca (the lowest rating on the subfactor scale), all else equal.

US’s Primary Balance/Interest Expense, our proxy for US’s EBIT/Interest Expense, is negative. We don’t have a proxy for the US’s EBITDA (earnings before interest, taxes, depreciation, and amortization), but let’s take our proxy for the US's EBIT and magically add back $2 trillion(!) worth of imaginary “depreciation and amortization.” Doing so gets us to an “EBITDA” of $1.7 trillion. In this hypothetical, its Debt/EBITDA is still over 10x, which would correspond to a rating of Ca (all else equal) for a diversified technology company.

Even in the rosiest possible proxy for EBITDA, in which we suppose USA has zero expenditures(!), and thus its EBITDA would simply equal its revenue, the hypothetical Debt/EBITDA would be 3x, which maps to a rating of Ba, all else equal, for a diversified technology company.

Viewing the US’s long-term fiscal situation with a more critical lens, we might consider the future fiscal impact of Social Security and Medicare – which are underfunded by $46.7 trillion over the next 75 years (per the Fiscal Year 2016 Financial Report of the U.S. Government jointly produced by the US Treasury and the Office of Management and Budget of the Executive Office of the President). 

Yet, Moody’s and many of the other rating agencies don't seem overly concerned, rating the US Aaa (stable outlook).

Into the finer details, now, there are several quantitative factors that might be equally or more relevant to these entities’ respective ratings (e.g. EBITDA margin or FCF/Debt for Apple; Interest Expense/GDP or Inflation for the US), but we tried to highlight metrics in this chart which are most comparable between the two debt issuers. 

Keep in mind that there are also key qualitative characteristics that Moody’s considers when rating corporates and sovereigns. For example, Moody’s gives significant weight to considerations such as management financial policy (“management and board tolerance for financial risk”) for diversified technology corporations, and institutional strength (specifically, “government effectiveness”, “rule of law”, and “control of corruption”) for sovereigns.  

Notably: 
  • The United States government has the legal authority to compel its “customers” (i.e. taxpayers) to pay more, if necessary (although political willingness might be another matter), while a corporation has no such relationship with its customers.
  • Apple lacks a printing press, whereas the USA can print its own currency. 
  • The US has a central bank that has the ability to monetize federal debt, whereby the Federal Reserve can essentially finance fiscal deficits by purchasing as much government debt as the federal government issues, although technically the Fed maintains its independence from political interference. 
  • (Moody’s does consider inflation as an important ingredient in its sovereign ratings, so the rating itself might suffer in a scenario in which the country printed its way of a fiscal hole, but there technically would still be no default.)
Altogether, Apple’s revenue is growing faster than the US’s (99% vs. 31%, over 5 years), it has much less debt than the US (relative to revenue: 44% vs. 304%), and its interest expense is much lower (relative to revenue: 1.2% vs. 7.7%).

So the question is, are the US’s other strengths or advantages -- its ability to raise more revenue through taxes if truly needed, and its unique ability to service its debts by either printing more of the world’s reserve currency or having its central bank purchase its debt -- enough to justify a Aaa rating?  In deciding this, one must consider not only the US's current trillion dollar deficits at a point in the economic cycle that does not beg for drastic fiscal stimulus, but also the fact that we have a Social Security and Medicare funding gap of nearly $47 trillion, in present value terms, that is only growing worse. (At this juncture, it seems that our elected officials have chosen to do nothing about the funding gap.)

Remember, the question is not whether or not the US will default, or how it may grow itself out of the current situation -- but whether the likelihood of there being an issue here is so remote as to warrant a Aaa rating, a rating higher than that of Apple's debt, which is currently well-supported.

It is worth considering Stein’s Law as we end this blog: "If something cannot go on forever, it will stop" or "Trends that can't continue, won't."  Interestingly, Stein meant this in the sense that there is no need for action or a program to make it stop, much less to make it stop immediately; it will stop of its own accord.

