tag:blogger.com,1999:blog-37649120397419740372024-03-14T02:17:56.205-04:00Expect[ed] Loss––– a weblog focusing on fixed income financial markets, and disconnects within themPF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.comBlogger252125tag:blogger.com,1999:blog-3764912039741974037.post-82349004503333267172022-02-07T15:00:00.002-05:002022-02-07T15:01:28.457-05:00Users DO care about being tracked <div style="text-align: justify;">With Big Tech's PR machine busy at work, the narrative has become quite popular that <i>people don't care about privacy</i> and the supporting "evidence" is readily at hand that individuals share readily all sorts of personal information on social media outlets. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Elon Musk, on the Joe Rogan Experience podcast in September 2018, pushed back when asked about the future of security and privacy, responding by asking the question, "Do people want privacy, because they seem to put everything on the internet?"</div><div><div class="separator" style="clear: both;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEgaGNs-5ieLn0RjDPg7-K5JSmeaQwEf7uZeBQGOCp-DVFiKIXpw-ejxh1NiJaWq08niFHyg_GX66n7-gG5eqKft2GUgKh_NlUIVyaZzP1P62jcwpWLjEyO1bej9O3FI1NQJSvk-x9l_atwszQEex_sQCPrBuD1kBXxwIYRIbaPQMB350fJtJn0iFnIwgA=s859" style="display: block; padding: 1em 0px; text-align: center;"><img alt="" border="0" data-original-height="432" data-original-width="859" height="322" src="https://blogger.googleusercontent.com/img/a/AVvXsEgaGNs-5ieLn0RjDPg7-K5JSmeaQwEf7uZeBQGOCp-DVFiKIXpw-ejxh1NiJaWq08niFHyg_GX66n7-gG5eqKft2GUgKh_NlUIVyaZzP1P62jcwpWLjEyO1bej9O3FI1NQJSvk-x9l_atwszQEex_sQCPrBuD1kBXxwIYRIbaPQMB350fJtJn0iFnIwgA=w640-h322" width="640" /></a></div><div style="text-align: justify;">Of course, Musk's shortcoming here is that he is extrapolating a little too generously. In other words, sure, <i>some people</i> post personal information in public forums; but that does not allow one to conclude that <i>all people</i> disregard the value of their personal information. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The rubber seems to have (finally) met the road, with compelling data coming out that, sure, some people do care about the data.</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Recent changes made by Apple to its iOS operating system have enabled users to opt whether or not they want to be tracked. The majority, and perhaps vast majority, of users are saying "No!" (According to <a href="https://www.flurry.com/blog/ios-14-5-opt-in-rate-att-restricted-app-tracking-transparency-worldwide-us-daily-latest-update/" target="_blank">Flurry Analytics</a>, it may be that north of 90% of users are saying "track me not, thank you.")</div></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Last week, when Meta (formerly Facebook) released its earnings, it explained the "headwinds" to its marketing engine that come with the changes Apple introduced. In its earnings call, Meta (<a href="https://investor.fb.com/home/default.aspx" target="_blank">transcript here</a>) explained: </div><div style="text-align: justify;"><blockquote><span style="font-size: medium;">"we believe the impact of iOS overall as a headwind on our business in 2022 is on the order of $10 billion, so it's a pretty significant headwind for our business."</span></blockquote><p><br /></p><p>Time for a change in narrative? </p></div>PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-58427966066380241422020-08-31T18:30:00.002-04:002020-08-31T18:33:42.647-04:00CLO Credit Ratings Gone Awry<p style="text-align: justify;"><span style="font-family: helvetica;">Co-authors Gene Phillips and Mark Adelson wrote the following article, which was published in the Fall 2020 edition of the <i>Journal of Structured Finance</i> (JSF); it is available in its entirety on the JSF's website at this <a href="https://jsf.pm-research.com/content/early/2020/08/27/jsf.2020.1.106" target="_blank">link</a>.</span></p><p style="text-align: center;">---</p><div style="text-align: justify;">The COVID-19 pandemic has had a broad reach, spanning most sectors and industries. This distinguishes it sharply from the mortgage meltdown and the 2008 financial crisis,
which were mostly confined to the housing sector and financial institutions, respectively. Collateralized loan obligations (CLOs), which were largely immune to
the perils of the mortgage meltdown and the financial crisis due to their diversity among corporate issuers, find
themselves exposed by the COVID-19 pandemic. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Rating agencies have been downgrading the speculative-grade loans that support these CLOs <i>en masse</i>: during the four-month period ending June 30, 2020, Moody’s downgraded the ratings of 755 speculative-grade borrowers, a full 31% of the speculative-graderated
universe, across a range of industries (Moody’s Investors Service, n.d.). The industry sectors most
affected are shown in Exhibit 1. </div><div style="text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiHiAC8FamIgqj56AzPQsLRuI9LStJwGxrhed6cgWFXp_JTIT_QSZOBRyJ3QgP-gzSoiG4foHp2260xkzwPIq9j6VmV2OyvnqfOouMennqxvIBHLAf32E3Z9xLUK7vdW4O5j0ONAXSFhng-/s761/EXHIBIT+1.PNG" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="661" data-original-width="761" height="356" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiHiAC8FamIgqj56AzPQsLRuI9LStJwGxrhed6cgWFXp_JTIT_QSZOBRyJ3QgP-gzSoiG4foHp2260xkzwPIq9j6VmV2OyvnqfOouMennqxvIBHLAf32E3Z9xLUK7vdW4O5j0ONAXSFhng-/w410-h356/EXHIBIT+1.PNG" width="410" /></a></div><div class="separator" style="clear: both; text-align: center;"><br /></div><div style="text-align: justify;">While the loan-level downgrades continue, the rating agencies are also downgrading the CLOs backed by the loans. Meanwhile, corporate defaults are already on the high end. As of the end of July 2020, S&P
reported 98 year-to-date defaults, already surpassing the full-year corporate default tally for 2008, which reached 95 (Serino, Kesh, and Pranshu 2020). </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">This note focuses primarily on CLO ratings —
but there have been oddities in the rating of residential mortgage-backed securities (“MBS”) during the pandemic as well. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">While the credit rating agencies are actively
downgrading speculative-grade corporate loans and
outstanding CLOs backed by these loans, they continue to rate new CLOs at the same time. Their approaches
to this tricky proposition, and their communications
describing their approaches, give us pause. We find that
they are: 1) not being transparent about how they apply
their methodologies, 2) either not applying their methodologies
or not applying them consistently, and 3) not
being consistent in their deviations when they deviate
from their official methodologies. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>RATINGS DOWNGRADES
AND NEW RATINGS </b></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In an inauspicious report of May 2020, titled “How
COVID-19 Changed the European CLO Market in
60 Days” (Ryan and Tamburrano 2020), S&P explained that the changes have come “in a sudden and marked
way” and that the “wave of negative [corporate loan]
rating actions has affected several sectors, geographies,
and products.” Strikingly, S&P noted that “[m]arket
challenges that existed before COVID-19, including
high leverage ratios, EBITDA add-backs, and cov-lite
loans, are causing speculation that this may be the perfect
storm for CLOs.” </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">As of early June, Moody’s had placed 1,100 CLO
notes on watch for possible downgrade. That amounted
to 24% of all CLO notes by count and 7% by balance
(Deshpande, Mogunov, and Chatterjee 2020). The rating
agency stated, “Moody’s actions today follow the CLO
actions Moody’s took on 17 April 2020, and are primarily
prompted by a continuing decline in the credit quality of
CLO portfolios as a result of economic shocks stemming
from the coronavirus pandemic. Since April, the decline
in corporate credit has resulted in a significant number of
downgrades among the assets underlying some CLOs.” </div><div style="text-align: justify;"><br /></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhjqV7XXXZSzhdCbqXd4QjUOYiubAyuMrUl0EiwyCh3D-6zUP2X0_Hxaiel9oycZW2G0blZf5oiHkoaI6sNvlV8fmM61QVnV4mpv5B3bi_Zouy5iNz7zvEbSq5Wf7UCglY21eiPFAGn2jst/s1416/EXHIBIT+2.PNG" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="746" data-original-width="1416" height="337" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhjqV7XXXZSzhdCbqXd4QjUOYiubAyuMrUl0EiwyCh3D-6zUP2X0_Hxaiel9oycZW2G0blZf5oiHkoaI6sNvlV8fmM61QVnV4mpv5B3bi_Zouy5iNz7zvEbSq5Wf7UCglY21eiPFAGn2jst/w640-h337/EXHIBIT+2.PNG" width="640" /></a></div><br /><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The downgrading continues, but some of it has
been tepid. When downgrading, Moody’s has often
opted for only a single notch downgrade. For example,
on July 1, Moody’s noted significant collateral deterioration
in a CLO called Nassau 2017-II Ltd. The rating
agency stated: </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><blockquote><span>Based on Moody’s calculation, the weighted
average rating factor (WARF) was 3764 as of
June 2020, or 25% worse compared to 3006
reported in the March 2020 trustee report.
Moody’s calculation also showed the WARF
was failing the test level of 3022 reported in the
June 2020 trustee report by 742 points. Moody’s
noted that approximately 40% of the CLO’s par
was from obligors assigned a negative outlook and
7% from obligors whose ratings are on review
for possible downgrade. Additionally, based on
Moody’s calculation, the proportion of obligors
in the portfolio with Moody’s corporate family
or other equivalent ratings of Caa1 or lower (after
any adjustments for negative outlook and watchlist
for possible downgrade) is approximately 30%
as of June 2020 (Aeron and Ham 2020). </span></blockquote></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Nevertheless, despite significant deterioration,
and in the face of a 30% exposure to Caa1 or lowerrated
assets, Moody’s downgraded the Class C, Class D,
and Class E notes by only a single notch, from A2,
Baa3, and Ba3 to A3, Ba1, and B1 respectively. Moody’s
affirmed the rating of the Class B at Aa2. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In late July, S&P downgraded 63 CLO tranches
by an average of 1.2 rating notches. But 496 tranches
across 287 CLOs remained on CreditWatch negative.
As shown in Exhibit 2, data on the “S&P CLO
Insights 2020 Index” reflected the weakened condition
of the deals. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Meanwhile, the performance of CLOs is to a
degree based on the vigor with which the rating agencies
downgrade the corporate loans. In addition to default
events, downgrades themselves can impact a CLO managers’
ability to trade assets, especially once they start to
fail collateral-quality tests. With CLOs being so heavily
laden with B-rated collateral, even minor downgrades
tend to quickly make an impression on their bucket for
CCC-rated assets. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>LACK OF TRANSPARENCY </b></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The rating agencies’ communications around
their ratings actions are confounding. This riddle is no
easier to disentangle when visiting the rating agencies’
remarks. They provide only limited clarity about the
specifics of how (if at all) they are considering the impact
of the COVID-19 pandemic in their rating actions. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">When downgrading CLOs, Moody’s mentions that
its “analysis has considered the effect of the coronavirus
outbreak on the US economy as well as the effects that
the announced government measures, put in place to
contain the virus, will have on the performance of corporate
assets” (Deshpande, Mogunov, and Chatterjee,
2020). But there are no specifics: Moody’s does not
explain how. In what ways is Moody’s changing its
approach to reflect the analysis it purports to be making?
Did the prepayment rate assumptions change? Did the
default rate assumptions change? Did the correlation
assumptions change? Did the recovery rate assumptions
change? Given that Moody’s identifies a largely quantitative
methodology article (Kim, et al. 2019) as the
“principal methodology” used in the downgrades, it is
odd that Moody’s did not express its approach in any
way that enables users of ratings to apply the purported
considerations within a quantitative framework. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">S&P is similarly opaque. When rating new deals
and reviewing existing deals, S&P sometimes mentions
the pandemic and sometimes does not. For example, in
April, S&P never mentioned the effect of COVID-19 on
its rating of Deerpath Capital CLO 2020-1 (Kalinauskas,
et al. 2020). Moreover, when S&P does discuss the
impact of the pandemic, it does so in a nebulous way,
which leaves the reader guessing about the particulars of
how the rating agency accounts for the pandemic when
assigning ratings. When S&P assigned new ratings in May
2020 to notes issued by Guggenheim CLO 2020-1 Ltd,
its sole mention of the pandemic was the following boilerplate
language: </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><blockquote><span>S&P Global Ratings acknowledges a high degree
of uncertainty about the rate of spread and peak
of the coronavirus outbreak. Some government
authorities estimate the pandemic will peak about
midyear, and we are using this assumption in
assessing the economic and credit implications.
We believe the measures adopted to contain
COVID-19 have pushed the global economy
into recession (see our macroeconomic and credit
updates here: www.spglobal.com/ratings). As the
situation evolves, we will update our assumptions
and estimates accordingly. (Kalinauskas and
Davis 2020).</span><span style="font-size: x-small;"> </span></blockquote></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>DEPARTURES AND DEVIATIONS FROM
METHODOLOGIES, AND INCONSISTENT
APPLICATIONS </b></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Beyond the disappointing lack of transparency,
another challenge for investors is that rating agencies
appear to be deviating from their published methodologies
for assigning and maintaining ratings. Moreover,
they deviate in inconsistent ways from one deal
to the next. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Example 1</b>. In one telling example (Jiang and
Vasudevan 2020), Moody’s downgraded 48 MBS
on April 15, 2020. The rating agency identified a
mostly-quantitative methodology as the “principle
methodology” for the rating actions (Vasudevan,
Hannoun-Costa, and Muni 2019). Of note, the principle
methodology predates the start of the pandemic. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">What was particularly striking about the April 15
rating actions was that Moody’s downgraded all of 48
MBS to the same rating level (Baa3) even though they
previously carried ratings at a variety of levels (A3, Baa1
and Baa2). Moody’s did not describe a concrete basis for the Baa3 outcome. Although it explained the need for
taking action, it provided no details about why Baa3
was the right rating level for the 48 tranches. The rating
agency stated: “Our analysis has considered the increased
uncertainty relating to the effect of the coronavirus outbreak
on the US economy.” But later in the press release
it revealed that it “did not use any models, or loss or
cash flow analysis, in its analysis” and that it “did not
use any stress scenario simulations in its analysis” (Jiang
and Vasudevan 2020). It is difficult to reconcile that
statement with others to the effect that 1) a quantitative
methodology was used and 2) the analysis considered
the increased uncertainty relating to the onset of the
pandemic. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In June, Moody’s took action on 415 US MBS, confirming
its ratings on 35 of them, while downgrading the
other 380 (Rossetti and Vasudevan 2020). The announcement,
however, contained no language about Moody’s
departing from the application of any models. Instead, the
boilerplate verbiage in the announcement stated: </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><blockquote><span>Moody’s estimates expected collateral losses or
cash flows using a quantitative tool that takes into
account credit enhancement, loss allocation and
other structural features, to derive the expected
loss for each rated instrument. <i>Moody’s quantitative
analysis entails an evaluation of scenarios that stress
factors</i> contributing to sensitivity of ratings and
take into account the likelihood of severe collateral
losses or impaired cash flows. Moody’s
weights the impact on the rated instruments
based on its assumptions of the likelihood of the
events in such scenarios occurring (Rossetti and
Vasudevan 2020, emphasis added). </span></blockquote></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Most interestingly, 47 of the 48 MBS, which had
been downgraded to Baa3 in April (without the use of
a model), were addressed again in June (Rossetti and
Vasudevan 2020), this time ostensibly using a quantitative
tool. The results were that the securities received
different ratings: </div><div style="text-align: justify;"><ul><li>10 MBS maintained their Baa3 ratings upon review
with a model.</li><li>15 were downgraded to Ba2 (i.e., a further two notch
downgrade). </li><li>22 were downgraded to B1 (i.e., a further four notch
downgrade). </li></ul></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>Example 2</b>. In recent surveillance updates on
CLO ratings, Fitch appears to be applying new scenarios
that are not included in its official methodology. For
example, in the updates for Jubilee CLO 2014-XII and
Penta CLO 5, the agency explained: </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"></div><blockquote><div style="text-align: justify;"><span>Coronavirus Baseline Scenario Impact: Fitch
carried out a sensitivity analysis on the current
portfolio to envisage the coronavirus baseline
scenario. The agency notched down the ratings
for all assets with corporate issuers on Negative
Outlook regardless of sector. </span></div><div style="text-align: justify;"><span><br /></span></div><div style="text-align: center;"><span>∗ ∗ ∗ </span></div><div style="text-align: justify;"><span><br /></span></div><div style="text-align: justify;"><span>In addition to the base scenario, Fitch has defined
a downside scenario for the coronavirus crisis,
whereby all ratings in the ‘B’ category would be
downgraded by one notch and recoveries would
be lowered by 15% (Kelmer and Brewer 2020a;
Segato and Brewer 2020a). </span></div></blockquote><div style="text-align: justify;"></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">More pointedly, Fitch has been regularly deviating
from its model-implied ratings (MIRs) in downgrading
CLOs notes. In addition, the deviations have not been
consistent. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">For example, in reviewing certain European
CLOs, Fitch refrained from downgrading tranches for
which the MIR indicated a one-notch drop. Where
the MIR indicated a two-notch drop, the rating agency
either refrained from downgrading[1], or did so by just one
notch[2]. In some cases, Fitch explained that the deviations
were because the MIR results had been “driven by
the back-loaded default timing scenario only” (Choraria
and Brewer 2020; Ishidoya and Brewer 2020; Segato
and Brewer 2020a, 2020b). In other cases, Fitch asserted that it had deviated from the MIRs because the results
did not comport with its view of credit quality and also
because the MIRs had been “driven by the rising interest
rate scenario only, which is not our immediate expectation”
(Kelmer and Brewer 2020a, 2020b). </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Fitch made several similar out-of-model adjustments
when reviewing the ratings across seven CLOs in
late July (Torres and Pak 2020). The rating agency stated: </div><div style="text-align: justify;"><br /></div><blockquote><div style="text-align: justify;"><span>The class C notes in PSLF 2018-4, Ltd., class B
notes in PSLF 2019-4, Ltd., and class B notes in
PSLF 2020-1, Ltd. experienced shortfalls in some
scenarios and the model-implied ratings (MIRs)
of these notes were one notch below their current
rating levels. However, Fitch considered the
magnitude of these failures as minor and isolated
to the back-loaded default timing and rising
interest rate scenario that was given less weight
in the analysis. </span></div><div style="text-align: justify;"><span><br /></span></div><div style="text-align: center;"><span>∗ ∗ ∗ </span></div><div style="text-align: center;"><span><br /></span></div><div style="text-align: justify;"><span>In addition, MIRs of the following classes were
at least one notch higher than their current ratings
based on current portfolio analyses, but were
not upgraded in light of the ongoing economic
disruption … (Torres and Pak 2020). </span></div></blockquote><div style="text-align: justify;"></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In contrast to its surveillance practices, Fitch generally
makes no mention of ignoring its model-based
outcomes in rating new US CLOs. However, in some
cases, Fitch has indicated that it is applying stress scenarios
in a way similar (but not identical) to surveillance
stress scenarios. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">For example, when providing ratings to two newly-issued
CLO in July 2020, the rating agency explained: </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"></div><blockquote><div style="text-align: justify;"><span>Fitch has applied two additional stress scenarios
to the indicative portfolio that envisage negative
rating migration as a result of business disruptions
from the coronavirus. The first scenario applies a
one-notch downgrade (with a CCC-floor) for all
assets in the indicative portfolio with a Negative
Rating Outlook.… <i>The second scenario</i> assumes
a 5% increase in the indicative portfolio’s PCM
rating default rates (RDR) for all rating levels. </span></div><div style="text-align: justify;"><span><br /></span></div><div style="text-align: center;"><span>∗ ∗ ∗ </span></div><div style="text-align: justify;"><span><br /></span></div><div style="text-align: justify;"><span>Fitch added a sensitivity analysis that contemplates
a more severe and prolonged economic
stress caused by a re-emergence of infections in
the major economies, before a halting recovery
begins in 2Q21. (See Weiss, Joswiak, and Hughes
2020; Hunter, Lycos, and Hughes 2020, with
emphasis added). </span></div></blockquote><div style="text-align: justify;"></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The <i>second</i> stress scenario used in rating new
deals is entirely absent when performing surveillance.
It is unclear whether the downside scenarios are being
applied equally, as Fitch has left the specifics undefined. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">It is somewhat surprising that Fitch would choose
to make manual, ad-hoc, overrides to its model-driven
outputs in every pandemic-era CLO surveillance action
we found because it could not rely on the results produced
using its official methodology. Under such a scenario,
it would be easier to understand a basic adjustment
to the methodology (and the associated model), so that it
provides a reliable result that reflects Fitch’s actual views. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>WHY IT ALL MATTERS </b></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Investors and other market participants use credit
ratings as signals or indicators of creditworthiness that
figure, inter alia, into their processes for valuing securities
and allocating capital. Securities can also be interrelated.
The ratings awarded to some securities also, as
we note above, directly impact the performance of other
securities that reference or support them. In order for
credit ratings to be useful, they must embody a measure
of reliability. One of the key aspects of that reliability
is that ratings are produced through a consistent, replicable
process: the application of a rating agency’s official
methodologies. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">The ideas of applying official methodologies to
produce ratings and doing so in a consistent manner are
prominent features of each rating agency’s code of conduct
(Moody’s Investors Service 2020, § 1.3; S&P Global
Ratings 2018, § 1.2; Fitch Ratings 2017, § 2.1.3). At least
one court has held that statements in a rating agency’s
code of conduct constitute “specific assertions of current
and ongoing policies” and cannot be dismissed as
mere puffery upon which investors cannot reasonably rely, United States v. McGraw Hill (2013). Today, applying
official methodologies to produce ratings is explicitly
required under US [3] and European [4] law . </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Likewise, the rating agencies undertake, in their
codes of conduct, to provide clear explanations of the
rationale behind each rating action (Moody’s Investors
Service 2020, § 3.6(b), (c); S&P Global Ratings 2018,
§ 4.1; Fitch Ratings 2017, § 4.1.3). That is also required
under US [5] and European [6] law. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">There are compelling reasons for why rating agencies
are required to produce ratings by applying their
official methodologies. One reason is that it decreases
the potential for an individual analyst or team of analysts to abandon criteria in an effort to win new deals by
providing advantageous ratings. Rating agencies might
argue that they must have some flexibility to stray from
their methodologies. To the extent that such a position
is valid (and does not violate a rating agency’s legal obligations),
we believe that when a rating agency deviates
from its official methodology, it has an obligation to
explain the rationale for the deviation and to explain
in detail how it arrived at the rating produced with
the deviation. Moreover, when deviations become the
norm, or when they are inconsistent or poorly articulated,
we believe that the rating agencies have gone too
far. At times, as shown herein, rating agencies have deviated
from their methodologies, but failed to explain the
analyses that ensued and how they determined the final
ratings that they assigned. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>CONCLUSION </b></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">In the aftermath of the 2008 financial crisis, the
credit rating agencies experienced criticism, private
litigation, and government enforcement actions.
