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Monday, April 28, 2014

Bank of America’s Real Surprises

Roy C. Smith

An accounting mistake reveals how questionable bank financial reporting has come to be, and how weak two of our largest banks still are.

Earlier today Bank of America announced that, due to a material accounting error going back to 2009, it was cancelling its long sought four cents per share quarterly dividend increase and $4 billion stock buyback plan. The Federal Reserve only recently approved this payout plan after its 2013 Comprehensive Capital Analysis and Review (CCAR) of Bank of America’s capital position.
The event calls attention to the extraordinary complexity of bank financial reporting and its dubious value for important regulatory or investment purposes.  Always voluminous, Bank of America’s annual report had 141 pages of financial statements in 2007, and but 257 in 2013, reflecting new disclosures imposed since the crisis.  So much data is bound to contain errors or need correcting from time to time. In any event, it is more than even skilled investment analysts or regulators can process
The event may also be an additional argument for why the Fed should emphasize “qualitative considerations” in assessing a bank’s overall financial position, as it did in its recent rejection of Citigroup’s plan to return capital to its shareholders after meeting the quantitative requirements of its CCAR.
But it also reminds us that both Bank of America and Citigroup continue to be economic basket cases, six years after the crisis. Without government assistance, (since repaid) both banks would have failed.  But neither bank is out of the woods, even now.
Bank of America recently reported another quarterly loss, its fourth such since 2010. Both it and Citigroup reported returns on equity for the first quarter of 2014 approximately 13% less than their costs of equity capital, and both of their shares trade at 72% of book value despite a significant rise over the last 2 years. 
Both banks have failed to cover their cost of capital, and have traded well below book value, for the last 21 quarters.
Both have bond ratings from Moody’s of Baa2, lower than all of their peers.
Both banks also pale in comparison to their biggest national banking competitor, Wells Fargo, the most valuable financial services firm in the US with a market capitalization of $260 billion. Wells Fargo reported a return on equity 4.65% greater than its cost of equity capital for the 1Q2014 period, and trades at 1.6 times book value.  Its dividend and stock buyback payout ratio is 55%, compared to 1% for both Bank of America (after the announcement) and Citigroup. 
Wells Fargo is not hampered by an extensive and difficult to manage commitment to trading and investment banking. Citicorp’s acquisition by Travelers in 1998 put it into these businesses (through Salomon Bros., previously acquired by Travelers), and Bank of America acquired Merrill Lynch in 2008, along with the endlessly toxic Countrywide Financial.
It may be that neither Bank of America nor Citi will be able to get back to “normal” until they shed (or greatly diminish) their investment banking businesses and refocus themselves on a consumer and commercial banking business model more like Wells Fargo’s.

Thursday, April 24, 2014

Moelis Reflects New Industry Trends

Roy C. Smith

Moelis & Co., one of Wall Street’s newest merger boutiques went public last week, making it the fifth one to be publicly traded. The offering illustrates three new and important trends in today’s investment banking business.

Despite a weak market that forced a reduction in offering size and price, Moelis, raised $163 million and emerged with a market capitalization of $1.3 billion, about the same as old-timers Evercore and Greenhill.

Most of the money raised will be used to redeem some of the $300 million of capital invested in the firm to date by early backers.  Ken Moelis and his two co-founders will control 97% of the firm after the offering through special shares with 10-1 voting rights.

Migration of Talent

The first is that experienced merger professionals continue to migrate to boutiques like Moelis and Perella Weinberg (formed in 2006, but still privately owned). Today boutiques altogether employ around 2,000 merger advisers and generated advisory fees of about $2 billion in 2013, about the same as Goldman Sachs, the M&A market leader.

The boutiques offer much richer compensation prospects than the major banks. Moelis paid out 65% of revenues in 2013 as compared to 37% at Goldman Sachs, but also offers employees ownership of stock that the market capitalizes at a higher price-earnings ratio than the major banks’ (Moelis’ P/E ratio is 24, Goldman Sachs’ is 10).

These prospects are tied directly (and solely) to the global M&A business. The boutiques are expecting this business, operating now at only about 50% of the peak volume in 2007, to bounce back with economic recovery. At Goldman Sachs, where senior banker pay is tied to firm-wide performance and subject to bonus caps or regulatory constraints, M&A fees comprised only 6% of revenues for 2013.