Lisa Benson Editorial Cartoon used with the permission of Lisa Benson, the
Washington Post Writers Group and the Cartoonist Group.  All rights reserved.


Thursday, February 8, 2018

Market Trading Investigations - Layering, Spoofing, Front-Running, Stop-Loss Triggering

Adding to our prior compilations of valuation issues, questions of fairness in market executions, and fee disclosure concerns, we are adding a new set that looks at investigations into, and allegations of layering, spoofing, front-running, barrier-running and stop-loss triggering in the financial markets.
  1. Jan 2018: Spoofing - Precious Metals; S&P Futures. CFTC Files Eight Anti-Spoofing Enforcement Actions against Three Banks (Deutsche Bank, HSBC & UBS) & Six Individuals 
  2. Jan 2018: Front-running - FX. HSBC front-running victim (Prudential Plc) 
  3. Jan 2018: Front-running - FX. Barclays front-running of HPQ in $8.3bn FX options trade 
  4. Oct 2017: Front-running - FX. U.S. jury finds ex-HSBC executive guilty of fraud in $3.5 billion currency trade 
  5. Aug 2017: Spoofing - Treasury Futures; Eurodollar Futures. CFTC Finds that The Bank of Tokyo-Mitsubishi UFJ, Ltd. Engaged in Spoofing of Treasury Futures and Eurodollar Futures 
  6. Jul 2017: Spoofing - Commodity Futures (multiple). CFTC Orders New York Trader Simon Posen to Pay a $635,000 Civil Monetary Penalty and Permanently Bans Him from Trading in CFTC-Regulated Markets for Spoofing in the Gold, Silver, Copper, and Crude Oil Futures Markets 
  7. Jun 2017: Spoofing - Precious Metals. CFTC Finds Former Trader David Liew Engaged in Spoofing and Manipulation of the Gold and Silver Futures Markets and Permanently Bans Him from Trading and Other Activities in CFTC-Regulated Markets 
  8. Mar 2017: Spoofing - Equities (cash and contracts for difference). Ex-DBS Trader Convicted in Singapore's First Spoofing Case 
  9. Jan 2017: Spoofing - Treasury Futures. CFTC Orders Citigroup Global Markets Inc. to Pay $25 Million for Spoofing in U.S. Treasury Futures Markets and for Related Supervision Failures 
  10. Dec 2016: Stop-Loss Triggering - FX. Australian Securities and Investments Commission (ASIC) accepts Enforceable Undertaking from Commonwealth Bank of Australia (CBA) for triggering FX customer stop-loss orders 
  11. Dec 2016: Spoofing - Futures (equity index; crude oil; natural gas; cooper; VIX). Federal Court Orders Chicago Trader Igor B. Oystacher and 3Red Trading LLC to Pay $2.5 Million Penalty for Spoofing and Employment of a Manipulative and Deceptive Device, while Trading Futures Contracts on Multiple Futures Exchanges 
  12. Nov 2016: Spoofing - Equity Index Futures. Federal Court in Chicago Orders U.K. Resident Navinder Singh Sarao to Pay More than $38 Million in Monetary Sanctions for Price Manipulation and Spoofing 
  13. Jan 2015: Layering & Spoofing - Equities. Canadian Man Charged in First Federal Securities Fraud Prosecution Involving 'Layering' 
  14. Jul 2013: Spoofing - Commodity Future (multiple). CFTC Orders Panther Energy Trading LLC and its Principal Michael J. Coscia to Pay $2.8 Million and Bans Them from Trading for One Year, for Spoofing in Numerous Commodity Futures Contracts 
  15. Dec 2012: Spoofing - Wheat Futures. CFTC Files Complaint in Federal Court against Eric Moncada, BES Capital LLC, and Serdika LLC Alleging Attempted Manipulation of Wheat Futures Contract Prices, Fictitious Sales, and Non-Competitive Transactions