Enforcement actions in the US were taxing, culminating
in f ines of $1.375 billion for S&P and $864
million for Moody’s (US Department of Justice 2015,
2017). The enforcement actions particularly noted that
the rating agencies had violated their codes of conduct,
which required them to provide objective, independent
ratings. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Although the regulatory environment has gotten
tougher since the Dodd-Frank Act was signed into law,
we remain concerned that rating agencies continue to
deviate from their published methodologies whenever
it suits them. Based on recent evidence, they appear to
view the directive to determine ratings pursuant to their
official methodologies and to apply methodologies in a
consistent manner as mere suggestions, rather than as
mandatory rules. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>FOOTNOTES</b></div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">
[1] Adagio VII, classes E and F (Segato and Brewer 2020b);
St Paul CLO 5, class F-R (Kelmer and Brewer 2020b); St Paul CLO 6,
class E-R (Kelmer and Brewer 2020b); Jubilee 2014-XII, class F-R
(Kelmer and Brewer 2020a); Jubilee 2016-XVII, class F-R (Kelmer
and Brewer 2020a); Penta 5, class F (Segato and Brewer 2020a). </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">[2] Euro Galaxy III, class E (Choraria and Brewer 2020); Toro
European 4, class E (Ishidoya and Brewer 2020). </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">[3] 15 U.S.C. § 78o-7(r) (2018), https://www.govinfo.gov/content/pkg/USCODE-2018-title15/pdf/USCODE-2018-title15-chap2B-sec78o-7.pdf; 17 C.F.R. § 17g-8(a)(3)(i), (d) (2019), https://www.govinfo.gov/content/pkg/CFR-2019-title17-vol4/pdf/CFR-2019-title17-vol4-sec240-17g-8.pdf. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">[4] Regulation (EU) No 462/2013 of the European Parliament
and of the Council of 21 May 2013 amending Regulation (EC) No
1060/2009 on Credit Rating Agencies, Art. 1, § 10(a) & Annex II,
¶ 1(h), 2013 O.J. (L146/1) at 16, 31 (May 31, 2013), https://eurlex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32013R0462&from=EN; Commission Delegated Regulation (EU)
No 447/2012 of 21 March 2012 Supplementing Regulation (EC)
No 1060/2009 of the European Parliament and of the Council on
Credit Rating Agencies by Laying Down Regulatory Technical
Standards for the Assessment of Compliance of Credit Rating Methodologies,
Art. 5, § 1, 2012 O.J. (L140/14) at 15 (May 30, 2012),
https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32012R0447&from=EN; Regulation (EC) No 1060/2009 of
the European Parliament and of the Council of 16 September 2009
on Credit Rating Agencies, Art. 8, § 2, 2009 O.J. (L302/1) at 13
(November 17, 2009), https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32009R1060&from=EN. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">[5] 15 U.S.C. § 78o-7(s) (2018), https://www.govinfo.gov/content/pkg/USCODE-2018-title15/pdf/USCODE-2018-title15-chap2B-sec78o-7.pdf; 17 C.F.R. § 17g-7(a)(1)(ii)(B), (C) (2019),
https://www.govinfo.gov/content/pkg/CFR-2019-title17-vol4/pdf/CFR-2019-title17-vol4-sec240-17g-7.pdf. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">[6] Regulation (EU) No 462/2013 of the European Parliament
and of the Council of 21 May 2013 amending Regulation (EC)
No 1060/2009 on Credit Rating Agencies, Annex II, § 4(f), 2013
O.J. (L146/1) at 27 (May 31, 2013), https://eur-lex.europa.eu/legalcontent/EN/TXT/PDF/?uri=CELEX:32013R0462&from=EN;
Regulation (EC) No 1060/2009 of the European Parliament and
of the Council of 16 September 2009 on Credit Rating Agencies,
Annex II, Section D, ¶ 5, 2009 O.J. (L302/1) at 28 (November 17,
2009), https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32009R1060&from=EN. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><b>REFERENCES</b> </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Aeron, N., and D. Ham. 2020. “Moody’s Downgrades Ratings
on $72 Million of CLO Notes Issued by Nassau 2017-II
Ltd.; Actions Conclude Review.” Moody’s press release.
July 1. </div><div style="text-align: justify;">https://www.moodys.com/research/Moodys-downgrades-ratings-on-72-million-of-CLO-notes-issued--PR_
427681. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Choraria, P., and A. Brewer. 2020. “Fitch Downgrades One
Tranche of Euro Galaxy III CLO B.V., Maintains RWN
on One and Affirms the Rest.” Fitch press release. May 7. </div><div style="text-align: justify;">https://www.fitchratings.com/research/structured-finance/fitch-downgrades-one-tranche-of-euro-galaxy-iii-clo-bv-maintains-rwn-on-one-affirms-rest-07-05-2020. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Deshpande, A., L. Mogunov, and D. Chatterjee. 2020.
“Moody’s Places Ratings on 241 Securities From 115 US
CLOs on Review for Possible Downgrade; Also Places
Ratings on 2 Linked Securities on Review for Possible Downgrade.”
Moody’s press release. June 3. </div><div style="text-align: justify;">https://www.moodys.com/research/Moodys-places-ratings-on-241-securities-from-115-US-CLOs--PR_425620. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Dodd-Frank Wall Street Reform and Consumer Protection
Act, Pub. Law No. 111-203, 124 Stat. 1376 (2010)</div><div style="text-align: justify;">https://www.govinfo.gov/content/pkg/PLAW-111publ203/pdf/PLAW-111publ203.pdf. </div><div style="text-align: justify;"><br /></div><div style="text-align: left;">Fitch Ratings. 2017. “Code of Conduct and Ethics.” July. </div><div style="text-align: left;">https://assets.ctfassets.net/03fbs7oah13w/25SiZhnpbDYTLd1S8Elrc7/c75f55b3ac3ee5c95c9bdbfeda95488b/Bulletin_01_Code_of_Conduct_and_Ethics.pdf. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Hu, D., S. Anderberg, R. E. Schulz, S. Wilkinson, and
R. Muthukrishnan. 2020. “CLO Insights: 63 CLO Tranches
Downgraded by 1.2 Notches on Average in July.” S&P
newsletter. July 31. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Hunter, M., K. Lycos, and A. Hughes. 2020. “Fitch Rates
Ballyrock CLO 2020-1 Ltd.” Fitch press release. July 8.
https://www.fitchratings.com/research/structured-finance/fitch-rates-ballyrock-clo-2020-1-ltd-08-07-2020. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Ishidoya, K. and A. Brewer. 2020. “Fitch Downgrades One
Tranche of Toro European CLO 4 DAC and Affirms Rest;
Two Tranches on RWN.” Fitch press release. May 18. </div><div style="text-align: justify;">https://www.fitchratings.com/research/structured-finance/fitch-downgrades-one-tranche-of-toro-european-clo-4-dac-affirms-rest-two-tranches-on-rwn-18-05-2020. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Jiang, Z., and S. Vasudevan. 2020. “Moody’s Places 404
Classes of Legacy US RMBS on Review for Downgrade.”
Moody’s press release. April 15. </div><div style="text-align: justify;">https://www.moodys.com/research/Moodys-places-404-classes-of-legacy-US-RMBS-on-review--PR_422633. </div><div style="text-align: justify;"><br /></div><div style="text-align: left;">Kalinauskas, P., and C. Davis. 2020. “Guggenheim CLO
2020-1 Ltd. Notes Assigned Ratings.” S&P press release. May
4. </div><div style="text-align: left;">https://www.standardandpoors.com/en_US/web/guest/article/-/view/type/HTML/id/2424307. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Kalinauskas, P., T. Walsh, W. Sweatt, and D. Haynes.
2020. “Deerpath Capital CLO 2020-1 Ltd. Notes Assigned
Ratings.” S&P press release. April 7. </div><div style="text-align: justify;">https://www.standardandpoors.com/en_US/web/guest/article/-/view/type/HTML/id/2408885. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Kelmer, S., and A. Brewer. 2020a. “Fitch Assigns Negative
Outlook to 1 Tranche and Downgrades Another of Jubilee
CLO 2014-XII B.V.” Fitch press release. July 3. </div><div style="text-align: justify;">https://www.fitchratings.com/research/structured-finance/fitch-assigns-negative-outlook-to-1-tranche-downgrades-another-of-jubilee-clo-2014-xii-bv-03-07-2020. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">——. 2020b. “Fitch Downgrades 2 St Paul’s CLOs with 3
Tranches of Each CLO on RWN or Negative Outlook.” Fitch
press release. June 29. </div><div style="text-align: justify;">https://www.fitchratings.com/research/structured-finance/fitch-downgrades-2-st-paul-clos-with-3-tranches-of-each-clo-on-rwn-negative-outlook-29-06-2020. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Kim, J., R.O. Torres, I. Perrin, T. Klotz, A. Remeza, and
J. Hu. 2019. “Moody’s Global Approach to Rating Collateralized
Loan Obligations.” Moody’s methodology report.
March 8. </div><div style="text-align: justify;">https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBS_1111156. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Moody’s Investors Service. n.d. “Non-Financial Corporates:
Rating Activity During COVID-19.” Moody’s infographic. </div><div style="text-align: justify;">https://www.moodys.com/sites/products/ProductAttachments/Infographics/non-finanancial-corporates-rating-activity-06July.pdf. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Moody’s Investors Service. 2020. “Code of Professional
Conduct.” March. </div><div style="text-align: justify;">https://www.moodys.com/uploadpage/Mco%20Documents/Documents_professional_conduct.pdf</div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Rossetti, N., and S. Vasudevan. 2020. “Moody’s Takes Action
on 415 US RMBS Bonds from 237 Deals Issued Prior to
2009.” Moody’s press release. June 9. </div><div style="text-align: justify;">https://www.moodys.com/research/Moodys-takes-action-on-415-US-RMBS-bonds-from-237--PR_425884. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Ryan, S., and E. Tamburrano. 2020. “How COVID-19
Changed the European CLO Market in 60 Days.” S&P comment.
May 6. </div><div style="text-align: justify;">https://www.spglobal.com/ratings/en/research/articles/200506-how-covid-19-changed-the-european-clo-market-in-60-days-11444644. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Segato, G., and A. Brewer. 2020a. “Fitch Ratings Revises One
Tranche of Penta CLO 5 DAC to Negative Outlook; Affirms
Ratings.” Fitch press release. July 6. </div><div style="text-align: justify;">https://www.fitchratings.com/research/structured-finance/fitch-ratings-revises-one-tranche-of-penta-clo-5-dac-to-negative-outlook-affirms-ratings-06-07-2020. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">——. 2020b. “Fitch Revises One Tranche of Adagio VII CLO
DAC to Negative Outlook; Affirms Ratings.” Fitch press
release. June 26. </div><div style="text-align: justify;">https://www.fitchratings.com/research/structured-finance/fitch-revises-one-tranche-of-adagio-vii-clo-dac-to-negative-outlook-affirms-ratings-26-06-2020. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Serino, N., S. Kesh, and S. Pranshu. 2020. “Default, Transition,
and Recovery: Consumer and Service Sector Defaults
Help Push The 2020 Corporate Tally To 147,” S&P comment.
July 31. https://www.spglobal.com/ratings/en/research/articles/200731-default-transition-and-recovery-consumer-and-service-sector-defaults-help-push-the-2020-corporate-tally-to-11596242. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">S&P Global Ratings. 2018. “S&P Global Ratings Code of
Conduct.” March 1. </div><div style="text-align: justify;">https://www.standardandpoors.com/en_US/delegate/getPDF?articleId=2194115&type=COMMENTS&subType=REGULATORY. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Torres, C., and A. Pak. 2020. “Fitch Affirms 38 Tranches from
Seven Static CLOs; Removes Rating Watch Negative,” Fitch
rating action commentary. July 29. </div><div style="text-align: justify;">https://www.fitchratings.com/research/structured-finance/fitch-affirms-38-tranches-from-seven-static-clos-removes-rating-watch-negative-29-07-2020. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">US Department of Justice. 2015. “Justice Department and
State Partners Secure $1.375 Billion Settlement with S&P for
Defrauding Investors in the Lead Up to the Financial Crisis.”
Press release. February 3. </div><div style="text-align: justify;">https://www.justice.gov/opa/pr/justice-department-and-state-partners-secure-1375-billion-settlement-sp-defrauding-investors. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">US Department of Justice. 2017. “Justice Department and
State Partners Secure Nearly $864 Million Settlement with
Moody’s Arising From Conduct in the Lead up to the Financial
Crisis.” Press release. January 13. https://www.justice.gov/opa/pr/justice-department-and-state-partners-secure-nearly-864-million-settlement-moody-s-arising. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">US v. McGraw Hill, No. CV-13-0779 (C.D.Ca., July
16, 2013) (order denying defendants’ motion to dismiss).
https://online.wsj.com/public/resources/documents/sandpdismiss0717.pdf. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Vasudevan, S., O. Hannoun-Costa, and K. Muni. 2019. “US
RMBS Surveillance Methodology.” Moody’s rating methodology.
February 22. </div><div style="text-align: justify;">https://www.moodys.com/research-documentcontentpage.aspx?&docid=PBS_1127300. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;">Weiss, C., A. Joswiak, and A. Hughes. 2020. “Fitch Rates
HalseyPoint CLO II, Ltd.” Fitch press release. July 1. </div><div style="text-align: justify;">https://www.fitchratings.com/research/structured-finance/fitch-rates-halseypoint-clo-ii-ltd-01-07-2020. </div><div style="text-align: justify;"><br /></div><div style="text-align: justify;"><i><b>----------</b></i></div><div style="text-align: justify;"><i><b><br /></b></i></div><div style="text-align: justify;"><i><b>Gene Phillips</b> is the CEO of PF2 Securities Evaluations, Inc. in
Los Angeles, CA. gene.phillips@pf2se.com </i></div><div style="text-align: justify;"><i><br /></i></div><div style="text-align: justify;"><i><b>Mark Adelson </b>is the editor of The Journal of Structured Finance,
in New York, NY. m.adelson@pageantmedia.com</i></div>PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com1tag:blogger.com,1999:blog-3764912039741974037.post-77896318387184794602020-07-21T14:43:00.000-04:002020-07-21T14:43:33.931-04:00Fraud as a Pathogen of Humanity<h4 style="background-color: white; margin: 0px; position: relative; text-align: center;">
<span style="font-weight: normal; text-align: justify;"><span style="font-family: inherit;"><i>by Joe Pimbley, who consults for PF2, and director Gene Phillips</i></span></span></h4>
<div>
<span style="font-weight: normal; text-align: justify;"><span style="font-family: inherit;"><br /></span></span></div>
<div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;">The sudden crash of <em style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;">Wirecard</span></em> dominates
headlines. Though pernicious, the fraudulent activity of this
eminent European company is quite common. Fraud is everywhere and we
must guard against it just as our bodies resist harmful disease.</span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<strong style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;"><span style="font-family: inherit;"><br /></span></span></strong></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;"><strong style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;">Fraud at </span></strong><em style="box-sizing: inherit; outline: 0px;"><b><span style="border: 1pt none windowtext; padding: 0in;">Wirecard</span></b></em></span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<em style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;"><span style="font-family: inherit;"><br /></span></span></em></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;"><em style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;">Wirecard</span></em>, the large
German payment processor and DAX 30 constituent, filed insolvency proceedings
in late June 2020.[i] The firm
had long faced contested allegations of false or questionable bookings of
revenue and profits with pressure increasing in January 2019.</span>[ii]<span style="font-family: inherit;"> In a final
blow, <em style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;">Wirecard</span></em>’s audit firm could not verify the existence
of stated balance sheet cash of EUR 1.9 billion.</span>[iii] <span style="font-family: inherit;">An apt
description of <em style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;">Wirecard</span></em>’s subsequent corporate
fate is Lemony Snicket’s “death swooped down like a bat.”</span>[iv]</div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<strong style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;"><span style="font-family: inherit;"><br /></span></span></strong></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<strong style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;"><span style="font-family: inherit;">Fraud is everywhere</span></span></strong></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;"><br /></span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;">Fraudulent statements and
behavior of human beings are as old as humanity itself and will continue until
the death of our species. This sentiment is not a denunciation of
people; it is merely a characterization of human society. As the
joke of our current era goes: human guile is not a bug; it’s a
feature.</span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;"><br /></span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;">Our definition of “fraud”
casts a wide net to include one extreme of telling blatant lies, for example,
to sell the Brooklyn Bridge to tourists, while also capturing the other extreme
of deliberately failing to correct a false impression that others may have of
you. (We know of a Physics Nobel laureate who, in answer to a direct
question, told the U.S.-based interviewer for his first professional job that
his college grade-point-average was 4.0. The interviewer was visibly
impressed. Surprised by this reaction and realizing the
interviewer’s likely error, the future laureate did not qualify the information
by stating that 4.0 was a terrible GPA in his home country of Norway.)</span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;"><br /></span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;">The Brooklyn Bridge story is
the classic fraud example. Most of us would consider the interviewer’s
ignorance of the Norwegian GPA scale not to be an act of fraud on the part of
the young job applicant. Of course, there is a vast middle ground
between these extremes. We see all sections of this middle ground in
our personal and professional lives. Here are a few “middle ground”
examples of varying import one of the authors witnessed directly with past
employers or learned confidentially from colleagues:</span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;"><br /></span></div>
<div style="background: white; vertical-align: baseline;">
</div>
<ul>
<li style="text-align: justify;"><span style="font-family: inherit;">On
a derivative trading floor, managers assigned trade identification numbers in a
manner that would give counterparties the impression that the trading floor
executed ten times more trades than the actual number. </span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">A
risk manager discovered an error in a capital adequacy calculation agreed a
decade earlier with the firm’s dominant regulator; the General Counsel chose
not to inform the regulator because "it would be confusing.”</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">A
senior executive of a credit rating agency told a rating analyst what the final
rating should be for the debt of a new client (<em style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;">i.e</span></em>., “just prepare
an analysis that reaches the rating we want”).</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">Following
the ouster of a CEO during a year of painful losses, the new CEO entered and
asked the internal accountants to find and take as many additional losses as
possible for that current year.</span></li>
</ul>
<div style="text-align: justify;">
<span style="font-family: inherit;">So fraud, in the sense of
giving deceptive information or withholding information for the purpose of
helping an individual, group, or company, is everywhere. These four
examples are somewhat trivial and one might consider only one or two, or perhaps
none, of them to be “true fraud.”</span></div>
<br />
<div style="background: white; text-align: justify; vertical-align: baseline;">
<strong style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;"><span style="font-family: inherit;"><br /></span></span></strong></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<strong style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;"><span style="font-family: inherit;">The Ponzi scheme template for
fraud</span></span></strong></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;"><br /></span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;">Broadly, the fraud allegations
against <em style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;">Wirecard</span></em> are for
misstatements of financial condition and activity. Instead of
delving into the <em style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;">Wirecard</span></em> details, we discuss
a simpler, generic variant of such fraud that the financial industry calls “the
Ponzi scheme.”</span>[v]</div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;"><br /></span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;">In a Ponzi scheme, an
investment manager solicits funds from investors to make specified purchases of
assets (for example, real estate, stocks, bonds, small businesses, <em style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;">et
cetera</span></em>). Either through losses on these assets or
embezzlement of the manager or both, the value of total assets
falls. This situation becomes a Ponzi scheme when the investment
manager deliberately misstates the current asset value in reports to the fund
investors. Believing the fund to be healthy and relying on the
(false) manager statements, current investors will tend to keep their principal
invested and new investors will add money to the fund. The Ponzi
fraud may remain undetected as long as investor redemption requests do not
exceed the sum of (diminished) assets and inflows of new investor money.</span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;"><br /></span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;">In its mildest form, the
perpetrator of a Ponzi fraud does not begin the enterprise with criminal
intent. Rather, the manager’s investments perform poorly and,
fearing investor withdrawals and business failure as consequences of honest
disclosure of this performance, the manager chooses to make false statements. This
is the paradigm for <em style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;">Wirecard</span></em>-like
frauds. Management makes false statements and obfuscations to cover
poor performance or to gain some undeserved short-term benefit.</span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<strong style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;"><span style="font-family: inherit;"><br /></span></span></strong></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<strong style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;"><span style="font-family: inherit;">Fraud is a pathogen of human
society</span></span></strong></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;"><br /></span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;">A pathogen is a virus,
bacterium or other agent that produces disease. Pathogens are
ubiquitous, both internal and external to our bodies. We have
developed practices as well as natural and man-made defenses to counter most
pathogens. Humanity would not exist otherwise. Pathogens
vary widely in their infection frequency and lethality and generally do not
kill their hosts (not immediately, at least).</span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;"><br /></span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;">Fraud is very much a pathogen
of society. Its goal is not to kill the host since, without a mostly
healthy society, fraud would not be fruitful. Like pathogens, fraud
is everywhere and there is no prospect or possibility of eliminating all fraud.</span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;"><br /></span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;">But society has an immune
system deriving from learned and innate caution and skepticism. We
also have experiences and stories of the personal and business worlds that
become lessons for best practices.</span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<strong style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;"><span style="font-family: inherit;"><br /></span></span></strong></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<strong style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;"><span style="font-family: inherit;">Combat fraud as we would a