And, boutiques claim to offer a more collegial, less political working environment that is much less likely to be disrupted by unwanted media or regulatory attention.

Unbundling of Financial Services

The second is that the boutiques have been enjoying an increasing share of M&A advisory work, which is a reflection of clients’ desire to unbundle the all-in-one financial services model of the major banks.  Clients want advice from several sources.

The boutiques are now big and global enough to keep up with the major banks. They are equipped with deep industrial expertise and their rainmakers know many, if not all, of the heads of the major companies in particular industries.

Altogether, seven merger boutiques were among the top twenty advisers in completed M&A deals in 2013, representing approximately 18.5% of the total transactions reported by advisers. (Because multiple advisers are often used, the value of transactions reported greatly exceeds the actual value of transactions completed). In 2007, the record year for completed merger transactions, only 4 boutiques were among the top twenty advisers, then accounting for 12.2% of the completed deals. In 2013, eight of the ten largest M&A deals had boutique advisers, up from three in 2003.

The unbundling is not in mergers alone. The market share of all global investment banking transactions (bond and stock offerings, syndicated loans and M&A) of the top ten banks declined to 70% in 2013 from 94% in 2006. This has occurred at a time when the major investment banks have been under prolonged duress from increased regulatory constraints, scandals and litigation, and pressure on their stock prices and compensation ratios.

Fewer Conflicts of Interest

Boutiques also offer themselves as uncomplicated and familiar people to work with, with few, if any, conflicts of interest.  

Because of the many different lines of business at major banks, including other client engagements, trading positions, and affiliated hedge and private equity fund activities – all now interpreted more stringently -- conflicts of interest invariably appear.  The Delaware Chancery Court’s highly critical rulings in two recent merger cases (Del Monte, 2011, and El Paso, 2012) held corporate directors liable for closely monitoring their advisers for conflicts of interest, These have made many corporate boards more cautious when hiring big bank advisers:

One way to address conflicts with an adviser is to hire more than one. Over the past decades, companies have increased the number of advisers they employ on transactions, often using two or more.

The Big Banks Resist But are Under Pressure

Giving merger advice is less an art, if it ever was one, than a well-perfected professional process. There are lots of competent firms offering the process, including the boutiques, but the industry leaders have not backed away and remain well entrenched.

The top five advisers handled 54% of the deals reported by the top twenty firms as they have for most of the last decade. It does appear, however, that the boutiques are taking market share away from the others.

That is not to say that the boutiques will continue to do so in the future. Big banks have multiple relationships with clients who trust and rely on them, and including them as merger advisers is an easy way to reward them for accumulated services.  Highly professional teams are always available at these firms, even when a star banker leaves or retires. At the boutiques, holding the firms together after the star fades is never easy so relations may be less solidly entrenched.

Still these three trends are powerful ones that reflect the considerable pressures now being felt by large “systemically important” global investment banks.  New, non-systemic, non-bank boutiques, including hedge funds and private equity firms are being formed all over the market to compete with big banks, not only in investment banking and credit provision, but in trading and investment management as well.

Some of this because the big banks are under considerable pressure to reengineer their business models and, while doing so, they may be seen to be weakened enough to encourage challengers.  Thus competitive pressures compound the regulatory constraints imposed on the systemically important firms.

Monday, April 21, 2014

Whatever Happened to Swiss Bank Secrecy?

Ingo Walter 
Financial secrecy is a "product" that has intrinsic value, one that can be bought and sold, consumed and produced. What’s it worth?

Financial secrecy – or more politely “confidentiality” - involves non-disclosure of financial information concerning individuals, firms, financial institutions and governments. It is a key element of banking and financial services, fiduciary relationships, and regulatory structures. It is vital in tax evasion, the drug trade, organized crime, money laundering, terrorism, political and economic corruption, and host of other activities that can cause real damage to civil society. But financial privacy can equally be considered a human right – what regime hasn’t made great efforts to compromise personal privacy in the name of the state? 
What financial secrecy is worth depends on where the money came from and the consequences of disclosure, all the way from family tensions to the firing squad. And who’s tasked with safeguarding financial secrets? All the usual suspects ranging from uncle Harry, lawyers, accountants investment advisers, banks, and the ultimate gold standard – highly reputable financial institutions operating abroad in politically and economically stable sovereign countries that maintain tough secrecy laws and blocking statutes. 
As long as the bankers can keep it up there’s a treasure trove of fees to be earned and high-paying jobs to be had, much more reliably than grinding away at the mug’s game of trying to outperform the competition on investment returns and risk. As in any good market, financial secrecy is bought and sold and both sides are happy – albeit sometimes at the expense of somebody else.