pathogen</span></span></strong></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;"><br /></span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;">There are many strategies for
investors to avoid fraud just as there are strategies for people to avoid
disease. Our list below blends some time-tested ideas with those
that are most relevant to the <em style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;">Wirecard</span></em> debacle.</span></div>
<div style="background: white; text-align: justify; vertical-align: baseline;">
<span style="font-family: inherit;"><br /></span></div>
<div style="background: white; vertical-align: baseline;">
</div>
<ol>
<li style="text-align: justify;"><span style="font-family: inherit;">Be
consciously aware that fraud is possible in any investment. It may
seem that significant fraudulent activity is less likely in a widely studied
investment such as a <em style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;">Microsoft</span></em> or <em style="box-sizing: inherit; outline: 0px;"><span style="border: 1pt none windowtext; padding: 0in;">Wirecard</span></em>,
but fraud at some level is everywhere.</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">Think
for yourself, ask your own questions. The apparent confidence of
many other investors can provide a false sense of comfort.</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">Realize
that many people are inherently dishonest, and certainly “less than
honest.” People do lie.</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">Think
critically about “the story” of the investment you’re
considering. If it does not make sense to you, don’t
invest. Trust yourself more than you trust anyone who tells a story
you do not understand or believe.</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">Three
elements of the financial world’s “immune system” to fight fraud are auditors,
regulators and credit rating agencies. For any potential investment,
determine whether there are relevant auditors, regulators and rating agencies
and consult their findings. Illness sometimes prevails because an
immune system component fails to fulfil its role.</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">Auditors
make mistakes. Audit firms investigate the financial statements of
their clients to certify absence of material misstatements and adherence to
accepted accounting policies. Since the client pays the auditors for
the service, the auditors have a “moral hazard motive” not to press fraud
investigations vigorously. While most audit firms DO have strong
motives to protect their brands and reputations by maintaining high standards
for their investigations, that is no guarantee that individual audit groups
will do their jobs honestly or competently. Hence, do not base a
positive investment decision on satisfied auditors.</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">Regulators
are government employees. They and the regulations they supervise
and enforce are generally well intended. But corporate entities that
are willing to deceive investors will also deceive the
regulators. Ironically, regulators will often defend their regulated
firms from external accusations because it “looks bad” for the regulators if
such accusations are valid. Further, the mission of regulators
favors protection of the banking system and government interests over those of
investors in individual firms. Hence, do not base a positive
investment decision on satisfied regulators.</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">Credit
rating agencies are non-government companies that claim to advocate for
investors. They would like you to think of them as “expert
investors” that provide unbiased opinions of investment risk. But
this profile is inaccurate. The rating agencies do not invest and,
therefore, do not take the risk you will take as an
investor. Further, their paying clients are the corporate firms
themselves, which means that the rating agencies have the same “moral hazard
motive” as the auditors. Though the meanings of the credit ratings
themselves are poorly defined, we do consider it valuable to have one or more
ratings for corporate debt securities you may purchase. For
“investment-grade” credit ratings, ~80% of such securities will have reasonably
low risk (allowing for the errors that these rating agencies do
make). Do not rely only on a credit rating for a positive investment
decision on a debt security.</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">Pay
attention to the statements of vocal critics of entities in which you have
invested or may invest. Financial journalists, investment advisors
and other investors will sometimes publish negative results from their own
investigations. Read such opinions skeptically since the reports may
be mistaken or deliberately false or exaggerated. Even when wrong or
mostly wrong, such third-party views and rebuttals from the investment entity,
if any, stimulate your own productive analysis. </span></li>
</ol>
<div style="text-align: center;">
<span style="font-family: inherit;">------------------------------------</span></div>
<div>
<span style="font-family: inherit;"><br /></span></div>
<div>
<span style="font-family: inherit;">[i] See “<a href="https://nypost.com/2020/06/25/german-payment-giant-wirecard-in-insolvency-owing-4-billion/" target="_blank">Wirecard files for insolvency owing $4 billion</a>,” New York Post </span></div>
<div>
<span style="font-family: inherit;">[ii] See B. Jennen and N. Comfort, “<a href="https://www.bloomberg.com/news/articles/2020-06-24/wirecard-whistleblower-tipped-off-german-regulator-in-early-2019" target="_blank">Wirecard Whistle-Blower Tipped German Watchdog in Early 2019</a>,” Bloomberg</span></div>
<div>
<span style="font-family: inherit;">[iii] See R. Browne, “<a href="https://www.cnbc.com/2020/06/19/wirecards-future-is-in-doubt-as-accounting-scandal-deepens.html" target="_blank">It was once Germany’s fintech star. Now, a missing $2 billion puts Wirecard’s future in doubt</a>” </span></div>
<div>
<span style="font-family: inherit;">[iv] See L. Snicket, The Miserable Mill, Scholastic, Inc., 2000. The excerpted quote is available at https://snicket.fandom.com/wiki/The_Dismal_Dedications.</span></div>
<div>
<span style="font-family: inherit;">[v] See the U.S. Securities and Exchange Commission <a href="https://www.sec.gov/fast-answers/answersponzihtm.html" target="_blank">discussion of Ponzi schemes</a></span></div>
<span style="font-weight: normal; text-align: justify;"><span style="font-family: inherit;"></span></span></div>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-75697211914918946392020-05-08T14:30:00.000-04:002020-05-08T14:30:10.242-04:00TruPS CDOs: What Virus?<div style="text-align: justify;">
While the rating agencies have been actively <a href="https://www.wsj.com/articles/bond-downgrades-begin-amid-coronavirus-slowdown-11585045800" target="_blank">downgrading bonds across almost all sectors</a>, we thought it may be fun to compare the performance of regional US banks during COVID-19 against their performance during the 2007-2008 financial crisis.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Bank TruPS CDOs are deals supported by trust preferred securities issued by regional/community banks. Interestingly enough, since the onset of the coronavirus, the TruPS CDOs (if anything) have been going up from a ratings perspective.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Yesterday, Kroll Bond Rating Agency affirmed the ratings of a 2018 deal, without making any mention of the coronavirus. Meanwhile in a series of (we count four) ratings releases since March, Fitch has upgraded dozens of tranches, and affirmed many others too. No downgrades, and no mention of COVID-19. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
So why the upgrades? The likely answer is that many of the upgrades have been lingering for a few years, and just had to happen at some stage, so why not now?</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Here's one of the more interesting bonds, the $70mm top tranche (originally <b>AAA</b>) of a 2005 deal called Regional Diversified Funding 2005-1, which has seen both crises. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Read the chart from the bottom up. Pre-crisis, Fitch has it at <b>AAA</b>, until it was (rather dramatically) downgraded on a single day to <b>CCC</b> in 2009. That's incredible. Okay, fast forward and it's single <b>C</b> in 2010, Fitch's lowest rating: an expectation of full or almost full wipeout. </div>
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjJhzKrn34fpvejf9eDCcKdlMpVUopohYBoAW9iE9Z1Tkajv9v3GQwwdrcnqQ2jRe5KBWlE_pylPpQrB3KnDJVea3qh8PMv6G0GQ6BjxmO4RSrWqf0-UCPlDYHbCZlc4bkNDMPGGsTC9JO0/s1600/Reg+Divesified.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="368" data-original-width="593" height="395" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjJhzKrn34fpvejf9eDCcKdlMpVUopohYBoAW9iE9Z1Tkajv9v3GQwwdrcnqQ2jRe5KBWlE_pylPpQrB3KnDJVea3qh8PMv6G0GQ6BjxmO4RSrWqf0-UCPlDYHbCZlc4bkNDMPGGsTC9JO0/s640/Reg+Divesified.PNG" width="640" /></a></div>
<br />
<div style="text-align: justify;">
Since it had gone from <b>AAA</b> (sacrosanct) to <b>C</b> (a dead-beat) it's just as incredible that it has since marched back up to <b>CC</b> (in 2015, of all times) and then <b>CCC</b>, <b>BB</b> and now <b>A </b>(as of yesterday), which is a serious investment grade rating. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Nevermind the coronavirus!</div>
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhvsc3CYGDFgmDxTAbIFLKeYRmeWQzcLODvwy9HF-q9eT1_LY2M2UiiEelD7OQBW87nIFaReZCugcNhKzOhuYf6bqx84MjFWn_8Mb8Vc4VjpwT-Ui2AQnhuwryu5OA0WzUNjbe-ad8ZZmQu/s1600/Reg+Diversified+Details.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="531" data-original-width="998" height="340" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhvsc3CYGDFgmDxTAbIFLKeYRmeWQzcLODvwy9HF-q9eT1_LY2M2UiiEelD7OQBW87nIFaReZCugcNhKzOhuYf6bqx84MjFWn_8Mb8Vc4VjpwT-Ui2AQnhuwryu5OA0WzUNjbe-ad8ZZmQu/s640/Reg+Diversified+Details.PNG" width="640" /></a></div>
<br />
<br />PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-31848742801523086922020-04-28T16:06:00.000-04:002020-04-28T16:08:28.939-04:00Rating Agency Déjà Vu<br />
<div class="MsoNormal" style="text-align: justify;">
<span style="line-height: 107%;"><b><span style="font-size: large;">Short Shrift for Surveillance</span></b><o:p></o:p></span></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
There seems to be a scramble on at the rating agencies, but we
think we’ve seen this scramble before. </div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
Beginning late in 2006 the subprime and alt-A residential
mortgage-backed securities (RMBS) market began its long downward slide into
unimaginable losses. </div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
The credit rating agencies – of which S&P,
Moody’s, and Fitch have the leading market shares – appeared to be slow to
respond. Perhaps there was good reason in the early months of
2007. Or perhaps not. An argument against promptly
downgrading the RMBS was to wait for a few monthly reporting periods to
validate the trend of rising mortgage delinquencies. The risk in
waiting, of course, is that it suddenly becomes “too late” and you are required
to implement larger, more frantic downgrades than in the alternative in which
you had been downgrading incrementally if and when appropriate. But
while ratings were yet to be downgraded there was no doubt, however, that the
values and prospects of both the RMBS and their underlying mortgages were
tumbling violently.</div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
We’re reminded of the iconic J.P. Morgan himself who once said
(paraphrase): “Every man has two reasons for doing
something. There’s the reason he gives that sounds good and then
there’s the real reason.” </div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
The rating agencies had at least one “real” reason for not
downgrading RMBS bonds promptly: for RMBS and other structured products, they
were ill-equipped to provide the services! From our perspectives
having been in the industry, reviewing Congressional testimony and materials
from the Financial Crisis Inquiry Commission, and having conferred with others
playing similar roles at other agencies, we can tell you that the rating
agencies did not have the capacity to methodically or efficiently oversee their
models and ratings on the RMBS bonds they purported to be
monitoring. There was very little that was programmatic to it. The
process for the supposedly continuous, ongoing surveillance of thousands of
RMBS bonds was (shockingly) manual. Or it was not done at all.</div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
The rating agencies were much more concerned with clipping high
revenue-generating new deal rating tickets, and much less concerned about
providing the required surveillance on existing deals. Monies for
surveillance, after all, get paid whether or not the service is provided.</div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
So the RMBS downgrades came in waves spaced out over many months
in 2007. The rating agencies placed many bonds on <i>downgrade watch</i> prior
to the requisite modeling and analysis based on mortgage characteristics,
transaction vintage, and broad market performance. This “watch
period” supposedly bought the rating agencies time to perform the actual analysis
before specifying actual downgrades.</div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
Of course, while the existing ratings were intermittently “wrong”
or awaiting correction, there was much ado about how to rate new deals or other
existing deals that depended on those outstanding – but yet to be addressed –
ratings.</div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
Now it’s 2020 and we wonder if the ratings surveillance process
has improved at all. The tremendous economic stress of the
coronavirus (“COVID-19”) raises doubts of the sudden inability of homeowners to
continue making mortgage payments. Many of these debtors are now
unemployed with much uncertainty for the future. The house prices
themselves may be greatly depressed – we won’t know until the end of this
suspension period for real estate transactions. Falling home prices
in 2007-2008 themselves prompted many mortgage defaults. Thus, it’s
fair to say that RMBS bonds have much greater risk of default than they did at
the beginning of the year.</div>
<div class="MsoNormal" style="text-align: justify;">
<span style="line-height: 107%;">Moody’s acknowledges the impact of the coronavirus, and the
substantial uncertainty it brings with it. </span></div>
<div style="margin: 0in 0in 0.0001pt;">
</div>
<blockquote class="tr_bq" style="text-align: justify;">
“<i>Our analysis has considered the
increased uncertainty relating to the effect of the coronavirus outbreak on the
US economy as well as the effects of the announced government measures which
were put in place to contain the virus. We regard the coronavirus outbreak as a
social risk under our ESG framework, given the substantial implications for
public health and safety.</i>”[1]</blockquote>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
Importantly, Moody’s accepts
that “It is a global health shock, which makes it extremely difficult to
provide an economic assessment.” However, Moody’s is in the business
of making these assessments, meaning it needs a robust and methodical way of
tackling the new variable, and accounting for the uncertainty that comes with
it. </div>
<div style="text-align: left;">
<span style="text-align: justify;">The rating agencies have two very
interesting vocations at present. </span></div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
First, they’re actively downgrading
RMBS (and most other bonds too).</div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
Next, they’re actively rating new
deals, even though some of the new deals are backed by assets that they’re
simultaneously downgrading. For example, rating agencies rated five
new CLO deals, backed by loans in April; meanwhile, as of early April JPMorgan
was showing that loan downgrades were outpacing upgrades at a rate of 3.5-to-1.<o:p></o:p></div>
<div style="margin: 0in 0in 0.0001pt; text-align: justify;">
<br /></div>
<div style="margin: 0in 0in 0.0001pt; text-align: justify;">
<b>Part 1: Ratings Downgrades</b></div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
Moody’s announced, on April 15, its
placement of 356 RMBS bonds on review for downgrade and the actual downgrade of
48 bonds to the <b>Baa3</b> level.[2] The downgraded certificates remain on watch for further downgrade.</div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
Placing bonds on watch for
potential downgrade is not, alone, all that interesting. But the
downgrades were interesting. Moody’s rationale:</div>
<div style="margin: 0in 0in 0.0001pt; text-align: justify;">
<u1:p></u1:p></div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="line-height: 107%;">“<i>The rating action reflects the heightened risk of interest
loss in light of slowing US economic activity and increased unemployment due to
the coronavirus outbreak. In its analysis, Moody's considered the sensitivity
of the bonds' ratings to the magnitude of projected interest shortfalls under a
baseline and stressed scenarios. In addition, today's downgrade of certain bond
ratings to Baa3 (sf) is due to the sensitivity of the ratings to even a single
period of missed interest payment […]</i>”</span></blockquote>
<div style="margin: 0in 0in 0.0001pt; text-align: justify;">
There are a few things that
are interesting here. </div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
First, the lack of specificity.
Moody’s does not specify any quantitative elements of its analysis – Moody’s
does not cite to changes in default rates, severity rates, recovery rates or
prepayment speeds – that were adjusted to accommodate COVID-19 or that justify
the downgrade action or explain the specific rating as <b>Baa3</b>, which is (curiously) the
lowest level of investment-grade. It is all rather vague.</div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
Second, you might have noticed some
unusual language there. The “downgrade of … ratings … is due to the
sensitivity of the ratings…” That is all meaningless. One does not
downgrade a rating because of the sensitivity of the rating. All
ratings, aside perhaps from some Aaa ratings, are “sensitive.” One
downgrades because of a higher potential for default or loss, as ascertained by
an analysis performed – not because of the sensitivity. </div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
That brings us to the next issue:
what analysis was performed? The short answer is, well, that there
was no proper analysis performed! Aside from Moody’s failure to
describe the specific analysis performed, we have at least two reasons to
believe that no analysis was performed. </div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
</div>
<ol>
<li><span style="text-indent: -0.25in;">Moody’s does not have a
methodology for incorporating the coronavirus stress: Moody’s explicitly
acknowledges that the principal methodology used in these ratings was the "US
RMBS Surveillance Methodology" published in February 2019, which of course
was pre-COVID-19</span></li>
<li><span style="text-indent: -0.25in;">Moody’s acknowledges that
it did no modeling: “Moody's did not use any models, or loss or cash flow
analysis, in its analysis. Moody's did not use any stress scenario simulations
in its analysis.” </span></li>
</ol>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
<u1:p></u1:p>Why
does it matter that Moody’s did no <i>modeling</i>? Because the Feb. 2019
methodology referenced is a quantitative one, and it requires extensive
modeling. One simply cannot apply a quantitatively-heavy methodology
while applying no models. Ergo, we suspect that Moody’s did not apply, or
could not have properly applied, the Feb. 2019 methodology.</div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
<span style="font-family: inherit;">Altogether,
we see 48 bonds downgraded to </span><b style="font-family: inherit;">Baa3</b><span style="font-family: inherit;">, absent</span><span style="font-family: inherit;">:</span><br />
<ul>
<li>an updated methodology that reflects the key new coronavirus risk,
despite acknowledgment of the key importance of this risk to the deals;</li>
<li>a
proper application of the existing methodology from Feb 2019 or any explanation as to the
deviations from the methodology; and</li>
<li>the application of any models at all.</li>
</ul>
It is commendable to tell investors that you have not modeled cash flows, or
performed any stress scenario analyses. But the questions are then:
What was done and how exactly did you arrive at a <b>Baa3</b> rating? What is the
point of publishing a ratings methodology if you are not going to follow it, or
describe specific deviations from it, so that investors can similarly follow
your reasoning?</div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
<o:p></o:p></div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
Strictly
speaking and adhering to the meaning of Moody’s ratings, it is extraordinarily
difficult to imagine how Moody’s could determine that 48 bonds should
simultaneously earn the new, lower rating of <b>Baa3</b> <i>without
analysis</i>. With no quantitative estimate for increased loss or diminished
and re-directed cash flow, how can Moody’s determine the precise new rating
level?<o:p></o:p></div>
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One
thought, however, is that Moody’s guessed at the rating based on the
methodology, and perhaps because there were no models to apply: in the rush of
rating new deals, maybe Moody’s hadn’t gotten around to building
well-functioning models to replace the old ones? Or, equally
plausible is the possibility that Moody’s models do not exist <i>in the cloud</i>,
meaning that the Moody’s analysts and supervisors working from remote (home)
locations could not access the necessary models, data or tools to perform their
reviews. What an astounding disclosure this would be, if true, for a global
data-centric organization!<o:p></o:p></div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
Whatever
the reason, the <b>Baa3</b> ratings are flawed. No analysis by an outsider,
or perhaps even a Moody’s insider, when applying Moody’s methodology, can
credibly achieve an outcome of <b>Baa3</b>. It is just a guess.<br />
<br /></div>
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<b>Part
2: New Ratings</b><o:p></o:p></div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
The
rating agencies are actively downgrading bonds, loans, and credit instruments
across most sectors and industries.[3] Many of these downgrades may
be well-intended, due to newly introduced COVID-19-related
risks. But while they are downgrading these (newly unstable) credits
they are rating new structured finance credits that are supported by these very
same unstable credits. Their structured finance ratings
problematically look to their own ratings of the credits, which are being
downgraded daily. Thus, new ratings cannot be said to be robust to
the degree the rating agencies lack confidence in the sturdiness of their own
underlying ratings. Moreover, the new structures are not being rated
according to any new, post-coronavirus methodology. So we might
expect those newly-created bonds to be similarly downgraded, too, in short
order. <o:p></o:p></div>
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When
S&P rated Harriman Park CLO, a new deal, on April 20th, S&P said
nothing at all about coronavirus in its press release. In explaining
how it came about its ratings, S&P cited only to related criteria and
research from 2019 and earlier. There is no evidence that any
scenario was run at all differently by S&P. No mention is made
of any newly-imposed stress scenario being run. <o:p></o:p></div>
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When
Fitch rated this same deal, Fitch explained its thought
process and how it is deviating from its pre-existing
methodologies. That’s a whole lot better than S&P in this case,
but even Fitch failed to explain the “why.” Fitch simply explained
what it is doing, but not why what is doing makes sense. How have they calibrated their models (if at all)? How do we know the new assumptions are adequate or comprehensive? <o:p></o:p></div>
<blockquote class="tr_bq" style="line-height: 14.45pt; text-align: justify;">
<i><span style="line-height: 107%;">“Coronavirus Causing Economic Shock: Fitch has made
assumptions about the spread of the coronavirus and the economic impact of
related containment measures. As a base-case scenario, Fitch assumes a global
recession in 1H20 driven by sharp economic contractions in major economies with
a rapid spike in unemployment, followed by a recovery that begins in 3Q20 as
the health crisis subsidies. As a downside (sensitivity) scenario provided in
the Rating Sensitivities section, Fitch considers a more severe and prolonged
period of stress with a halting recovery beginning in 2Q21.</span> </i></blockquote>
<blockquote class="tr_bq" style="line-height: 14.45pt; text-align: justify;">
<i><span style="line-height: 107%;"></span>Fitch has identified the following sectors that are
most exposed to negative performance as a result of business disruptions from
the coronavirus: aerospace and defense; automobiles; energy, oil and gas;
gaming and leisure and entertainment; lodging and restaurants; metals and
mining; retail; and transportation and distribution. The total portfolio
exposure to these sectors is 9.9%. Fitch applied a common base scenario to the
indicative portfolio that envisages negative rating migration by one notch
(with a 'CCC-' floor), along with a 0.85 multiplier to recovery rates for all
assets in these sectors. Outside these sectors, Fitch also applied a one notch
downgrade for all assets with a negative outlook (with a 'CCC-' floor). Under
this stress, the class A notes can withstand default rates of up to 61.8%,
relative to a PCM hurdle rate of 53.9% and assuming recoveries of 40.6%.”</i></blockquote>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
While it continues to rate new deals,
S&P (for example) has placed roughly 9% of all its CLO ratings on watch
negative since March 20th.[4]</div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
The rating agencies suffered
tremendous reputational damage when they were found to be rating new CDO deals
in 2007 while they already knew they could no longer rely on the RMBS ratings
supporting those deals, as they would imminently be downgraded. Once
the CDO rating analysts knew the RMBS ratings were unstable and about to be
downgraded, the CDO analysts were taking a legal risk in producing
ratings they knew would not be robust. It can be difficult to turn
away the sizable revenues that come with rating new deals – even when you do not have a
sustainable ratings methodology or any conviction in the credibility of the data
(including ratings) you are relying on.</div>
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The essence of formulating credit ratings for all entities (structured, corporate, municipal, etc.) requires the ability to estimate future revenues, expenses, and liabilities for a multi-year time period. Such estimates are critical to the rating process. As we write, forecasting for the broad economy and for most specific entities is highly uncertain. We do not see how it is possible to perform meaningful rating analysis amidst this uncertainty. Hence, the credit rating agencies should arguably pause all new ratings until uncertainty declines <u>or</u> until they develop rating methodologies that fully incorporate the wide uncertainty. <o:p></o:p></div>
<div style="margin: 0in 0in 0.0001pt; text-align: justify;">
<br /></div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
<b>Part 3: Summary/Conclusions</b><o:p></o:p></div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
Stale
ratings, inflated ratings and other faulty ratings can sometimes go unnoticed
during an upswing. But shortcomings become most pronounced during an economic
downturn or crisis. We are concerned that we are (again) seeing the
result of years of prior, weak, ratings mismanagement.<o:p></o:p></div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
When
crises occur, rating agencies should be able to swiftly update their
methodologies, models and ratings. And rating
agencies should stave off rating new deals until and unless they have strong
and current methodologies in place to explain their new ratings and how their
ratings accommodate the upheaval, whatever it may be.<o:p></o:p></div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
Rating
agencies seem quickly to have forgotten (or simply to have ignored) the lessons
they should have learned from the last crisis. Regulatory
settlements with the DOJ for subprime crisis-era misconduct (S&P for
$1.375 billion[5], and Moody’s, in the amount of
$864 million[6]) concerned issues in which they
deviated from their code, which required them to provide objective, independent
ratings. Those were not about the rating agencies being wrong, or
failing to predict the downturn, but closer to argument that the rating agencies failed to
believe their own ratings.[7] </div>
<div class="MsoNormal" style="line-height: 18pt; margin: 6pt 0.3in 8pt 0in; text-align: justify;">
In the above case, we would
have to ask how Moody’s can be sure that <b>Baa3</b> is the right rating – for all 48
bonds, across different deals, structure types and vintages – consistent with
its methodology, given it failed to apply any modeling? <o:p></o:p></div>
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<br /></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh6ndJTtAqxLCyiCVe1QRegAk4x4XLyTCM_2tpMDxlx9l4USPCGz8bIgfeaRis7a0QzSUA-uxTND59O7hDV6I5ybu5Bidwol2Mgg2zNHF49iPzr3vQdBk7YxILRcxKAObC0KKulo2QNNtbK/s1600/Table+of+ratings.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="914" data-original-width="864" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh6ndJTtAqxLCyiCVe1QRegAk4x4XLyTCM_2tpMDxlx9l4USPCGz8bIgfeaRis7a0QzSUA-uxTND59O7hDV6I5ybu5Bidwol2Mgg2zNHF49iPzr3vQdBk7YxILRcxKAObC0KKulo2QNNtbK/s1600/Table+of+ratings.png" /></a></div>
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<u1:p></u1:p><span style="line-height: 107%;"><br clear="all" />
<o:p></o:p></span></div>
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</span></div>
<h4>
<span style="background-color: white; color: #222222; font-weight: normal; text-align: justify;"><span style="font-family: inherit;">This article was co-written by Joe Pimbley, who consults for PF2.</span></span></h4>
<h4>
<ol>
<li><u style="text-align: justify;"><span style="color: blue;"><span style="font-family: inherit; font-size: x-small;"><a href="https://www.moodys.com/research/Moodys-places-404-classes-of-legacy-US-RMBS-on-review--PR_422633" style="font-weight: normal;">https://www.moodys.com/research/Moodys-places-404-classes-of-legacy-US-RMBS-on-review--PR_422633</a></span></span></u></li>
<li><u style="text-align: justify;"><span style="color: blue; font-family: inherit; font-size: x-small;"><a href="https://www.moodys.com/research/Moodys-places-404-classes-of-legacy-US-RMBS-on-review--PR_422633" style="font-weight: normal;">https://www.moodys.com/research/Moodys-places-404-classes-of-legacy-US-RMBS-on-review--PR_422633</a></span></u></li>
<li><span style="font-weight: normal;"><span style="font-family: inherit; font-size: x-small;">https://www.wsj.com/articles/bond-downgrades-begin-amid-coronavirus-slowdown-11585045800</span></span></li>
<li><u style="text-align: justify;"><span style="color: blue; font-family: inherit; font-size: x-small;"><a href="https://www.opalesque.com/industry-updates/5969/96-reinvesting-clo-ratings-placed-on-creditwatch.html" style="font-weight: normal;">https://www.opalesque.com/industry-updates/5969/96-reinvesting-clo-ratings-placed-on-creditwatch.html</a></span></u></li>
<li><u style="text-align: justify;"><span style="color: blue; font-family: inherit; font-size: x-small;"><a href="https://www.justice.gov/opa/pr/justice-department-and-state-partners-secure-1375-billion-settlement-sp-defrauding-investors" style="font-weight: normal;">https://www.justice.gov/opa/pr/justice-department-and-state-partners-secure-1375-billion-settlement-sp-defrauding-investors</a></span></u></li>
<li><u style="text-align: justify;"><span style="color: blue; font-family: inherit; font-size: x-small;"><a href="https://www.justice.gov/opa/pr/justice-department-and-state-partners-secure-nearly-864-million-settlement-moody-s-arising" style="font-weight: normal;">https://www.justice.gov/opa/pr/justice-department-and-state-partners-secure-nearly-864-million-settlement-moody-s-arising</a></span></u></li>
<li><u style="text-align: justify;"><span style="color: blue; font-family: inherit; font-size: x-small;"><a href="https://www.bloomberg.com/news/articles/2013-02-05/s-p-won-t-employ-first-amendment-defense-in-u-s-ratings-lawsuit" style="font-weight: normal;">https://www.bloomberg.com/news/articles/2013-02-05/s-p-won-t-employ-first-amendment-defense-in-u-s-ratings-lawsuit</a></span></u></li>
</ol>
</h4>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com7tag:blogger.com,1999:blog-3764912039741974037.post-70564011961763402242020-04-17T14:11:00.002-04:002020-04-17T20:52:58.578-04:00Wrong Zoom ReZooms Trading - An Inefficient Market<br />
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</div>
<div class="MsoNormal" style="text-align: justify;">
The <i style="mso-bidi-font-style: normal;">right</i> Zoom is
taking off.<span style="mso-spacerun: yes;"> </span>But, the <i style="mso-bidi-font-style: normal;">wrong</i> Zoom has really taken off!<o:p></o:p></div>
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<br /></div>
<div class="MsoNormal" style="text-align: justify;">
ZOOM is the equity ticker of <i>wrong</i> Zoom, a Chinese
company called Zoom Technologies that has done nothing remarkable this
year.<span style="mso-spacerun: yes;"> </span>But at one point, <i>wrong</i> Zoom's stock was
up <b>1890%</b> since year-end 2019.<o:p></o:p></div>
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<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Meanwhile <i>right</i> Zoom, Zoom Video Communications, is based in
California.<span style="mso-spacerun: yes;"> </span>It stock trades under the ticker ZM and has enjoyed some
nice gains too (max of <b>135%</b> up since year-end).<o:p></o:p></div>
<div style="text-align: justify;">
<br /></div>
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</div>
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On March 25, 2020, the SEC suspended trading in <i>wrong</i>
Zoom: </div>
<blockquote class="tr_bq" style="text-align: justify;">
“<span style="font-size: 11.5pt; line-height: 107%;">It appears to the
Securities and Exchange Commission that the public interest and the protection
of investors require a suspension of trading in the securities of Zoom
Technologies, Inc. (“ZOOM”) (CIK# 0000822708) because of concerns about the
adequacy and accuracy of publicly available information concerning ZOOM,
including its financial condition and its operations, if any, in light of the
absence of any public disclosure by the company since 2015; and concerns about
investors confusing this issuer with a similarly-named NASDAQ-listed issuer,
providing communications services, which has seen a rise in share price during
the ongoing COVID-19 pandemic.”</span></blockquote>
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<o:p></o:p></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiOBPGr9sRodKNDep1ZgE1wGWekUbbudhrSgGqBFx_PU5NCcIhu0tHYjWIFl34D_Sy8KDQ7zXBZRWezqdCh_y4heduJvPLKTaUnMuLk3JtgJsm-bkp8CDajj1LFsgfso0DG7WkF5h3pZFg6/s1600/March+Madness.JPG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="612" data-original-width="1027" height="379" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiOBPGr9sRodKNDep1ZgE1wGWekUbbudhrSgGqBFx_PU5NCcIhu0tHYjWIFl34D_Sy8KDQ7zXBZRWezqdCh_y4heduJvPLKTaUnMuLk3JtgJsm-bkp8CDajj1LFsgfso0DG7WkF5h3pZFg6/s640/March+Madness.JPG" width="640" /></a></div>
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<u><br /></u></div>
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<u><br /></u></div>
<div class="MsoNormal" style="text-align: justify;">
<u>Notes on <i>wrong</i> Zoom</u>: Zoom Technologies Inc., headquartered in Beijing, has
zero reported revenue since 2011.<span style="mso-spacerun: yes;"> </span>It was
delisted from NASDAQ in October 2014.<span style="mso-spacerun: yes;">
</span>The stock trades OTC in the US,
specifically in the “Grey Market,” and dealers may only quote the stock on
behalf of an unsolicited customer order.<span style="mso-spacerun: yes;"> </span></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Since April 18, 2019 OTC Markets has designated the stock “Caveat
Emptor” (along with a skull and cross-bones marker),<span style="font-family: "calibri" , sans-serif;"><span style="font-size: 14.6667px;"> </span></span>to highlight to market participants that Zoom Technologies Inc. (ticker: ZOOM) is
not related to Zoom Video Communications, Inc. (ticker: ZM). [1] <i>Caveat
Emptor</i> is a designation that OTC Markets reserves for the sketchiest of
penny stocks. </div>
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<br /></div>
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On March 25, 2020, the SEC
suspended trading in ZOOM. <i>Wrong</i> Zoom's stock resumed trading April
14, 2020 under the ticker ZTNO.</div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
We are not aware of anyone making the case that the market
for grey market OTC stocks with “Caveat Emptor” designations is an efficient
market; but still, who were/are these purchasers of ZOOM?<span style="mso-spacerun: yes;"> </span>Did many actually confuse <i>wrong</i> Zoom with <i>right</i> Zoom, or was it predominantly speculative traders betting that other
folks would confuse the two stocks, under a “greater fool” theory?<o:p></o:p></div>
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<span style="font-size: x-small;"><span style="text-align: justify;">[1] </span><a href="https://www.otcmarkets.com/stock/ZTNO/news/OTC-Markets-Designates-Zoom-Technologies-Inc-with-Caveat-Emptor?id=225417">https://www.otcmarkets.com/stock/ZTNO/news/OTC-Markets-Designates-Zoom-Technologies-Inc-with-Caveat-Emptor?id=225417</a></span></div>
</div>
</div>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-92123384665422451382020-03-16T12:25:00.000-04:002020-03-16T12:25:39.318-04:00Investor Protections (of a Legal Variety) in the Aftermath of a Meltdown<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgZNaXOdDoItxbSlKE5RlMjfxpFFbpLE8WUz73lP4O_BXRQfjiSWYqtYZVN-2hnESHc02AmRD_k3AwzCCj_sI8MsqWlKEIfL8w1YFidFP5Oi03LPRHVOtIpQMg3wOYJww8W6RBukXTJrFIU/s1600/Capture.JPG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="606" data-original-width="918" height="210" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgZNaXOdDoItxbSlKE5RlMjfxpFFbpLE8WUz73lP4O_BXRQfjiSWYqtYZVN-2hnESHc02AmRD_k3AwzCCj_sI8MsqWlKEIfL8w1YFidFP5Oi03LPRHVOtIpQMg3wOYJww8W6RBukXTJrFIU/s320/Capture.JPG" width="320" /></a></div>
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<span style="color: #222222; font-family: inherit;">In a recent journal article available <a href="https://doi.org/10.3905/jsf.2020.1.095" target="_blank">here</a>, mortgage guru Mark Adelson has compiled another of his terrific analyses of the mortgage meltdown, and some of the letdowns of post-crisis legislation.</span></div>
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<span style="color: #222222; font-family: inherit;">You have to read the piece in its entirety, but here are just some of his analytical gems and opinions to give you a flavor for what’s inside:</span></div>
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<ul>
<li style="text-align: justify;"><span style="color: #222222;"><span style="font-family: inherit;">“The mortgage meltdown produced $1 trillion (±20%) of losses from 2007 through 2016. The losses were borne primarily by investors in non-agency mortgage-backed securities (MBS).”</span></span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">“Investors around the world invest in the US markets because they have integrity and there are multiple checks in place to ensure that misrepresentations are remedied.”</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">“Nonetheless, the Mortgage Meltdown of the late 2000s left many investors reeling. They suffered huge losses on non-agency mortgage-backed securities (MBS) issued from roughly 2005 through 2007. Those losses came from a wave of defaults and foreclosures on mortgage loans originated during those years. During that time, there was a broad deterioration of practices across the mortgage lending and securitization industry.”</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">“The full extent of the breakdown in practices started to come to light in 2013, when the US Department of Justice (DOJ) began settling lawsuits against the major banks.”</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">“Common types of defects included (i) defective appraisals that overstated the value of homes, (ii) exceptions allowed without sufficient compensating factors, (iii) missing or inaccurate documentation of borrower income or assets, and (iv) misstated occupancy status. When the loans were included in MBS deals, the offering materials did not disclose the defects.”</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">“By the time this mounting evidence came to light, it was too late for most investors to sue under the federal securities laws to recover their losses.”</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">“The legislative response to the mortgage meltdown and the broader financial crisis did not address the time limits issue. The time limit under the 1933 Act remains a critical piece of unfinished business. If it is not addressed, America’s capital markets will remain vulnerable to a repeat of the mortgage meltdown experience. We propose extending the 1933 Act’s maximum time limit to 12 years for actions based on misstatements or omissions in connection with the sale of non-agency MBS (i.e., actions under 1933 Act §§ 11 and 12(a)(2)).”</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">“Issuance of non-agency MBS fell off sharply following the mortgage meltdown. […] Attempts to revive the non-agency MBS market have been unsuccessful.”</span></li>
<li style="text-align: justify;"><span style="font-family: inherit;">“The aftermath of the mortgage meltdown offers potential lessons for lawyers, business professionals, and policy makers. The episode was arguably the largest failure of legal protections for investors since the Great Depression. Investors have recovered only a small percentage of their total losses.”</span></li>
</ul>
<br />
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<span style="font-family: inherit;"><span style="color: #222222;">That’s just a taste – for more, download the paper by <a href="https://doi.org/10.3905/jsf.2020.1.095" target="_blank">clicking here</a>.</span></span></div>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-86967871884649429752020-02-08T15:56:00.001-05:002020-02-08T19:17:57.918-05:00Leveraged Loan CLOs and Rating Agencies - Policy Solutions<br />
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Over the last couple of years, financial market commentators
have become concerned that leveraged loans and Collateralized Loan Obligations
(CLOs) are becoming the newest “<a href="https://www.businessinsider.com/warren-buffett-sold-195-million-of-derivatives-2016-8">financial
weapons of mass destruction</a>”.<span style="mso-spacerun: yes;"> </span>The
fear is that mispricing and over-production of these assets could lead to a
bubble that would ultimately take down our financial system – just as subprime
mortgage backed securities did a dozen year ago.<o:p></o:p></div>
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<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Further, critics worry that rating agencies – still
following the traditional issuer-pays model – lack the incentive to protect us
from a leveraged lending meltdown. Instead, agencies are thought to be engaged
in a "race-to-the-bottom," lowering their rating standards to enable (or keep)
even the less credible corporate borrowers in the <i style="mso-bidi-font-style: normal;">Investment Grade</i> category.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
If SEC-licensed Nationally Recognized Statistical Rating
Organizations (NRSROs) – or so-called credit rating agencies -- are not up to
the task, investors could turn to non-licensed analytics firms to more
objectively evaluate leveraged loans and the securitization vehicles that house
them. <span style="mso-spacerun: yes;"> </span>Outside of the market for debt and
credit-based financial products, we see many types of ratings published by <a href="https://www.blogger.com/null" style="mso-comment-date: 20200208T0737; mso-comment-reference: MJ_1;">non-licensed </a>providers.
For example, <i>Consumer Reports </i>assigns ratings to a wide array of products, <i>US
News</i> ranks colleges and <i>Yelp </i>assigns ratings to service establishments. These
systems are imperfect and sometimes deservedly attract criticism, but no rating
system is perfect and the widespread use of these assessments suggests that
users find them valuable.</div>
<div class="MsoNormal" style="text-align: justify;">
<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
The main barrier to entry for non-NRSROs that would want to
assess leveraged loans and CLOs specifically is lack of access to data, and
this is an issue that the SEC could rectify. The leveraged loans at the center
of CLOs are often borrowings made by privately held companies – including
holdings of private equity firms – that are not required to make their
financial statements public. Only current investors and the rating agencies
hired to rate these entities can see these financial statements.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
The SEC could simply require all such companies that borrow
on the leveraged loan market, subject to a minimum borrowing size, to file
their 10-Q and 10-K statements on the EDGAR system. That way independent firms
could assess their financial status and estimate default probabilities and
expected losses on their loan facilities.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Second, CLO issuers should be
required to post both their loan portfolios and details of their capital
structures on EDGAR as well. In such a scenario, CLOs could no longer be
exempted under Section 4(a)(2) of the Securities Act and sold as Rule 144A
private securities. Instead, they would be regulated as public securities.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Finally, many CLOs have complex rules governing how proceeds
from the collateral pool should be distributed among the various classes of
noteholders and the firms – like the asset manager – that provides services to
the CLO deal. These “priority of payment” provisions are outlined in dense
legalese included in the CLO's offering documents. Rather than compelling
investors and analysts to decipher these legal provisions, issuers should be
required to code them as computer algorithms which would also be published as
part of the deal’s disclosure. CLOs could then operate like any other “smart
contract,” easing the work of deal participants and third parties who need to
analyze the many “what-ifs” that can occur over the life of a transaction.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Leveraged loans and CLOs may or may not be the ticking time
bomb that will blow up our economy. One way to limit the potential for
bubble-creation is to remove dependence on parties (like the incumbent credit
rating agencies) that are financially motivated to provide high ratings, thus
prompting issuers and other market participants to seek out their services. Thus,
our solution is, in short, to make these transactions more transparent, so that
other third parties can access information on the securities and analyze them in a cost-effective manner.</div>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-8645828267649042732019-12-12T06:00:00.000-05:002019-12-15T16:09:48.913-05:00Mall Shooting Highlights Folly of Single Asset CMBS Ratings<br />
<div class="MsoNormal" style="text-align: justify;">
On Black Friday, the Destiny USA Shopping Mall in Syracuse,
New York was <a href="https://nypost.com/2019/11/30/syracuse-mall-evacuated-after-gunshots-ring-out-on-black-friday/">evacuated</a>
after a shooting in the food court. The following day, a knife fight broke out
in the mall’s <a href="https://www.syracuse.com/crime/2019/12/1-person-stabbed-during-fight-at-apex-entertainment-in-destiny-usa.html">entertainment</a>
complex, adding to shoppers’ <a href="https://cnycentral.com/news/local/shooting-stabbing-incidents-at-destiny-usa-dont-stop-some-shoppers">apprehension</a>
about visiting. This apprehension should be shared by holders of Commercial
Mortgage Backed Securities (CMBS) collateralized solely by Destiny USA loans,
including owners of $215 million in AAA-rated senior notes. While one
short-lived catastrophic event will not lead directly to bond defaults, the
outbreaks of violence at an already troubled mega-mall cast a harsh light on
rating agency decisions to assign their highest grades to structured notes
wholly lacking the protection afforded by diversification.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
As Marc <a href="http://expectedloss.blogspot.com/2015/01/sec-shines-light-on-inflated-cmbs.html">reported</a>
previously, rating agencies have repeatedly assigned top ratings to CMBS
secured by mortgages on only a single shopping mall. These shopping mall deals
are a subcategory of so-called Single Asset / Single Borrower (SASB) CMBS.
Buyers of AAA-rated SASB securities are protected from adverse performance only
by overcollateralization – the fact that subordinated bonds will take the first
hit when underlying loans fail to pay interest and principal in full and on
time.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
In the case of the Destiny Mall deal, JPCMM 2014-DSTY, the <a href="https://www.standardandpoors.com/en_US/web/guest/ratings/details/-/instrument-details/sectorCode/STRUC+-+CMBS/entityId/563889/issueId/1356265">S&P</a>
and <a href="https://www.krollbondratings.com/transactions/202/ratings">KBRA</a>
AAA-rated tranche accounts for half of the $430 million deal (excluding
interest only securities). A credit event that forces a write-down of the
underlying mortgages by more than 50% will trigger losses on the AAA notes.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
While unlikely, such an event is hardly unimaginable,
especially given the large number of <a href="http://www.deadmalls.com/stories.html">dead malls</a> dotting the
American landscape. Isolated shooting and stabbing incidents – even at the
height of the shopping season – probably won’t deliver a large blow to Destiny
USA, but if the mall gains a reputation for danger, shoppers will inevitably
begin to avoid it. In a weak environment for brick and mortar retail, reduced
foot traffic could trigger store closures, leading to a downward spiral of fewer
retailers and fewer shoppers. <o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Without diversification, the senior CMBS notes are
vulnerable to default under these circumstances. Facing such a highly plausible
default scenario, the senior notes do not justify a rating of AAA – an
ultra-safe category for which default should be virtually unimaginable. S&P,
for example, claims it expects AAA bonds to have a default probability of <a href="https://www.standardandpoors.com/ja_JP/delegate/getPDF;jsessionid=6AD78C164D8F437F68A32F6FA5A703AE?articleId=1495226&type=COMMENTS&subType=CRITERIA">0.15%
over any 5-year period</a>.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Why would any rating agency believe a single property, even
with multiple businesses on this single property, should have such certainty that
a loss of greater than 50% of asset value is virtually impossible? KBRA, for
example, acknowledges the low diversity of SASB CMBS but asserts implicitly
that <a href="https://www.appraisalinstitute.org/assets/1/29/KBRA_CMBS_CMBS_Single_Borrower_amp_Large_Loan_Rating_Methodology.pdf">its
stress assumptions for net cash flow and capitalization rate</a> are sufficient
nonetheless.<span style="mso-spacerun: yes;"> </span>Yet the stresses at the AAA
level apparently do not permit the model to reach 50% loss. Et voila, it’s
possible to reach the AAA rating with 50% or lower LTV.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
While S&P and KBRA maintain AAA ratings on Destiny USA
mall bonds, two other rating agencies take a more critical view of the
facility. Both Moody’s and Fitch rate <a href="https://emma.msrb.org/IssueView/Details/EP374142">municipal bonds
supported by mall revenues</a>. In June, Moody’s <a href="https://www.moodys.com/research/Moodys-downgrades-Carousel-Center-Project-PILOT-revenue-bonds-to-Ba2--PR_402177">downgraded</a>
these securities to Ba2 – a speculative rating – citing Destiny’s challenging
operating environment. Fitch also <a href="https://emma.msrb.org/ES1283139-ES1004574-ES1406047.pdf">downgraded</a>
the bonds to BBB concluding that “a recent trend of weaker performance … is
likely to reduce the mall's value.”<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
The top ratings from S&P and KBRA are even harder to comprehend
since the CMBS are subordinated to the municipal bonds to which Moody’s and
Fitch assign the much lower ratings of Ba2 and BBB, respectively. These
municipals are secured by “Payments In Lieu of Taxes” (PILOT) from the mall. According
to <a href="https://emma.msrb.org/ES831428-ES652132-ES1047196.pdf">the Official
Statement</a> for these PILOT bonds: “The 2014 CMBS Mortgage securing the 2014
CMBS Loan is subordinate to the PILOT Mortgages securing the PILOT Bonds (Page
4).”<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
AAA ratings for CMBS bonds that are subordinate to Ba2/BBB
municipal securities are very hard to fathom. The distinction of CMBS versus
municipal bonds is irrelevant since <a href="https://www.sec.gov/spotlight/dodd-frank-section.shtml#938">Dodd Frank’s
Universal Rating Symbols</a> mandate requires that rating agencies maintain
equivalent meaning of rating symbols across different asset classes.<span style="mso-spacerun: yes;"> </span><o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<span style="mso-spacerun: yes;"><br /></span></div>
<div class="MsoNormal" style="text-align: justify;">
A dozen years after the financial crisis, rating agencies
remain a <a href="https://reason.org/policy-study/dodd-frank-credit-rating-agencies-financial-system/">weak
link</a> in the financial system. We don’t know when the next financial storm
will occur or what it might look like, but overrated commercial mortgages are
clearly a vulnerability. Before the clouds start gathering, rating agencies
should take a harder, more skeptical look at deals collateralized by shopping
malls and those collateralized by pools lacking in diversity.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<span style="background-color: white; color: #222222; font-family: "arial" , "tahoma" , "helvetica" , "freesans" , sans-serif; font-size: 15.4px;">--------------------------------------------</span><br />
<br style="background-color: white; color: #222222; font-family: Arial, Tahoma, Helvetica, FreeSans, sans-serif; font-size: 15.4px;" />
<span style="background-color: white; color: #222222; font-family: "georgia" , "times new roman" , serif; font-size: 15.4px;">This piece was written by Marc Joffe and Joe Pimbley, who both consult for PF2. Marc Joffe is a Senior Policy Analyst at the Reason Foundation. Joe Pimbley is the Editor of the Journal of Derivatives.</span></div>
<div style="text-align: justify;">
<br /></div>
Marc Joffehttp://www.blogger.com/profile/14238629927052142269noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-14409158792285650002019-04-04T13:49:00.002-04:002019-04-22T13:51:32.623-04:00Lawsuits "Without Merit"<div style="text-align: justify;">
<b>Theranos</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Hero-turned-villain Elizabeth Holmes is once again the talk of the town, with HBO's documentary <i><a href="https://www.hbo.com/documentaries/the-inventor-out-for-blood-in-silicon-valley" target="_blank">Out for Blood in Silicon Valley</a></i> bringing her into our living rooms. (A feature film, <i>Bad Blood</i>, will be coming soon, starring Jennifer Lawrence.)</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Back in 2015, <i>Forbes</i> listed Holmes as one of America's Richest Self-Made Women, with a net worth of $4.5 billion. Now, Holmes' net worth is closer to zero, and she awaits her day in court -- facing fraud charges -- while Theranos, the $9 or $10 billion company she "built" is now defunct. (Dollar numbers based on valuations/private fundraisings at its peak.)</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>1MDB</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Meanwhile on the other side of the world former Malaysian Prime Minister Najib's trial has begun. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Most of the charges laid against him concern the siphoning of monies (billions!) from the state development fund, 1MDB. <i>Some</i> of those monies are alleged to have found their way back to Najib and his wife. <i>Much of the rest</i> seems to have been spent, and often wasted, by the energetic and now notorious Jho Low, who bought yachts and houses, bottles of Cristal, jewelry (for models), threw parties and otherwise lived the life of the rich and famous alongside his good friends Jamie Foxx, Leo Di Caprio, Paris Hilton, Pharrell Williams and other celebs.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But <i>some</i> of the 1MDB monies also found their way to Goldman Sachs and its prized individuals. (Goldman would confer honors on those individuals.) Goldman Sachs partner Tim Leissner has since pleaded guilty to bribery and money laundering. While Goldman made (an outrageous) ~$600 million out of the 1MDB issuances, Leissner pocketed some $40 million + just for himself. Good work if you can get it.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>Cases Without Merit</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Bringing this all together, what's interesting about Elizabeth Holmes and Goldman Sachs is that the allegations made against them are "without merit" -- they assure us.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In May 2016, when Theranos was hit with class action lawsuits, Theranos was quick to <a href="https://www.theverge.com/2016/5/26/11787884/theranos-second-class-action-lawsuit-casey-jones">explain</a> to the press that: "The lawsuit filed today against Theranos is without merit," she wrote in an email. "The company will vigorously defend itself against these claims."</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
When Partner Fund Management LP, a hedge fund based in San Francisco, sued Theranos in October 2016 for a "series of lies" and material misstatements, <a href="https://gizmodo.com/major-theranos-investor-sues-elizabeth-holmes-for-serie-1787639419">Theranos told</a> the <i>Wall Street Journal</i> that this lawsuit “is without merit and Theranos will fight it vigorously. The company is very appreciative of its strong investor base that understands and continues to support the company’s mission.”</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Walgreens also sued. You can predict this one: Walgreen's lawsuit, too, was "<a href="https://www.wsj.com/articles/theranos-had-200-million-in-cash-left-at-year-end-1487277878" target="_blank">without merit</a>."</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Back in 2015, when suspicion was cast on the extraordinary fees being paid to Goldman, and the nature of their conduct warranting these fees, a Goldman Sachs spokesperson was quick to justify them, <a href="https://www.afr.com/news/world/asia/goldman-in-focus-as-scandal-plagues-malaysias-1mdb-and-najib-razak-20150722-gihv14" target="_blank">explaining</a>: "These transactions were individually tailored financing solutions, the fee and commissions for which reflected the underwriting risks assumed by Goldman Sachs on each series of bonds, as well as other prevailing conditions at the time, including spreads of credit benchmarks, hedging costs, and general market conditions."<br />
<br />
When the Malaysian authorities filed criminal charges against Goldman, in December 2018, Goldman was quick to <a href="https://www.washingtonpost.com/business/2018/12/17/malaysia-files-criminal-charges-against-goldman-sachs-after-fund-looted-billion/?utm_term=.4a67aea7b8c6">dismiss them</a>, reassuring its shareholders. “We believe these charges are misdirected and we will vigorously defend them and look forward to the opportunity to present our case. The firm continues to cooperate with all authorities investigating these matters," the bank said in a statement.</div>
<br />
<b>Other Lawsuits Without Merit</b><br />
<br />
<div style="text-align: justify;">
Some cases, of course, have no merit. Others have merit. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But the question we ask is what confidence shareholders can draw from prepared, public statements made by companies that the lawsuits against them have no merit? If companies roll out a standard defense, reassuring shareholders that no major liability lies before them, can shareholders be assured that this is a truthful statement, as opposed to simply a negotiating technique?</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Holmes and Goldman might well successfully defend the actions against them. Who knows - stranger things have happened. (The Theranos and 1MDB sagas, themselves, are pretty out-there as occurrences go!)</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But whether they win or not, Theranos is done and dusted: it has been shut down. Goldman, meanwhile, has suffered significant fallout in its Malaysian operations: Goldman is struggling to get any share deals done, and has reportedly <a href="https://www.bloomberg.com/news/articles/2016-05-24/goldman-sachs-sees-malaysian-deals-evaporate-amid-1mdb-concerns" target="_blank">dropped to 18th</a> in the local M&A deal rankings. And Mubadala, the Abu Dhabi state investment fund, has <a href="https://www.ft.com/content/a124dbf6-46e5-11e9-b168-96a37d002cd3" target="_blank">reportedly</a> ceased doing any new business with Goldman. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
We pulled together an enlightening list of some (handsome) settlements entered into by financial institutions in the near aftermath of dismissing cases against them as being meritless -- and having promised to vigorously defend them -- only to settle for large amounts, sometimes soon thereafter. (emphasis added)<br />
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh59aoaZgiPp7dqeyUAO2MRSGKnGGwg6wb6NwRzXeoz76y_EaVP4WmigriGsSPmvs1_D7oMLv2KmNU2F4bzO9CJYbKFuCVYyeSEHRMzv2AkikblnLVTtbfdSMh9lSCa6NjmYXHMLPE48w1A/s1600/table2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="486" data-original-width="817" height="380" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh59aoaZgiPp7dqeyUAO2MRSGKnGGwg6wb6NwRzXeoz76y_EaVP4WmigriGsSPmvs1_D7oMLv2KmNU2F4bzO9CJYbKFuCVYyeSEHRMzv2AkikblnLVTtbfdSMh9lSCa6NjmYXHMLPE48w1A/s640/table2.png" width="640" /></a></div>
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<div class="separator" style="clear: both; text-align: center;">
</div>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-63000430217129049982019-02-24T15:47:00.000-05:002019-02-24T18:14:45.948-05:00Lloyd v. Google<div style="text-align: justify;">
If it were simply a play, Shakespeare might have called it "Privacy, or What You Will."<br />
<br />
On Friday, the <i>Wall Street Journal </i>broke just the latest <a href="https://www.wsj.com/articles/you-give-apps-sensitive-personal-information-then-they-tell-facebook-11550851636" target="_blank">story</a>, its lens aimed on Facebook, concerning the all-too-fluid movement of smartphone users' information from (other) apps to Facebook.</div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="color: #666666;">"It is already known that many smartphone apps send information to Facebook about when users open them, and sometimes what they do inside. Previously unreported is how at least 11 popular apps, totaling tens of millions of downloads, have also been sharing sensitive data entered by users. The findings alarmed some privacy experts who reviewed the Journal’s testing."</span></blockquote>
<div style="text-align: justify;">
According to the <i>WSJ</i>'s tests, heart-rate monitoring apps were sharing users' hearts rates with Facebook. And period-and-ovulation tracking apps "told Facebook when a user was having her period..." (As you might have guessed, much or all of this intra-app <i>sharing</i> reportedly occurred without the user's consent - the apps share the information with Facebook, but do not share the with their users that they will share their information with Facebook. And so, consumers come to realize that they are the product, not the customer.)</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Why would Facebook care to know? One answer is that if Facebook understands its users better, it can send them more targeted advertising. If you're known to be pregnant, you're perhaps more likely to click on diaper or baby-crib adverts. (This is, <i>ostensibly</i>, a benefit to Facebook's users, who enjoy receiving advertisements more likely to be of interest to them. Ostensibly!)</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>Lloyd v. Google</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<table cellpadding="0" cellspacing="0" class="tr-caption-container" style="float: right; margin-left: 1em; text-align: right;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEixTRluOlFWvEcpNwG1BetsenY2xZq9c5o2lG4MB5lMGVMPr2OR9fnJ3J0_7YXGfUbGavsUmtKPdaQ2M9BtttFgKSCydRUwWJpB9s_cv70d9U4SxVyECo8Mwemj9Z8pPva61DhZ_A9rKTQ-/s1600/key.jpeg" imageanchor="1" style="clear: right; margin-bottom: 1em; margin-left: auto; margin-right: auto;"><img border="0" data-original-height="335" data-original-width="500" height="212" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEixTRluOlFWvEcpNwG1BetsenY2xZq9c5o2lG4MB5lMGVMPr2OR9fnJ3J0_7YXGfUbGavsUmtKPdaQ2M9BtttFgKSCydRUwWJpB9s_cv70d9U4SxVyECo8Mwemj9Z8pPva61DhZ_A9rKTQ-/s320/key.jpeg" width="320" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">The "key" to your online data - unsecured</td></tr>
</tbody></table>
Over the last few months, we have been researching an interesting lawsuit (and ruling) out of London. The lens in that case was focused on Google, but many of the issues were similar.<br />
<br />
In the Google matter, Google was alleged to have found a way around Apple's safety guards, imposing its own third-party cookies on Apple users' iPhone devices - so that Google could track iPhone user's web activities.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
When looking into online privacy-related actions in the UK, at least 3 interesting similar examples came to light, in each case with the <span style="text-align: start;">U.K. Information Commissioner’s Office (the ICO) leading the charge in fining entities:</span></div>
<div style="text-align: justify;">
</div>
<ol>
<li style="text-align: justify;"><a href="https://ico.org.uk/media/action-weve-taken/mpns/2614260/leaveeu-incident-1-monetary-penalty-notice.pdf" target="_blank">ICO fined the Leave.EU campaign</a> for “serious breaches of electronic marketing laws” during the 2016 Brexit referendum. The ICO found a significant relationship (e.g., overlapping directors) to exist between Leave.EU and an insurance company Eldon Insurance Services Ltd (“Eldon”). Commissioner Denham noted that it “is deeply concerning that sensitive personal data gathered for political purposes was later used for insurance purposes and vice versa. It should never have happened.” Eldon would, for example, pitch Leave.EU campaign supporters by way of email newsletters offering “10% off” for Leave.EU supporters. Leave.EU did little, if anything, to protect the acquired data when sharing it with Eldon (which trades as GoSkippy Insurance). “It was confirmed that there is no formal contract in place between Leave.EU and GoSkippy to provide direct marketing, and that the inclusion was an informal arrangement.</li>
<div>
<br /></div>
<li style="text-align: justify;"><a href="https://ico.org.uk/about-the-ico/news-and-events/news-and-blogs/2018/08/emma-s-diary-fined-140-000-for-selling-personal-information-for-political-campaigning/" target="_blank">ICO found that Emma’s Diary</a> (a website that provides pregnancy and related advice to mothers and mothers-to-be) illegally collected and sold personal information on over one million people to Experian Marketing Services, a branch of the consumer credit rating agency, “specifically for use by the Labour Party.” </li>
<div>
<br /></div>
<li style="text-align: justify;"><a href="https://ico.org.uk/about-the-ico/news-and-events/news-and-blogs/2018/10/facebook-issued-with-maximum-500-000-fine/" target="_blank">ICO fined Facebook</a> £500,000 for serious violations of data protection law – the maximum fine allowable under the applicable laws at the time the incidents occurred. The ICO determined that “between 2007 and 2014, Facebook processed the personal information of users unfairly by allowing application developers access to their information without sufficiently clear and informed consent ....” According to Commissioner Denham, “Facebook failed to sufficiently protect the privacy of its users before, during and after the unlawful processing of this data.” The personal information of over one million users was harvested and consequently “put at risk of further misuse.” </li>
</ol>
<div style="text-align: justify;">
Putting the ICO fines and the <i>Lloyd v. Google</i> case itself together, we see at least one common theme and outcome: people’s <i>social </i>information (often personal/private) is clearly being mixed with their <i>financial</i> and <i>political</i> interests, whether they are aware of it or not.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
We have also gone back to the late 1800s and early 1900s to quote the revered jurist Louis Brandeis. In his famous dissent, in <i>Olmstead</i>, he defined the “right to be let alone” as “the most comprehensive of rights, and the right most valued by civilized men.” Olmstead v. United States, 277 U.S. 438 (1928). </div>
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------------</div>
<div>
<span style="text-align: justify;">Our analysis of the </span>London High Court's ruling in <i style="text-align: justify;">Lloyd v. Google</i><span style="text-align: justify;"> is now </span><a href="https://www.pf2se.com/uploads/5/4/5/0/54500123/pf2_case_notes_-_lloyd_v_google.pdf" style="text-align: justify;" target="_blank">available</a><span style="text-align: justify;"> to be reviewed by anyone interested. We have sought to add a data market analysis to the commentary, so that readers can easily come to terms with how one might value personal data (and in an effort to make it an engaging read!). </span></div>
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<div style="text-align: justify;">
For our prior coverage of consumer data markets, click the "Consumer Data Markets" label on the right hand panel of this blog.</div>
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PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-2429265439121816192018-11-25T22:03:00.002-05:002018-11-26T17:47:24.184-05:00SocGen Regulators - Be Not Proud!<div style="text-align: justify;">
<span style="font-family: inherit;"><span style="background-color: white;">Last week, the news media made much of the latest penalty imposed by US authorities on French banking giant </span><span style="background-color: white;">Société Générale</span><span style="background-color: white;"> SA (SocGen) for processing sanctions-violating transactions.</span></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><span style="background-color: white; font-family: inherit;"><br /></span></span></div>
<div style="text-align: justify;">
On the back of the settlements, the US Attorney General for SDNY, Berman, has been <a href="https://www.justice.gov/usao-sdny/pr/manhattan-us-attorney-announces-criminal-charges-against-soci-t-g-n-rale-sa-violations" target="_blank">full of celebratory praise</a> for the "outstanding work" done by his team and his fellow investigative bodies. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But we have examined the settlements, and they don't seem at all impressive. Rather, they seem the result of defective investigative work. Current SocGen shareholders, and ADR-holders, should be vexed.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<table cellpadding="0" cellspacing="0" class="tr-caption-container" style="float: right; margin-left: 1em; text-align: right;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgZZeNfs1cSt7v5u4WEscGBrXatFBp9PkXt08iynyVMiir2bwoTYIdkTR4H_GAjr0HWaFH73mWffTBIqJLloMAGUf_hX1YwpGUou0uMVpUwunkspxWAEEm6n5aVOITKvdV0zLIT52BYqStc/s1600/SocGen+ADR+shareholders.PNG" imageanchor="1" style="clear: right; margin-bottom: 1em; margin-left: auto; margin-right: auto;"><img border="0" data-original-height="756" data-original-width="1276" height="236" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgZZeNfs1cSt7v5u4WEscGBrXatFBp9PkXt08iynyVMiir2bwoTYIdkTR4H_GAjr0HWaFH73mWffTBIqJLloMAGUf_hX1YwpGUou0uMVpUwunkspxWAEEm6n5aVOITKvdV0zLIT52BYqStc/s400/SocGen+ADR+shareholders.PNG" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Snapshot of Holders of SocGen's Sponsored ADR, including<br />Oregon Public Employees Retirement System<br />(incomplete list) via Bloomberg LP</td></tr>
</tbody></table>
Let's explain.</div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><span style="font-family: inherit;"><span style="background-color: white;"><br /></span></span></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><span style="font-family: inherit;"><span style="background-color: white;">The </span></span><span style="background-color: white;">$1.4 billion settlement will come out of SocGen's shareholders' pockets <span style="background-color: #fafafa; color: #3f3f3f; font-family: "cento" , sans-serif; font-size: 16px;">–</span> not from the employees involved in the long-enduring misconduct nor the supervisors overseeing it. </span></span><br />
<span style="font-family: inherit;"><span style="background-color: white;"><br /></span></span>
<span style="font-family: inherit;"><span style="background-color: white;">Thus, shareholders have long paid the wrongdoers' (no doubt handsome) salaries and now pay for their bad decision-making. Or, said another way, current shareholders are paying for a concealed, misguided scheme which, as we will see, spanned an 8 or 9-year period ending 8 years ago. </span></span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><span style="font-family: inherit;"><br /></span></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><span style="background-color: white;">To be clear, this was no idle incident. As admitted to by SocGen, this was broad, </span><span style="background-color: white;">intentional misconduct, spanning many years, comprising thousands of illicit transactions, deliberately implemented (with procedures drawn up) and concealed. The wrongdoers were aware, throughout, that they were breaking the law.</span></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Excerpts from the <span style="background-color: white;">Statement of Facts mutually agreed-to by the US Justice Department and SocGen, include:</span></span></div>
<br />
<ul>
<li style="text-align: justify;"><span style="font-family: "georgia" , "times new roman" , serif;">In total, SG engaged in more than 2,500 sanctions-violating transactions through financial institutions located in the County of New York, valued at close to $13 billion, during this period.</span></li>
</ul>
<ul>
<li style="text-align: justify;"><span style="font-family: "georgia" , "times new roman" , serif;">For example, a senior member of SG’s Money Market department back office (“MMBO”) wrote to another MMBO employee in 2004 that “[t]he American authorities have now identified the procedure we were using (two MT 202s) to ‘circumvent’ the OFAC rules.”</span></li>
</ul>
<ul>
<li style="text-align: justify;"><span style="font-family: "georgia" , "times new roman" , serif;">In total, SG processed over 9,000 outgoing transactions that failed to disclose an ultimate sanctioned party sender or beneficiary (“non-transparent transactions”), with a total value of more than $13 billion. The overwhelming majority of these transactions involved an Iranian nexus and would have been eligible for the U-Turn License. There were, however, at least 887 non-U-turn transactions with a total value of $292.3 million that were both nontransparent and violated U.S. sanctions. 381 of these transactions with a total value of $63.6 million were related to the Cuban credit facility conduct described below, while the remaining 506 transactions with a total value of $228.7 million involved other SG business with a sanctioned nexus.</span></li>
</ul>
<ul>
<li style="text-align: justify;"><span style="font-family: "georgia" , "times new roman" , serif;">Between 2003 and 2010, in connection with the Cuban Credit Facilities, SG engaged in 3,100 unlawful U.S. dollar transactions that were processed through United States financial institutions located in the County of New York, worth approximately $15.1 billion</span></li>
</ul>
<ul>
<li style="text-align: justify;"><span style="font-family: "georgia" , "times new roman" , serif;">Since at least 2002, SG engaged in the Concealment Practice in order to minimize the risk that sanctions-violating transactions would be detected and/or blocked in the United States. SG employees used cover payments for this purpose, in which SG would send one SWIFT payment message to the relevant U.S. bank, located in the County of New York, omitting the “beneficiary” field that would otherwise disclose the ultimate beneficiary of the payment, and listing only the bank to which the funds should be sent. SG would then send a second SWIFT message to the non-U.S. recipient bank, providing the name of the sanctioned party beneficiary to whom the funds should be remitted. Using this procedure (the “Cover Procedure”), SG would ensure that the sanctioned party beneficiary information was not disclosed to the United States bank that was involved in the transaction.</span></li>
</ul>
<br />
<div style="text-align: justify;">
<span style="background-color: white;"><span style="font-family: inherit;">So, it was rather easy to get around the sanctions controls, and SocGen's employees did so many times .... which is hardly comforting. But now that that's been uncovered we would, o</span></span><span style="background-color: white;"><span style="font-family: inherit;">f course, have several SocGen employees awaiting criminal prosecution. Oh, no <span style="background-color: #fafafa; color: #3f3f3f; font-family: "cento" , sans-serif; font-size: 16px;">–</span> there's none of that. </span></span><br />
<span style="background-color: white; font-family: inherit;"><br /></span>
<span style="background-color: white; font-family: inherit;">Let's understand why. </span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><span style="font-family: inherit;"><br /></span></span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><span style="font-family: inherit;"><b>SocGen failed to self-report its misconduct </b><span style="background-color: #fafafa; color: #3f3f3f; font-family: "cento" , sans-serif; font-size: 16px;">–</span><b> oops!</b></span></span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><span style="font-family: inherit;"><br /></span></span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><span style="font-family: inherit;">From the looks of it, SocGen didn't disclose the individual misconduct until after the statutory clock had run for bringing criminal claims. </span></span><br />
<span style="background-color: white;"><span style="font-family: inherit;"><br /></span></span>
<span style="background-color: white;"><span style="font-family: inherit;">In other words, even after the so-called "Investigating Agencies" were onto them, they let SocGen self-report any individual violations (which they didn't do!), failed to follow up on a timely basis, and then simply fined the shareholders and declared that a success. The Investigating Agencies seem to have outsourced their decision-making to the party being investigated, and that party obliged by sending the investigators down the wrong path. </span></span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><span style="font-family: inherit;"><br /></span></span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><span style="font-family: inherit;">Now SocGen's stakeholders <span style="background-color: #fafafa; color: #3f3f3f; font-family: "cento" , sans-serif; font-size: 16px;">–</span> which include US pension funds, and likely you and us! <span style="background-color: #fafafa; color: #3f3f3f; font-family: "cento" , sans-serif; font-size: 16px;">–</span> are compensating US authorities for the misconduct of bank individuals 8 or more years back. </span></span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><span style="font-family: inherit;"><br /></span></span></div>
<div style="text-align: justify;">
<span style="background-color: white;"><span style="font-family: inherit;">Here are some choice (or inconvenient) extracts regarding the scope of the operation and the statute of limitations running, with our emphasis added.</span></span></div>
<br />
<ul>
<li style="text-align: justify;"><span style="font-family: "georgia" , "times new roman" , serif;">Despite the awareness of both Group Compliance and senior SG management that SG had engaged in both the Concealment Practice and the unlawful U.S. dollar payments under the Cuban Credit Facilities, SG did not disclose its conduct to OFAC or any other U.S. regulator or law enforcement agency prior to the commencement of the present investigation.</span></li>
</ul>
<ul>
<li style="text-align: justify;"><span style="font-family: "georgia" , "times new roman" , serif;">SG did not disclose the Concealment Practice or the Cuban Credit Facilities during these discussions, <b>and its proposals for the scope of </b><b>that lookback did not include the time period, business lines, or geographic regions that would </b><b>have revealed that unlawful conduct</b>. It was only after SG performed a detailed forensic analysis based on the broader scope of investigation required by the Investigating Agencies that it <u>disclosed, in October 2014</u>, the Concealment Practice and the Cuban Credit Facilities to the Investigating Agencies.</span></li>
</ul>
<ul>
<li style="text-align: justify;"><span style="font-family: "georgia" , "times new roman" , serif;">As a result of this untimely disclosure, the statute of limitations for [<span style="background-color: white; text-align: start;">Trading with the Enemy Act]</span> or [International Economic Emergency Powers Act] violations relating to the Concealment Practice, and to much of the <b><u>individual conduct</u> </b>involving the Cuban Credit Facilities, had already run by the time the Investigating Agencies learned of them.</span></li>
</ul>
<div style="text-align: justify;">
Given enforcement agencies knew in 2014 that there were governance issues and large-scale unsustainable business practices ongoing at SocGen concealed from shareholders, why has it taken until 2018 to share that crucial information? Regulators often have a specific mission that would encourage the dissemination of precisely this type of information, to ensure efficient and orderly public markets, and maintain the public's trust and all. (The SEC's mission, for example, reads: "The mission of the SEC is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. The SEC strives to promote a market environment that is worthy of the public's trust.")<br />
<br /></div>
<div style="text-align: justify;">
It's worth reading the <a href="https://www.justice.gov/usao-sdny/press-release/file/1112461/download" target="_blank">entire document</a>, as there seems also to be evidence that US regulators could earlier have shut down the misconduct at SocGen, had they earnestly tried. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<table cellpadding="0" cellspacing="0" class="tr-caption-container" style="float: right; margin-left: 1em; text-align: right;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhvAHPplbMWokq_2Xkf5m3ATiOrZchn7fCrxRMV5c0aChxQuegaAZnXEd1VgzeVIj7hnRxg5D92rsbe9H1jo09O80x8_8o0i6AsBHja_GxBkMDgLEY5PswOG6TZzuFqQXW9QUAKKtb_aov8/s1600/High_5s_No_Achievement.jpg" imageanchor="1" style="clear: right; margin-bottom: 1em; margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1166" data-original-width="1600" height="233" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhvAHPplbMWokq_2Xkf5m3ATiOrZchn7fCrxRMV5c0aChxQuegaAZnXEd1VgzeVIj7hnRxg5D92rsbe9H1jo09O80x8_8o0i6AsBHja_GxBkMDgLEY5PswOG6TZzuFqQXW9QUAKKtb_aov8/s320/High_5s_No_Achievement.jpg" width="320" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">High 5s all around - but little achievement</td></tr>
</tbody></table>
<span style="font-family: inherit;">Manhattan US Attorney Berman warns: </span><br />
<blockquote class="tr_bq">
<span style="font-family: inherit;"><span style="background-color: white;"><span style="font-family: "georgia" , "times new roman" , serif;">"Other banks should take heed: Enforcement of U.S. sanctions laws is, and will continue to be, a <b>top priority</b> of this Office and our partner agencies.</span><span style="font-family: inherit;">" </span><span style="font-family: "georgia" , "times new roman" , serif;">(emphasis added)</span></span></span></blockquote>
</div>
<div style="text-align: justify;">
But was it a "top priority?"<br />
<br />
It took years to identify pretty basic noncompliance. Much of the misconduct was reported to them, or else it was missed. There doesn't seem to be much <i>enforcement</i> here, aside from the fining of shareholders.<br />
<br />
<b>Top priority</b> enforcement would mean identifying anomalous transactions early and shutting down promptly any misconduct before it escalates <span style="background-color: #fafafa; color: #3f3f3f; font-family: "cento" , sans-serif; font-size: 16px;">– </span>not fining an institution's shareholders 8 years after the last of a series of illicit transaction has taken place, which themselves in many cases endured for 8 or 9 years. The Investigating Agencies let SocGen define the scope of the investigation, and then followed the bait.</div>
<div style="text-align: justify;">
<br />
It seems very much like the fox was running the hen-house. And it results simply in more pain for the punter.</div>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-11668557317846367082018-11-14T09:36:00.000-05:002018-11-20T11:49:01.855-05:00Can Technology Freshen Up Stale CMBS Ratings?<div style="text-align: justify;">
Sears' recent bankruptcy filing underscored the challenges confronting shopping malls in the late 2010s. Because mortgages on these facilities often account for the lion’s share of CMBS asset pools, shopping mall performance needs to be top of mind for those analyzing (or rating) CMBS tranches.<br />
<br />
New technology – originally targeted at investors analyzing retail sector stocks – might also be applicable to CMBS analysts.<br />
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<b>Foot Traffic</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Consider, for example, <a href="http://www.advan.us/">Advan Research</a>. The company processes billions of daily foot traffic measurements from cellphone applications, and computes foot traffic data pertaining to 1,800 companies including both retailers and Real Estate Investment Trusts. Since many REITs own shopping malls, the company collects foot traffic data for these retail centers.</div>
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<br /></div>
<div style="text-align: justify;">
I asked Advan for data on a mall discussed in a <a href="http://expectedloss.blogspot.com/2018/09/s-maintains-investment-grade-rating-on.html" target="_blank">previous post</a>. A mortgage on The Mall at Stonecrest in Lithonia, Georgia accounts for almost all of the remaining collateral supporting Banc of America Commercial Mortgage Series 2005-1. Fitch rates the most senior remaining tranche, Class B, at <b>Single-B</b>. S&P assigns the same tranche a low investment grade rating of <b>BBB-</b>. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Who’s right? The data from Advan suggests a downward trend in foot traffic at Stonecrest, as shown in the accompanying chart. Average estimated visitors for the five Saturdays in July 2017 were 19,816; for the five Saturdays falling 52 weeks later, the average fell to just 12,659. On the other hand, a similar comparison between October 2017 and October 2018 shows only a slight drop, suggesting that perhaps the decline in visits has been arrested. </div>
<div style="text-align: justify;">
<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhMXpfb_tkatlmi_6YUJ_CufIY9o_P5k7iPo7ljEA_5UURJJrR6LLz_AU9VcKM4EjqjRvhTG0vdHdzax3c0A1FXtpsKKpNpTnhEOPRYQKSmMj21hl9JJqBMd32e2h8M-kacJbHyCY0Le7gJ/s1600/Stonecrest_Mall_Visits.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="393" data-original-width="828" height="302" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhMXpfb_tkatlmi_6YUJ_CufIY9o_P5k7iPo7ljEA_5UURJJrR6LLz_AU9VcKM4EjqjRvhTG0vdHdzax3c0A1FXtpsKKpNpTnhEOPRYQKSmMj21hl9JJqBMd32e2h8M-kacJbHyCY0Le7gJ/s640/Stonecrest_Mall_Visits.png" width="640" /></a></div>
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<div style="text-align: justify;">
To the extent that Advan’s data can be relied upon, it seems to give us a more recently refreshed gauge on the shopping mall’s health than other data sources. Certainly, the trustee report is not giving us up-to-date guidance. The November report includes the following special servicer comments: </div>
<blockquote class="tr_bq" style="text-align: justify;">
Modification closed and funded 8/5/2017. The loan is currently paying as agreed. The loan matures in 8/2018 and the Borrower advises that the proposed adjacent 100 acre sports project has been put on hold due to lack of funding. Although the collateral is 97% occupied, the dark Kohl's and Sears may trigger some co-tenancy issues. The Borrower advises it is in the market seeking refinancing, but due to the current situation with the sports project and 2 dark anchors, refinancing may not be sufficient to pay off the loan in full at maturity. The Borrower has engaged CREMAC to aid it in its workout negotiations with the Lender/Special Servicer. A new appraisal has been ordered and received. Valuation is under review. Maturity Date extend to 8/1/18; principal reduction in the amount of $1,233,073.95 for a balance of $92,066,680.26; no change in rate of 5.603%. </blockquote>
<div style="text-align: justify;">
These comments do not appear to have been revised since the most recent term extension for the Stonecrest mortgage which was through August 1, 2018.<br />
<br />
<b>Social Media and Other Sources</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In addition to reviewing foot traffic, analysts can monitor the web and social media for news about relevant shopping malls. For example, a local newspaper, the Springfield News-Sun, <a href="https://www.springfieldnewssun.com/news/crime--law/nearly-100-car-break-ins-reported-one-night-georgia-mall/BIMmrbe4pU0OE8lQy59TXL/">reported</a> that nearly 100 cars in the mall’s parking lot were broken into on October 5, 2018. A nail salon employee at Stonecrest argued that the mall does not provide video surveillance of the parking lot, making it harder to identify and apprehend any wrongdoers. A <a href="https://twitter.com/search?src=typd&q=%23stonecrestmall">search</a> for #stonecrestmall on Twitter reveals that a shooting occurred at the center – but it took place three years ago.</div>
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<br /></div>
<div style="text-align: justify;">
While it is possible to use free tools like Google Alerts to monitor individual shopping centers, that approach might not scale well to a large portfolio. Specialized search services like <a href="http://www.bitvore.com/">Bitvore</a> (for which I used to consult) enable analysts to track news on large numbers of positions, even allowing news searches by CUSIP number.</div>
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<br /></div>
<div style="text-align: justify;">
Cell phone activity, web content and social media posts offer new ways for rating agencies and other analysts to track CMBS mall collateral <i>real time</i>. Finding or compiling the nuggets of useful data from these information streams is a challenge that new technology firms can help solve.<br />
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<br />
--------------------------------------------<br />
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<span style="font-family: "georgia" , "times new roman" , serif;"><span style="background-color: white; color: #222222;">This piece was written by Marc Joffe, who consults for PF2. </span><span style="background-color: white; color: #222222;">Marc Joffe is a Senior Policy Analyst at the Reason Foundation and a researcher in the credit assessment field. </span></span></div>
Marc Joffehttp://www.blogger.com/profile/14238629927052142269noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-31807259543664257772018-11-08T17:14:00.001-05:002018-11-08T17:14:05.110-05:00KPMG's Big Announcement<div style="text-align: justify;">
If you're ever in the UK or Australia, you'll notice that local newspapers run what seem to be daily articles portraying popular dissatisfaction with the quality of audits being performed.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The <i>Financial Times</i>, back in August, ran a terrific series of articles entitled "<i><a href="https://www.ft.com/content/29ccd60a-85c8-11e8-a29d-73e3d454535d" target="_blank">The Big Flaw: Auditing in Crisis</a>." </i>The <i>FT</i>'s series, and much of the debate generally, has centered on two broad themes:</div>
<ol>
<li style="text-align: justify;">the potential for consulting arms of the Big Four to jeopardize the independence of their audit function (to the degree they consult for clients they audit too)</li>
<li style="text-align: justify;">the lack of competition in the audit sector</li>
</ol>
<div style="text-align: justify;">
These issues are serious and thorny. They are not, however, new. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Back in 2002, in the near aftermath of Enron's failure (then big-5 firm Arthur Andersen was the auditor) at a congressional hearing concerning WorldCom's failure, Congressman Bernie Sanders castigated an Arthur Andersen representative:</div>
<div style="text-align: justify;">
<blockquote class="tr_bq">
<i><span style="font-size: large;">Mr. Dick, it appears very clearly that Arthur Andersen failed in their audit of WorldCom. You failed in the audit of Enron. You failed in the audit of Sunbeam. You failed in the audit of Waste Management. You failed in the audit of McKesson. You failed in the audit of Baptist Foundation of Arizona. What was Arthur Andersen doing? I mean, how do you—it is incomprehensible to me that a major accounting firm can have such a dismal record in trying to determine what the financial health of a company is. It’s almost beyond comprehension.</span></i></blockquote>
</div>
<div style="text-align: justify;">
<div>
<div style="text-align: justify;">
Recent, topical examples include perceived deficiencies in the audits of Taylor, Bean & Whitaker (Deloitte); Steinhoff (Deloitte); Wells Fargo (KPMG); GE (KPMG); Carillion (KPMG); Abraaj</div>
</div>
<div>
<div style="text-align: justify;">
(KPMG); Colonial Bank (PWC); Vocation (PWC); and Sino Forest (Ernst & Young).</div>
</div>
<div>
<br /></div>
<div>
In the news again this week is the 1MDB saga, said to be among the largest of a new generation of frauds. 1Malaysia Development Berhad (or 1MDB) went through three of the Big Four between 2010 and 2016. Each of E&Y, KPMG and Deloitte was either fired or resigned from the role. KMPG and Deloitte signed off on 5 annual reports between them, with 1MDB <a href="https://www.ft.com/content/3a375b84-53cd-11e6-befd-2fc0c26b3c60" target="_blank">reportedly announcing</a> that its 2013 and 2014 audited financials should not be relied on. Oh well.</div>
</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>Today, KPMG made a significant announcement</b>. <br />
<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhz9JcNOz91qWYRM3Rj7tHC_xdhTMAwxs_BRk-L7H6qcW3g9IP9VRNhRpxXgYAWhr7XBSsuU-MQYkNY3evQJdREwySHyOl-mNyHyaFeIf2ATGoyzocalCKyYipwBGSDwq6SaG0WiRfmxSEU/s1600/Audit_Consulting.PNG" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"><img border="0" data-original-height="606" data-original-width="857" height="282" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhz9JcNOz91qWYRM3Rj7tHC_xdhTMAwxs_BRk-L7H6qcW3g9IP9VRNhRpxXgYAWhr7XBSsuU-MQYkNY3evQJdREwySHyOl-mNyHyaFeIf2ATGoyzocalCKyYipwBGSDwq6SaG0WiRfmxSEU/s400/Audit_Consulting.PNG" width="400" /></a></div>
Having been <a href="https://www.frc.org.uk/getattachment/5e1ac2d1-f58c-48bc-bb91-1f4a189df18b/Developments-in-Audit-2018.pdf" target="_blank">criticized</a> by UK accounting regulator, the Financial Reporting Council, for their audits having deteriorated to an "unacceptable level," KPMG decided to limit or stop all consulting work for those large UK clients for which it also acts as an auditor. <br />
<br />
(Interestingly, our understanding is that it was never shown to be the case that this specific conflict undermined the quality of the audit provided; but the possibility remains that it <i>can</i> undermine auditor independence ... and perception can be as important as reality.)<br />
<br />
This raises a number of questions:<br />
<br />
<ul>
<li>If the conflict is real, why only implement this procedure for <i>large </i>clients? </li>
<li>Why only in the UK? </li>
<li>If this makes sense for accounting firms, would it also make sense for other providers of financial services, like price providers or credit rating agencies: should rating agencies that rate corporates limit their ability to consult for them too (e.g., in the sale of analytics).</li>
</ul>
</div>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-51219088740693494432018-09-20T08:00:00.000-04:002018-09-20T09:27:01.815-04:00S&P Maintains Investment Grade Rating on CMBS Tranche Mainly Collateralized by a Defaulted Loan<span style="text-align: justify;">The Class B notes of Banc of America Commercial Mortgage Series
2005-1 (</span><a href="https://www.sec.gov/Archives/edgar/data/1321893/000095013605001967/file001.htm" style="text-align: justify;" target="_blank">BACM2005-1</a><span style="text-align: justify;">) are currently collateralized by two commercial mortgages.</span><span style="text-align: justify;"> </span><br />
<span style="text-align: justify;"><br /></span>
<span style="text-align: justify;">One of these mortgages, a $92 million loan on
the Mall at Stonecrest in Lithonia, GA accounts for 96.9% of the collateral
pool and is in “special servicing” – a fancy name for workout. Yet S&P
maintains an investment grade rating of <b>BBB- </b>on this risky instrument.</span><br />
<div class="MsoNormal" style="text-align: justify;">
<o:p></o:p></div>
<div class="MsoNormal">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
The most recent remittance report on BACM 2005-1 (available at <a href="https://www.ctslink.com/a/seriesdocs.html?shelfId=BAC&seriesId=20051" target="_blank">CTSLink</a>) includes
the following language with respect to the Mall at Stonecrest mortgage:<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="margin-left: 0.5in; text-align: justify;">
The loan matures in 8/2018 and the
Borrower advises that the proposed adjacent 100 acre sports project has been
put on hold due to lack of funding.<span style="mso-spacerun: yes;">
</span>Although the collateral is 97% occupied, the dark Kohl's and Sears may
trigger some co-tenancy issues.<span style="mso-spacerun: yes;"> </span>The
Borrower advises it is in the market seeking refinancing, but due to the
current situation with the sports project and 2 dark anchors, refinancing may
not be sufficient to pay off the loan in full at maturity.<span style="mso-spacerun: yes;"> </span>The Borrower has engaged CREMAC to aid it in
its workout negotiations with the Lender/Special Servicer.<o:p></o:p></div>
<div class="MsoNormal" style="margin-left: 0.5in; text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
The “sports project” mentioned in the report is <a href="https://www.atlantasportcity.com/" target="_blank">Atlanta Sports City</a>, a 200-acre
sports and entertainment complex planned for a plot adjacent to the mall.<span style="mso-spacerun: yes;"> </span>If and when Atlanta Sports City opens, it will presumably generate substantial foot traffic in the vicinity of Stonecrest.<span style="mso-spacerun: yes;"> </span>But construction has been <a href="http://www.crossroadsnews.com/news/local/a-year-later-atlanta-sports-city-facing-delays/article_539623ac-07af-11e8-a1d2-23cbbc0e4546.html">delayed</a>
and there is no clear timeline for completing the project, leaving a large
vacant parcel next to the mall for the time being.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Since the servicing note quoted above is dated September 4
and the maturity date was August 1, the Stone Crest loan would appear to be in
default. This default follows an August 2017 loan modification at which time the maturity
date was extended and principal was reduced by over $1 million.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
So how can a CMBS tranche backed almost entirely by a defaulted
shopping mall loan be investment grade?<span style="mso-spacerun: yes;">
</span>Well, the Class B notes do benefit from “overcollateralization”: two subordinated
bonds would absorb losses on the loan before the BBB- class is impacted.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Fitch appears to have a less sanguine view of this overcollateralization
benefit:<span style="mso-spacerun: yes;"> </span>they <a href="https://www.fitchratings.com/site/pr/10030349">rate</a> the notes at
single B – deep into junk territory. In its latest update, Fitch reported: <o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="margin-left: 0.5in; text-align: justify;">
The overall mall and collateral
occupancy have continued to decline. As of the September 2017 rent roll,
overall mall occupancy declined to 76.1% (from 85.5% one year earlier) after
Sears vacated its 145,000sf non-collateral store in January 2018.<o:p></o:p></div>
<div class="MsoNormal" style="margin-left: 0.5in; text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
S&P’s relatively high rating could be the result of insufficient
monitoring, an overly sanguine view of shopping mall collateral or some combination
of both.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
S&P’s last <a href="https://www.standardandpoors.com/en_US/web/guest/article/-/view/type/HTML/id/2004717">report</a>
on BACM 2005-1 is dated March 2, 2018. The write-up does not refer to press
reports about the delay of Atlanta Sports City, so it is unclear whether this
news was considered. Further, the certificates have not been downgraded, placed
on watch or assigned a negative outlook since the latest remittance report
appeared. Since that report indicates that the Stonecrest mortgage was neither repaid
nor refinanced by its August 1, 2018 maturity date, some rating action would
appear to be warranted. <o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
<b>Overrated Shopping Mall CMBS</b><o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
In 2015, I <a href="http://expectedloss.blogspot.com/2015/01/sec-shines-light-on-inflated-cmbs.html">argued strongly against</a> inflated credit ratings on Commercial Mortgage Backed Securities, especially
those with a collateral pool consisting of a single shopping mall loan. Because
they lack diversification, such deals expose investors to event risk inconsistent
with the AAA ratings assigned to the senior tranches in these deals.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
With six NRSROs competing for generous fees on rating CMBS transactions,
the ability for deal underwriters to engage in rating shopping is high and the
incentives for rating agencies to lower their credit standards is strong. Assigning
inflated ratings in any one asset class violates Dodd Frank’s universal rating
symbol mandate, according to which symbols must have the same risk implications across
all asset classes. Moody’s was recently <a href="http://www.sec.gov/litigation/admin/2018/34-83966.pdf" target="_blank">sanctioned</a> by
the SEC for its apparent failure to apply universal rating symbols when rating CLO Combo Notes. <o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Although none of the single mall deals I listed in 2015 has
experienced credit events thus far, they have yet to be tested by a recession. <span style="mso-spacerun: yes;"> </span>In the meantime, we have seen abundant evidence
that shopping malls are vulnerable. Brick and mortar retail faces a stiff challenge
from Amazon and other online retailers. Several national retail chains have filed
for bankruptcy or announced large-scale store closures, creating mall vacancies.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br />
<b>Back to BACM</b><br />
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Although BACM 2005-1 launched with a diversified portfolio securing the issued notes,
it had a heavy retail weighting – loans in this category comprised 35.8% of the
initial collateral pool. The Class B certificates received initial ratings of
<b>AA</b> from both S&P and Fitch, levels that proved too optimistic given the performance
of the collateral pool. <o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
Thus far the deal has realized $193 million in cumulative
losses, representing 8.4% of initial collateral. The failure of Stonecrest Mall
SPE to pay off its loan on the original maturity date of October 1, 2014 has left
Class B investors in the deal for a much longer duration than originally expected. This bond’s estimated final distribution date was March 10, 2015 according to the <a href="https://www.sec.gov/Archives/edgar/data/1321893/000095013605001967/file001.htm">original
prospectus</a>.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
What remains now closely approximates a single asset CMBS, but
one with distressed collateral. Class B will probably pay off in full at some
point since junior notes are available to absorb some amount of additional
write-downs. But ratings are supposed to reflect a greater level of precision
than the word “probably” communicates.<span style="mso-spacerun: yes;"> </span>According
to S&P, obligations rated 'BB', 'B', 'CCC', 'CC', and 'C' are regarded as
having significant speculative characteristics. That seems to be a fair description
of the BACM 2005-1 Class B notes.<o:p></o:p><br />
<br />
<br />
<span style="font-family: inherit;">-------------------------------</span><br />
<span style="font-family: inherit;"><span style="background-color: white; color: #222222;">This piece was written by Marc Joffe, who consults for PF2. </span><span style="background-color: white; color: #222222;">Marc is a Senior Policy Analyst at the Reason Foundation and a researcher in the credit assessment field. </span></span></div>
<div style="text-align: justify;">
<br /></div>
Marc Joffehttp://www.blogger.com/profile/14238629927052142269noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-6561295730465419872018-04-16T14:58:00.000-04:002018-04-16T14:58:14.754-04:00A VIXing Problem<div style="text-align: justify;">
2017 was a banner year for equity investors across the globe, including in the U.S., as the S&P 500 index gained over 19% (excluding dividends). Moreover, those gains were accompanied by extraordinarily low levels of volatility. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
We are nearly three months into 2018, and to say that things have not been as smooth would be an understatement, as volatility has returned with a vengeance to equity markets. The increase in volatility was especially acute on the day of February 5, 2018, when the CBOE Volatility Index (VIX®) moved more than it ever had in history, closing over 20 points higher from the previous day’s close (rising from 17.31 to 37.32), while equity markets plunged (the S&P 500 fell over 4%).
</div>
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<br /></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjTU_rtJMb0iqvhiI4DhQz2hmsqmkxBRK8hqqj5dJ4fMoHDRcv2rv9bUdNSX9Cv2c2QfmKcfKviQZJlg65w4RHmkeNOhkmhkqkLULjvJiUQIkvAMA9si6kbIHtpIDFKsa5Of7FXMWlLMYW_/s1600/VIX+move.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="706" data-original-width="1207" height="233" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjTU_rtJMb0iqvhiI4DhQz2hmsqmkxBRK8hqqj5dJ4fMoHDRcv2rv9bUdNSX9Cv2c2QfmKcfKviQZJlg65w4RHmkeNOhkmhkqkLULjvJiUQIkvAMA9si6kbIHtpIDFKsa5Of7FXMWlLMYW_/s400/VIX+move.PNG" width="400" /></a></div>
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<div class="separator" style="clear: both; text-align: center;">
</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The 116% spike in the VIX reportedly triggered the implosion of a popular exchange-traded product called the VelocityShares Daily Inverse VIX Short Term ETN (ticker: XIV). XIV enabled investors to bet that low volatility would continue to rule the day. Through XIV, they would essentially be betting against short-term VIX futures. The VIX spike and XIV implosion has piqued the interest of investors, regulators, lawyers and journalists. Interested parties wanted to know the reasons for the volatility spike and whether there was any wrongdoing involved.
</div>
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<br /></div>
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjBNzIEWO-43lKxTskR0yxP0x0sPBVkwc-xYDXiQ4ANaHSgqJMEbKXh49vmQcWrCvTyvx3u3XXSKllAuU0M84g6dM1E_SaLIVfEmUNi4PL_0lQAkBVbz1hpsRdWXsCsTvtL00VPFcgL7Pet/s1600/XIV+move.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="548" data-original-width="932" height="235" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjBNzIEWO-43lKxTskR0yxP0x0sPBVkwc-xYDXiQ4ANaHSgqJMEbKXh49vmQcWrCvTyvx3u3XXSKllAuU0M84g6dM1E_SaLIVfEmUNi4PL_0lQAkBVbz1hpsRdWXsCsTvtL00VPFcgL7Pet/s400/XIV+move.PNG" width="400" /></a></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Before we consider the possibility of misconduct, we should take a step back to consider what exactly the VIX measures. The VIX is a market-based measure of expected, or <i>implied</i>, volatility. The Chicago Board of Exchange (CBOE) derives the VIX by backing out the volatility that is implied by market quotes for a portfolio of out-of-the-money put and call options on the S&P 500 index (SPX). With the aggregated option quotes we can gauge the volatility for the underlying SPX. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Back in May 2017, well before all of the recent VIX excitement, researchers <a href="https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2972979" target="_blank">Griffin and Shams released a paper</a> entitled, “Manipulation in the VIX?” The <i>Griffin</i> paper details how the VIX settlement process can be gamed by simply posting bids and offers (that may never lead to actual trade executions) to affect the VIX settlement. This possibility is reminiscent of <a href="http://www.pf2se.com/uploads/5/4/5/0/54500123/pf2_-_spoofing.pdf" target="_blank">spoofing conduct</a> reported across various markets such as FX, Treasury futures, precious metals futures, and equity index futures, where some market participants are thought to have influenced market prices by posting bids and offers that they have no intention of actually executing. <i>Griffin</i> concludes that price and volume data patterns are consistent with a trading strategy whose purpose is affecting the VIX settlement. The paper notes: </div>
<blockquote class="tr_bq" style="text-align: justify;">
<i>“In sum, our findings show that the VIX settlement appears susceptible to manipulation, and that the aggregate evidence aligns itself with what one would expect to see in the case of market manipulation of certain settlements. However, we cannot fully rule out all potential explanations without more granular data.” </i></blockquote>
<div style="text-align: justify;">
One week after the wild VIX ride of February 5, 2018, a DC-based law firm, Zuckerman Law, released a letter to the SEC and CFTC on behalf of its anonymous whistleblower-client, alleging manipulation of the VIX. The next day, former CFTC Commissioner Bart Chilton noted during a CNBC television interview that, “The VIX has been suspect for at least seven years.” </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
And on March 9 of this year, the law firm Cohen Milstein filed a purported class action complaint on behalf of Atlantic Trading USA, LLC against unknown John Does, alleging manipulation of the settlement price for VIX futures and options. The complaint alleges that defendants “caused the monthly final settlement price of expiring VIX contracts to be artificial. They did so by placing manipulative SPX options orders that were intended to cause, and at minimum recklessly caused, artificial VIX contract settlement prices in the expiring contracts.” </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
With the VIX being prone to manipulation, and billions of dollars’ worth of derivatives and exchange traded products tied to it, we’d like to see if there might be a better way of calculating expected volatility – a method that is not as prone to the vagaries of potential wrong-doers. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
PF2 consultant Joe Pimbley and PF2's Gene Phillips have done just this in a paper called <i>Fix the VIX</i>, which can be accessed <a href="http://www.garp.org/#!/risk-intelligence/all/all/a1Z1W000003fOTLUA2?utm_source=weekinrisk&utm_medium=email&utm_campaign=weekinrisk&utm_term=article1" target="_blank">here</a>, courtesy of the Global Association of Risk Professionals (GARP). </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Our investigation finds that three approximation techniques being implemented by the CBOE in “calibrating” the VIX may not be necessary, and may exacerbate errors or increase the VIX’s susceptibility to manipulation or error. Of course, volatility won’t go away. But the VIX will more accurately capture it and describe it, with a couple of … <i>fixes</i>.
</div>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-70914979955908388302018-04-06T15:02:00.001-04:002018-04-06T15:21:57.840-04:00Tesla Bonds – Revved Up by Moody’s?<div style="text-align: justify;">
There’s one thing about equity analysts talking up Tesla and getting behind the hype: equity investors enjoy the upside if their optimistic scenarios come true. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But bonds have only downside, and rating agencies are supposed to analyze various scenarios – the good the bad and the ugly – in coming up with bond ratings.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
It doesn’t look like Moody’s did that when rating Tesla <b>B2</b> and Tesla’s $1.8 billion bond issue <b>B3</b> in August 2017. Rather, they assumed as true Tesla’s optimistic production targets (or hopes) for Tesla’s Model 3 and rated Tesla based on those coming true. To exaggerate how bizarre this approach is, had Tesla said they hope and expect to produce a million cars a day, perhaps Moody’s would have rated them <b>Aaa</b>! <i>Click, whirr</i>. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Crucially, Moody’s provided Tesla, the company and its bonds, ratings based on a picture of its future financial that exceeded its true financial position, before Tesla had met the goals that would warrant the rating.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<a href="https://www.moodys.com/research/Moodys-assigns-B2-CFR-to-Tesla-B3-to-unsecured-notes--PR_370922" target="_blank">Moody’s rating rationale</a> reads as follows (with our emphasis added): </div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjdY60sjJy87U3IS8EDf9zDNXQ-r7T6n1v_EfcW6AULAex_phtexX3QTYbixfrmjyaVxId2-PdYruzT2IFYwLqmgolJLqM3Z-04RoJuYJCON5UsQhcIsXZ7KkSmyDH25HRYfO_OSBYepFNT/s1600/Moodys+Rationale.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="601" data-original-width="1115" height="215" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjdY60sjJy87U3IS8EDf9zDNXQ-r7T6n1v_EfcW6AULAex_phtexX3QTYbixfrmjyaVxId2-PdYruzT2IFYwLqmgolJLqM3Z-04RoJuYJCON5UsQhcIsXZ7KkSmyDH25HRYfO_OSBYepFNT/s400/Moodys+Rationale.PNG" width="400" /></a></div>
<blockquote class="tr_bq" style="text-align: justify;">
<i>"The B2 CFR reflects Moody's expectation that the launch, production ramp up, and market acceptance of the Model 3 will be successful enough to achieve approximately 300,000 unit sales during 2018 (a full-year sales rate averaging about 5,500 per week) with a gross margin approximating 25%. <b>This level of sales and profitability <u>would enable</u> Tesla to strengthen its performance from sizable losses to an operating position that supports the B2 CFR</b>. The B2 rating is further supported by Moody's expectation than in the event of severe financial or operating stress, Tesla's brand name, production facilities, and product lineup would have considerable value to another automotive OEM or technology firm targeting the electric vehicle and mobility markets."</i></blockquote>
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To use Moody's language, in short, the achievement of the goals "<b><u>would enable</u>"</b> Tesla to achieve the rating being provided now! Moody's has assumed a future, rosier picture of the company, and based its current rating on the achievement of this rosy future, rather than waiting for the financial position to warrant the rating provided. </div>
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Yet in its own press release, Moody’s rating analyst Bruce Clark (Senior VP) notes that "The major
challenge facing the company during the next twelve months will largely be the considerable execution risks associated with the rapid ramp up in production of a totally new vehicle." </div>
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So, why not see if Tesla can execute before rating Tesla <b>B2</b>, if the <b>B2</b> rating is contingent on execution at a level far beyond what Tesla has ever yet achieved? The answer, unfortunately, is that had they looked at Tesla’s actual then-current balance sheet, they would never have rated them <b>B2</b>, but probably in the <b>Caa</b> range. And Tesla might have gone elsewhere for its second rating (it landed up getting a B- rating from S&P) or scratched the idea of issuing this bond. In fact, Moody’s essentially acknowledges this pressure, which to us seems to be a potential conflict of interest: “Without the proceeds from the [proposed] note offering, Tesla's liquidity position would be stressed.”</div>
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<i>Moody’s didn’t exactly mark Tesla to market did it? Moody’s marked them to an optimistic future. </i></div>
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It does make one wonder where the Moody’s opinion lies if Moody's is simply going to take Tesla's management’s assumption as a given. A good job, if you can get it, but hardly an insightful opinion.
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As it happened, towards the end of March Moody’s noticed that Tesla was still far away from achieving its optimistic goals, having suffered some production hurdles and delays not atypical for a young company producing a new vehicle. </div>
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Moody’s downgraded the so-called “long-term” ratings in March 2018, a little more than half a year after the bonds were issued. The long-term ratings were ultimately based on very short-term expectations. <i>Click, whirr.</i> </div>
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<i>"[Moody’s downgrade of] Tesla's ratings reflect the significant shortfall in the production rate of the company's Model 3 electric vehicle. The company also faces liquidity pressures due to its large negative free cash flow and the pending maturities of convertible bonds ($230 million in November 2018 and $920 million in March 2019). Tesla produced only 2,425 Model 3s during the fourth quarter of 2017; it is currently targeting a weekly production rate of 2,500 by the end of March, and 5,000 per week by the end of June. This compares with the company's year-earlier production expectations of 5,000 per week by the end of 2017 and 10,000 by the end of 2018." </i></blockquote>
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Oddly, now Moody’s is no longer hinging its rating to Tesla's current expectations: “The rating could be raised if production rates of the Model 3 meet Tesla's current expectations and if the company maintains good liquidity.” </div>
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Bondholders ought to be frustrated. They have bought into a <b>B2</b> corporate family rating of a company which clearly wasn’t yet <b>B2</b> at the time of the issuance. They may well have taken <b>Caa</b>-like risk, but only been compensated for the taking of single <b>B</b> risk. </div>
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Tesla has already been <a href="https://www.moodys.com/research/Moodys-downgrades-Teslas-corporate-family-rating-to-B3-senior-notes--PR_381481" target="_blank">downgraded</a>, and it is arguable whether the new <b>B3 </b>rating is well-founded, too. The bonds have been downgraded from <b>B3</b> to <b>Caa1</b> and have lost roughly 3% in value on the day of the downgrade. Altogether, the bonds are down roughly 10% in price terms since issuance. </div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhDW_DVzve7bC6M90WRGPD7IVGV3YABjEB2m-pZy9IrnuUssTKFOAyo6An12AoXjr-LaV0M35irhMD4qPdbSRkPSCkqT5msyl_YgQPWB6J0YoOq0BAbJWwWVekiFnSvA2PCaNUo_ovM78Ez/s1600/Bonds+PX+Graphic.PNG" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="657" data-original-width="1201" height="348" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhDW_DVzve7bC6M90WRGPD7IVGV3YABjEB2m-pZy9IrnuUssTKFOAyo6An12AoXjr-LaV0M35irhMD4qPdbSRkPSCkqT5msyl_YgQPWB6J0YoOq0BAbJWwWVekiFnSvA2PCaNUo_ovM78Ez/s640/Bonds+PX+Graphic.PNG" width="640" /></a><span style="font-size: x-small;"><br /></span></div>
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<span style="font-size: x-small;">PF2 would like to thank Joe Pimbley for his contribution to this article.</span></div>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-91724782585968749572018-02-26T12:41:00.000-05:002018-02-26T12:41:33.060-05:00Florida Shootings Require Cultural & Mindset Changes<div style="text-align: justify;">
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. </div>
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The FBI and local law enforcement <a href="https://www.nytimes.com/2018/02/23/us/fbi-tip-nikolas-cruz.html" target="_blank">reportedly</a> 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:</div>
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<ul>
<li>9/11 <a href="http://content.time.com/time/politics/article/0,8599,1655995,00.html" target="_blank">could have been prevented</a> had the CIA and FBI done a better job of sharing and handling intelligence.</li>
<li>Russian intelligence <a href="https://www.reuters.com/article/us-usa-explosions-boston-congress/russia-warned-u-s-about-boston-marathon-bomb-suspect-tsarnaev-report-idUSBREA2P02Q20140326" target="_blank">warned the FBI</a> about Tamerlan Tsarnaev long before he carried out the Boston Marathon bombing.</li>
<li>In France, authorities <a href="http://www.independent.co.uk/news/world/europe/paris-terror-intelligence-agencies-missed-series-of-key-clues-before-attacks-a6737036.html" target="_blank">failed to act</a> on multiple clues that would have enabled them to prevent the Paris bombings that claimed 130 lives in November 2015. </li>
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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.<br />
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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 <a href="https://www.theguardian.com/business/2018/feb/20/mps-publish-full-unredacted-report-into-rbs-small-business-scandal" target="_blank">detailed</a> 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: </div>
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<i>“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.” </i></blockquote>
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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. </div>
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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.<br />
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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. </div>
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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. </div>
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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 <a href="http://www.nytimes.com/2007/11/19/business/19goldman.html" target="_blank">reviewed daily risk management reports</a> 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. </div>
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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. </div>
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<b>Conviction Dilemma </b></div>
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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. </div>
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In short, the personalities hired into risk-management roles often suffer from what we will term the “conviction dilemma,” which emanates from the <a href="https://www.newyorker.com/magazine/2005/12/05/everybodys-an-expert" target="_blank">work of Philip Tetlock</a> 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 <i>The McLaughlin Group</i>, were those who had vocal, unequivocal opinions, that could be articulated with utter conviction – but were often wrong. </div>
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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. </div>
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<b>Applying Technology </b></div>
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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. </div>
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<a href="https://www.palantir.com/solutions/intelligence/" target="_blank">Palantir</a> 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 <a href="https://news.ycombinator.com/item?id=8325441" target="_blank">not an inexpensive solution</a>, and may thus be beyond the budgets of smaller law enforcement agencies.
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Governments and NGOs may wish to invest in the development of free, open source data analysis. <a href="https://aleph.readthedocs.io/en/latest/index.html" target="_blank">Aleph</a> 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. </div>
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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.<br />
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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 <a href="http://www.pf2se.com/uploads/5/4/5/0/54500123/pf2_-_short-termism_and_its_influence_on_corporate_culture__sept_2016_.pdf" target="_blank">2016 piece</a> 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.”<br />
<br />
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. </div>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-65888051539149531602018-02-20T15:21:00.000-05:002018-02-20T22:12:46.976-05:00Apple or the United States: Which is the Stronger Credit?<div style="text-align: justify;">
In blogs like this, we sometimes like to begin discussions. </div>
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Today, we're going to present an interesting situation. Moody's holds that the US is a <b>Aaa</b> credit, while Apple Inc. is rated <b>Aa1</b> (both its debt and its corporate family ratings are <b>Aa1</b>). </div>
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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. </div>
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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.<br />
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<b>Comparing <i>Apples</i> & Oranges? </b><br />
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Recent fiscal developments have us thinking again about the US's credit rating.<br />
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February 9th’s budget and spending caps agreement tipped next year’s budget deficit over $1 trillion, according to the <a href="http://www.crfb.org/blogs/bipartisan-budget-act-means-return-trillion-dollar-deficits" target="_blank">Committee for a Responsible Federal Budget</a>, 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. </div>
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Last month, <a href="https://www.reuters.com/article/us-usa-ratings-dagong/chinese-agency-dagong-cuts-u-s-sovereign-ratings-to-bbb-from-a-idUSKBN1F50OU" target="_blank">Reuters reported</a> 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 <b>BBB+</b> (from <b>A-</b>), with a negative outlook. </div>
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<span style="font-family: "georgia" , "times new roman" , serif;">“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.”</span></div>
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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.<br />
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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' <a href="https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_179640" target="_blank">ratings methodology</a> for diversified technology companies, a negative EBIT/Interest Expense equates to a rating of <b>Ca</b> (the lowest rating on the subfactor scale), all else equal.<br />
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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 <b>Ca</b> (all else equal) for a diversified technology company.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiyLUQQu7mxE0BbB47cZNQLr-RnJzS88WHssKzq5b-GyRwBrlhXYvOHxiKoVtomZTkE_sEYgquuqwZ66PBue03aloyWAwXfhnJB8a81mQOV3qc1Tp002-snuzmrgC6PYuVRjwzXfc0zqh_g/s1600/APPLE_USA_Final.png" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"><img border="0" data-original-height="511" data-original-width="281" height="640" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiyLUQQu7mxE0BbB47cZNQLr-RnJzS88WHssKzq5b-GyRwBrlhXYvOHxiKoVtomZTkE_sEYgquuqwZ66PBue03aloyWAwXfhnJB8a81mQOV3qc1Tp002-snuzmrgC6PYuVRjwzXfc0zqh_g/s640/APPLE_USA_Final.png" width="348" /></a>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 <b>Ba</b>, all else equal, for a diversified technology company.<br />
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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 <a href="https://www.fiscal.treasury.gov/fsreports/rpt/finrep/fr/16frusg/01112017FR_(Final).pdf#page=69" target="_blank">Fiscal Year 2016 Financial Report of the U.S. Government</a> jointly produced by the US Treasury and the Office of Management and Budget of the Executive Office of the President). </div>
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Yet, Moody’s and many of the other rating agencies don't seem overly concerned, rating the US <b>Aaa</b> (stable outlook).<br />
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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. </div>
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Keep in mind that there are also key <i>qualitative</i> characteristics that Moody’s considers when rating corporates and sovereigns. For example, Moody’s gives significant weight to considerations such as management financial policy (“<a href="https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_179640" target="_blank">management and board tolerance for financial risk</a>”) for diversified technology corporations, and institutional strength (specifically, “government effectiveness”, “rule of law”, and “control of corruption”) for sovereigns. </div>
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Notably: </div>
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<li style="text-align: justify;">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.</li>
<li style="text-align: justify;">Apple lacks a printing press, whereas the USA can print its own currency. </li>
<li style="text-align: justify;">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. </li>
<li style="text-align: justify;">(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.)</li>
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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%).<br />
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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 <b>Aaa</b> 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.)<br />
<br />
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 <b>Aaa</b> rating, a rating higher than that of Apple's debt, which is currently well-supported.<br />
<br />
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.<br />
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<table align="center" cellpadding="0" cellspacing="0" class="tr-caption-container" style="margin-left: auto; margin-right: auto; text-align: center;"><tbody>
<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjqEYA1XpHBhZM1ZhNFI4f4c01LkgTXX9cFQ-PnzWUFfLiMinsvXXdueN5obLEUwzFYQ6Eb7NkazSqREG9_yynSP4dlekunudK21MkFYvNy65AtZ-pFHJ7o0ddc6ToROWmY5uIjGAbXHHJn/s1600/CARTOON+lb1180208_168406_rgb.jpg" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" data-original-height="1047" data-original-width="1600" height="418" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjqEYA1XpHBhZM1ZhNFI4f4c01LkgTXX9cFQ-PnzWUFfLiMinsvXXdueN5obLEUwzFYQ6Eb7NkazSqREG9_yynSP4dlekunudK21MkFYvNy65AtZ-pFHJ7o0ddc6ToROWmY5uIjGAbXHHJn/s640/CARTOON+lb1180208_168406_rgb.jpg" width="640" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;"><span style="font-family: "arial" , "helvetica" , sans-serif; font-size: xx-small;">Lisa Benson Editorial Cartoon used with the permission of Lisa Benson, the<br style="background-color: white; color: #222222; text-align: start;" /><span style="background-color: white; color: #222222;">Washington Post Writers Group and the Cartoonist Group. All rights </span><span style="background-color: white; color: #222222;">reserved.</span></span></td></tr>
</tbody></table>
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PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-83658931447955732812018-02-08T18:38:00.000-05:002018-02-16T18:39:02.154-05:00Market Trading Investigations - Layering, Spoofing, Front-Running, Stop-Loss Triggering<div style="text-align: justify;">
Adding to our prior compilations of <a href="http://expectedloss.blogspot.com.au/2011/04/contested-pricings-list.html" target="_blank">valuation</a> issues, questions of fairness in <a href="http://expectedloss.blogspot.com.au/2016/05/probes-into-trading-executions.html" target="_blank">market executions</a>, and <a href="http://expectedloss.blogspot.com.au/2015/10/investigations-of-fund-fees-and-fees.html" target="_blank">fee disclosure</a> concerns, we are adding a new set that looks at investigations into, and allegations of layering, <a href="http://www.pf2se.com/uploads/5/4/5/0/54500123/pf2_-_spoofing.pdf" target="_blank">spoofing</a>, front-running, barrier-running and stop-loss triggering in the financial markets.</div>
<div>
<ol>
<li style="text-align: justify;">Jan 2018: <b>Spoofing<b> - </b>Precious Metals; S&P Futures</b>. <a href="http://www.cftc.gov/PressRoom/PressReleases/pr7681-18" target="_blank">CFTC Files Eight Anti-Spoofing Enforcement Actions against Three Banks (Deutsche Bank, HSBC & UBS) & Six Individuals</a> </li>
<li style="text-align: justify;">Jan 2018: <b>Front-running<b> - </b>FX</b>. <a href="https://www.bloomberg.com/news/articles/2018-01-22/u-k-s-prudential-was-unnamed-victim-of-hsbc-s-front-running" target="_blank">HSBC front-running victim (Prudential Plc)</a> </li>
<li style="text-align: justify;">Jan 2018: <b>Front-running<b> - </b>FX</b>. <a href="https://finance.yahoo.com/news/u-charges-former-barclays-forex-090751621.html" target="_blank">Barclays front-running of HPQ in $8.3bn FX options trade</a> </li>
<li style="text-align: justify;">Oct 2017: <b>Front-running<b> - </b>FX</b>. <a href="https://uk.reuters.com/article/us-hsbc-usa-crime/u-s-jury-finds-ex-hsbc-executive-guilty-of-fraud-in-3-5-billion-currency-trade-idUKKBN1CS295" target="_blank">U.S. jury finds ex-HSBC executive guilty of fraud in $3.5 billion currency trade</a> </li>
<li style="text-align: justify;">Aug 2017: <b>Spoofing<b> - </b>Treasury Futures; Eurodollar Futures. </b><a href="http://www.cftc.gov/PressRoom/PressReleases/pr7598-17" target="_blank">CFTC Finds that The Bank of Tokyo-Mitsubishi UFJ, Ltd. Engaged in Spoofing of Treasury Futures and Eurodollar Futures</a> </li>
<li style="text-align: justify;">Jul 2017: <b>Spoofing<b> - </b>Commodity Futures (multiple)</b>. <a href="http://www.cftc.gov/PressRoom/PressReleases/pr7594-17" target="_blank">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</a> </li>
<li style="text-align: justify;">Jun 2017: <b>Spoofing<b> - </b>Precious Metals</b>. <a href="http://www.cftc.gov/PressRoom/PressReleases/pr7567-17" target="_blank">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</a> </li>
<li style="text-align: justify;">Mar 2017: <b>Spoofing<b> - </b>Equities (cash and contracts for difference)</b>. <a href="https://www.bloomberg.com/news/articles/2017-03-10/singapore-regulator-secures-first-market-spoofing-admission" target="_blank">Ex-DBS Trader Convicted in Singapore's First Spoofing Case</a> </li>
<li style="text-align: justify;">Jan 2017: <b>Spoofing<b> - </b>Treasury Futures</b>. <a href="http://www.cftc.gov/PressRoom/PressReleases/pr7516-17" target="_blank">CFTC Orders Citigroup Global Markets Inc. to Pay $25 Million for Spoofing in U.S. Treasury Futures Markets and for Related Supervision Failures</a> </li>
<li style="text-align: justify;">Dec 2016: <b>Stop-Loss Triggering<b> - </b>FX</b>. <a href="http://download.asic.gov.au/media/4120995/029744347.pdf" target="_blank">Australian Securities and Investments Commission (ASIC) accepts Enforceable Undertaking from Commonwealth Bank of Australia (CBA) for triggering FX customer stop-loss orders</a> </li>
<li style="text-align: justify;">Dec 2016: <b>Spoofing<b> - </b>Futures (equity index; crude oil; natural gas; cooper; VIX)</b>. <a href="http://www.cftc.gov/PressRoom/PressReleases/pr7504-16" target="_blank">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</a> </li>
<li style="text-align: justify;">Nov 2016: <b>Spoofing<b> - </b>Equity Index Futures</b>. <a href="http://www.cftc.gov/PressRoom/PressReleases/pr7486-16" target="_blank">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</a> </li>
<li style="text-align: justify;">Jan 2015: <b>Layering & Spoofing<b> - </b>Equities</b>. <a href="https://www.justice.gov/usao-nj/pr/canadian-man-charged-first-federal-securities-fraud-prosecution-involving-layering" target="_blank">Canadian Man Charged in First Federal Securities Fraud Prosecution Involving 'Layering'</a> </li>
<li style="text-align: justify;">Jul 2013: <b>Spoofing<b> - </b>Commodity Future (multiple)</b>. <a href="http://www.cftc.gov/PressRoom/PressReleases/pr6649-13" target="_blank">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</a> </li>
<li style="text-align: justify;">Dec 2012: <b>Spoofing<b> - </b>Wheat Futures</b>. <a href="http://www.cftc.gov/PressRoom/PressReleases/pr6441-12" target="_blank">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</a> </li>
</ol>
</div>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-3642052563638297282018-01-08T11:25:00.000-05:002018-01-08T11:25:00.126-05:00Blog 1 of 2018 / Markets for Consumer Data & User-Beware<div style="text-align: justify;">
Hello readers, and thanks for joining us for our first blog of the new year.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
This year, in addition to our typical musings on financial markets, we'll be writing a little more on consumer data.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Hacks have been all the rage for a while already (Equifax and Yahoo! more recently; Target in 2013, Sony Playstation in 2011 and TJ Maxx in 2007 are not too-distant memories).</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
But our interest lies somewhere else: in what is happening behind the scenes with <i>our data</i>.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>hiQ v LinkedIn</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
hiQ is a San Fran-based startup which was doing something pretty interesting: it was scraping data from LinkedIn and then selling that data or analyses done using that data.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
LinkedIn didn't much like this, with hiQ's automated robots ("bots") bypassing LinkedIn's security measures to scrape the data, which LinkedIn felt undermined LinkedIn’s privacy commitments to its members.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
They battled it out in court, with the court finding in August, probably reasonably, that LinkedIn could not stop hiQ from scraping the publicly-viewable information from LinkedIn's website. In fairness, LinkedIn doesn't own its users' data -- it's our data! -- and therefore couldn't limit hiQ's ability to access or study it.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The ruling is interesting for several reasons, including some of the First Amendment-type arguments made by hiQ to support its right to scrape. </div>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: "georgia" , "times new roman" , serif;"><span style="background-color: white; color: #444444; font-size: 18px;">“To choke off speech and the precursor of speech, the gathering of facts and the analysis of information, is a dangerous path down which we should not go,” </span></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="font-family: "georgia" , "times new roman" , serif;"><span style="background-color: white; color: #444444; font-size: 18px;"> </span><span style="background-color: white; color: #444444;">-- Harvard law professor Laurence Tribe, representing hiQ, <a href="https://www.courthousenews.com/linkedin-lawsuit-data-scraper-wide-implications/" target="_blank">reportedly</a> told the judge. </span><span style="background-color: white; color: #444444; font-size: 18px;"> </span> </span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="background-color: white; color: #313132; font-size: 18px;"><span style="font-family: "georgia" , "times new roman" , serif;">“hiQ believes that public data must remain public, and innovation on the internet should not be stifled by legal bullying or the anti-competitive hoarding of public data by a small group of powerful companies, ... It is important to understand that hiQ doesn’t analyze private sections of LinkedIn – we only review public profile information. We don’t republish or sell the data we collect. We only use it as the basis for the valuable analysis we provide to employers. ” </span></span></blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
<span style="background-color: white; color: #313132;"><span style="font-family: "georgia" , "times new roman" , serif;"><span style="font-size: 18px;"> </span> -- hiQ said in a <a href="https://www.hiqlabs.com/news-1/2017/8/15/hiq-wins-motion-for-preliminary-injunction-in-landmark-lawsuit-against-linkedin" target="_blank">statement</a> </span></span></blockquote>
<div style="text-align: justify;">
<br />
Okay, <i>meh</i>. But how about what happens next? Like Microsoft (which owns LinkedIn) firms like Facebook, Amazon, eBay and Google, control and study copious amounts of customer data (and they sometimes get hacked and lose control of it). But importantly they also sell it (as does hiQ). We might like to think that they only sell aggregate data, but how would we know? </div>
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<b>Personal, Personnel Information</b></div>
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<br /></div>
<div style="text-align: justify;">
What interests us is that hiQ sells information about LinkedIn users to those LinkedIn users' bosses, including information, generated from scraping LinkedIn, about the likelihood of an employee leaving. hiQ's clients reportedly include companies like CapitalOne and GoDaddy, and hiQ's products include their <i>Keeper</i> product, which identifies, for employers, when their employees are at risk of leaving for another job. (For example, when employees are "looking around," they tend to make connections on LinkedIn.) <br />
<br />
So that's a sale not necessarily of the more obvious, vanilla, personal information (name, address, date-of-birth), but user/employee/personnel's tendencies and movements. But it's almost certainly <i>not</i> aggregated: if it were aggregated, it would be worthless. Sure, they're not selling the individual's vanilla data itself but they've done a basic analysis of individual's behavior and are selling the analysis. Aggregated, it is not. <br />
<br />
hiQ would have no greater ownership interest in our data than LinkedIn would have. Through hiQ's bots, we just have a simple work-around (imagine, for example, that LinkedIn were simply to buy a stake in hiQ). If we knew that LinkedIn could "tell on us" to our employers -- and make money doing so -- would we have signed up?</div>
<div style="text-align: justify;">
<br />
We have the Latin expressions <i>caveat emptor</i> and <i>caveat venditor</i> to connote the short-hand principles of buyer-beware and seller-beware, when entering into transactions. In 2018, the awkward expression <i>caveat utilitor</i> -- user-beware -- might just become part of our lexicon.<br />
<br />
The value of Johnny's house, or Sandy's choice of handbags, is information that would help advertisers target Johnny or Sandy more appropriately. If Johnny's house price is on the low end, all else equal one wouldn't push Maserati ads at him. If Sandy is buying Louis Vuitton bags, well, maybe she would like this newly-released Prada bag or another Louis Vuitton bag. But whose <i>data</i> is that, and do companies have a right to sell and profit from that information? And how do we separate <i>data,</i> the sale of which may be limited on an individual basis, from <i>analysis</i> of data, which seems to be fair game. Are these two both <i>analyses</i>?<br />
<br />
<ul>
<li>Johnny's house was purchased for $200K this year</li>
<li>Last year, Sandy bought two of Brand X's bags and three of Brand Y's bags.</li>
</ul>
</div>
<div style="text-align: justify;">
<br />
All the best for 2018. Keep watching the Watchmen.<br />
<br />
~ PF2</div>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-10005166477369483182017-12-11T05:00:00.000-05:002017-12-11T05:00:59.986-05:00Al Franken's Complex Legacy and the Credit Rating Business<div class="MsoNormal" style="text-align: justify;">
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.<o:p></o:p></div>
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<span style="text-align: justify;"><br /></span></div>
<div class="MsoNormal" style="text-align: justify;">
<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
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.<o:p></o:p></div>
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<br /></div>
<div class="MsoNormal" style="text-align: justify;">
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.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
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.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
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.)<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
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 <i>Franken Amendment</i> 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. <o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
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.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
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.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
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.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
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.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<div class="MsoNormal" style="text-align: justify;">
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.<o:p></o:p></div>
<div class="MsoNormal" style="text-align: justify;">
<br /></div>
<br />
<div class="MsoNormal" style="text-align: justify;">
<i><a href="mailto:marc@publicsectorcredit.org">Marc Joffe</a> 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.<o:p></o:p></i></div>
Marc Joffehttp://www.blogger.com/profile/14238629927052142269noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-79688669301215128172017-11-17T15:15:00.001-05:002017-11-17T15:15:51.902-05:00Developments in FX and US Treasuries Litigation<div style="text-align: justify;">
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). </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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.<br />
<br /></div>
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<br /></div>
<div style="text-align: justify;">
<b>ForEx</b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The <a href="http://www.dfs.ny.gov/about/ea/ea171113.pdf" target="_blank">NY DFS consent order</a> presents its findings that Credit Suisse engaged in a myriad of transgressions in the FX market – including: </div>
<div style="text-align: justify;">
</div>
<ul>
<li><i>Efforts to manipulate prices around the “fix” and improper sharing of customer information with traders at other banks</i>, e.g.: </li>
<ul>
<li style="text-align: justify;"><b>"</b>... 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.” <b>"</b></li>
</ul>
<li><i>Attempts to front-run customer orders</i>, e.g.: </li>
<ul>
<li style="text-align: justify;"><b>"</b> 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.” <b>"</b></li>
</ul>
<li><i>Collusion with other banks to maintain wide bid-offer spreads</i></li>
<li><i>Price manipulation on behalf of certain customers</i>, e.g.: </li>
<ul>
<li style="text-align: justify;"><b>"</b> 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.” <b>"</b></li>
</ul>
<li><i>Abuse of last look via its electronic platform</i></li>
<li><i>Deliberately triggering (and front-running) customer stop-loss orders</i></li>
</ul>
<div style="text-align: justify;">
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.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b>U.S. Treasuries </b></div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
In the consolidated complaint, styled <i>In Re Treasuries Securities Auction Antitrust Litigation</i> (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). </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
According to the complaint: </div>
<blockquote class="tr_bq" style="text-align: justify;">
“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.” </blockquote>
<div style="text-align: justify;">
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. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
The boycotting allegations are similar to those made against interest rate swap and credit default swap dealers in cases such as <i>In Re Interest Rate Swaps Antitrust Litigation</i> (1:16-md-02704) and <i>Tera Group, Inc. et al v. Citigroup, Inc. et al</i> (1:17-cv-04302).<br />
<br />
<br />
------------<br />
For more detailed coverage of these matters, visit <a href="http://www.pf2se.com/uploads/5/4/5/0/54500123/___pf2_-_changing_landscape_of_financial_markets_litigation_may_2016.pdf" target="_blank">our piece here</a>.</div>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-62701926785018989532017-10-30T10:51:00.000-04:002017-10-30T10:51:13.980-04:00The Cost of NOT InvestingAsset price bubbles are a tricky thing. <br />
<br />
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.<br />
<br />
Now once you think you're seeing a bubble -- after all, a bubble is a bubble -- does that mean you should not invest?<br />
<br />
<b>Welcome to the Land Down Under</b><br />
<br />
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 <i>ongoing</i> debate. And this debate has been, err, <i>ongoing</i> for well over 15 years.<br />
<br />
Earlier this month, the Economist put out an <a href="https://www.economist.com/news/asia/21730004-and-australians-still-them-australia-admits-more-migrants-any-other-big-western-country" target="_blank">interesting article</a> that included this diagram. Wow, or booya, it sure looks like a housing bubble, doesn't it?<br />
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhymxsoLRolwKtOwxfU7Hqk0AUy8AmMl0B8z8Zx2PO2oaHtRVEeplIawS2ILErZZ7-_UMPH5KWTtko0Af6z0y6SqjX2TnDfoQdEDFaphyphenhyphen460214xgNAufExhJ8Nw_XRRQFDsVpypeosCiy4/s1600/Economist+Oct+2017.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="391" data-original-width="388" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhymxsoLRolwKtOwxfU7Hqk0AUy8AmMl0B8z8Zx2PO2oaHtRVEeplIawS2ILErZZ7-_UMPH5KWTtko0Af6z0y6SqjX2TnDfoQdEDFaphyphenhyphen460214xgNAufExhJ8Nw_XRRQFDsVpypeosCiy4/s400/Economist+Oct+2017.PNG" width="396" /></a></div>
<br />
<span style="text-align: justify;">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...</span><br />
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
<b><span style="color: #cc0000;">In May 2003</span></b>, the Economist magazine put out a story called <a href="http://www.economist.com/node/1794873" target="_blank">House of cards</a>, in which their economics editor explained that:</div>
<blockquote class="tr_bq" style="text-align: justify;">
"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<br />
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." </blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
... and ... </blockquote>
<blockquote class="tr_bq" style="text-align: justify;">
"This survey will conclude that the latest housing boom has inflated bubbles in several countries, notably America, Australia, Britain, Ireland, the Netherlands and Spain. <b>Within </b><b>the next year</b> <b>or so</b> those bubbles are <b>likely to burst</b>, leading to falls in average real house prices of 15-20% in America <b>and 30% or more elsewhere over the next few years</b>, in line with average price declines during past housing-market busts."</blockquote>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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.</div>
<div style="text-align: justify;">
<span style="color: #cc0000;"><br /></span></div>
<div style="text-align: justify;">
<span style="color: #cc0000;"><b>In June 2005</b></span>, the Economist would continue with an article called <a href="http://www.economist.com/node/4079027" target="_blank">In come the waves</a> 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.<br />
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjRZt8weslNmvDX8rfu6vakY1ErAROmRlM1zGOlHXmldsAkIwB9NxUo50py_K-PxoYWu4ygID39UHdma4q-KbDy522sqRb-99tOVRhBVh2VngxAc1dhvEv24FZDFltcbzX5jRs5P4-LhPAi/s1600/Economist+2005.PNG" imageanchor="1" style="clear: right; float: right; margin-bottom: 1em; margin-left: 1em;"><img border="0" data-original-height="272" data-original-width="279" height="389" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjRZt8weslNmvDX8rfu6vakY1ErAROmRlM1zGOlHXmldsAkIwB9NxUo50py_K-PxoYWu4ygID39UHdma4q-KbDy522sqRb-99tOVRhBVh2VngxAc1dhvEv24FZDFltcbzX5jRs5P4-LhPAi/s400/Economist+2005.PNG" width="400" /></a></div>
"<b>The most compelling evidence that home prices are over-valued</b> 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."<br />
<br />
"Calculations by <i>The Economist</i> 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. <b>This suggests that homes are even more over-valued than at previous peaks, from which prices typically fell in real terms</b>. House prices are also at record levels in relation to incomes in these nine countries."<br />
<br />
"The rapid house-price inflation of recent years is <b>clearly unsustainable</b>, yet most economists in most countries (even in Britain and Australia, where prices are already falling) <b>still cling to the hope that house prices will flatten rather than collapse</b>."<br />
<br />
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.<br />
<br />
<b>Conclusion</b><br />
<br />
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. <br />
<br />
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. <br />
<br />
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?</div>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0tag:blogger.com,1999:blog-3764912039741974037.post-17135451370881422682017-08-30T17:45:00.000-04:002017-08-30T17:54:59.740-04:00A Three Hour Trading Day ... or Two<div style="text-align: justify;">
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.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
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).</div>
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi9_8bjSiSOEyPFo_W01fcyNZnpIXDWRy3Qd8vaXDFb5mfx3GQ9lryBlMryMzIkh1oO3JFkCbEprWmhVwbXv4FtYuc4cJ6t3PCE5X7HVhOz8m0umUUoZ9CPANi9KBcKZUZomv08sfrnvCKQ/s1600/Barron%2527s+table+half-hours.PNG" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="514" data-original-width="923" height="355" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi9_8bjSiSOEyPFo_W01fcyNZnpIXDWRy3Qd8vaXDFb5mfx3GQ9lryBlMryMzIkh1oO3JFkCbEprWmhVwbXv4FtYuc4cJ6t3PCE5X7HVhOz8m0umUUoZ9CPANi9KBcKZUZomv08sfrnvCKQ/s640/Barron%2527s+table+half-hours.PNG" width="640" /></a></div>
<br />
<div style="text-align: justify;">
Which leaves us to propose two alternatives. </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
A shorter trading day, say 1 pm - 4 pm. Or splitting the trading day into two trading windows, say 9:30 - 10:30 am <i><u>and</u></i> 2 pm - 4 pm.</div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
Here are the many advantages, including several social benefits.</div>
<ol>
<li style="text-align: justify;">The markets would be more liquid. Always. (Reducing costs, adding efficiency.)</li>
<li style="text-align: justify;">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.)</li>
<li style="text-align: justify;">Traders could spend more time on research & strategy, and less time glued to their ever-changing screens.</li>
<li style="text-align: justify;">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.</li>
<li style="text-align: justify;">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.</li>
<li style="text-align: justify;">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!)</li>
</ol>
<div style="text-align: justify;">
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! </div>
<div style="text-align: justify;">
<br /></div>
<div style="text-align: justify;">
We welcome any pros or cons to be added to our list: we're know we're missing many ideas. </div>
PF2http://www.blogger.com/profile/13893025381406343985noreply@blogger.com0