Here are some FAQs about financial secrecy.[i]
Q. In the last couple of years the US Internal Revenue Service has run an aggressive campaign against US tax evaders and their use of Switzerland as a place to stash their wealth (taxed and untaxed) and evade paying further taxes on interest, dividends and capital gains. This now seems to be unraveling. Why?
A. The US tax code is a bit unusual in that income of American tax residents is universally taxed (not just when remitted back home), tax evasion is a criminal offense, (not just a civil offense), and anyone assisting in the process can be charged with aiding and abetting in the commission of a crime as well as conspiracy and possibly obstruction of justice. These are not good words, especially for Swiss banks heavily exposed to reputational risk. UBS was the first of these banks to face the music as a result of whistleblower testimony and eventually reached an expensive settlement with the US. Its arch-competitor Credit Suisse, engaged in similar practices and is now also in the dock. So are many smaller Swiss banks, some of whom picked-off tax-evading UBS American clients – although it didn’t take long for the spotlight to fall on them. Switzerland’s oldest bank, Bank Wegelin, collapsed after being indicted on criminal charges. Eventually an omnibus Swiss-US agreement was reached covering all Swiss banks, which is currently being implemented. 
Q. But UBS apparently had a clearly stated policy for its private bankers not to deal with offshore accounts of clients subject to US tax laws in ways that might constitute “aiding and abetting”  actions in criminal violation of the law. For offshore wealth management US clients were potentially toxic. Yet UBS private bankers evidently pursued such clients with enthusiasm. How do you explain that?
A. As in many large organizations, business units dealing with private banking clients are under heavy pressure to “make the numbers.” So despite general policies that play well in public and may be genuinely supported by senior management and boards of directors, line staff looking to make the numbers and generate performance bonuses have the incentive to increase the volume of profitable business. Sometimes these opportunities push very close to the edge of legality. Imperfect markets, after all, is where the money is. So UBS private bankers seem to have overstepped the limits imbedded in the Bank’s own policies. The question is how far up the management hierarchy this went. Testimony in a Florida court ultimately led to indictment of Raoul Weil, global head of the Bank’s private banking business, and an extradition request went to the Swiss government. In October 2013 he was arrested on a visit to Bologna, Italy, extradited to the US, and freed on $9 million bail pending trial. It is an open question whether the Bank’s Global Executive Board or its Supervisory Board was aware of the Bank’s actions or the extreme dangers involved as possible “unindicted co-conspiritors.”
Q. It’s fine to focus on the US, which likes to throw its weight around. But what about other countries?
A. The aggressive US pursuit of its tax evaders perked-up the antennae of tax authorities, all of whom have severe budgetary constraints that need to be addressed, in part through much tougher tax compliance. Embarrassing disclosures include tax evasion charges against former French Budget Minister Jerome Cahuzac and German sports hero and president of the Bayern München soccer club, Uli Hoeness, who was recently sentenced to 3½ years in jail. Of course, enthusiasm for merciless tax enforcement varies between countries and over time, especially when plenty of influential people play the game, so it’s far too early to write an obituary on either financial secrecy or tax evasion. And remember, there are lots of other reasons for needing financial secrecy than stiffing the tax man.
Q. Government victories in recent years in the battle against tax evasion have relied on bank data stolen by former employees and purchased by national tax authorities. Is it ethical for governments to use such data?
A. Governments use all kinds of sources of information to go after criminal activity. This includes undercover police, stool pigeons, eavesdropping and similar ploys. In some cases they are sanctioned by law, in other cases by court order before the fact, and in still other cases by a judge’s determination at trial regarding the admissibility of evidence. Evidence regarding financial secrecy enabling tax evasion would be covered by the same standards anchored in the law and the administration of justice, so there are no ethical questions once the rules of the game are set. This applies to cases where tax evasion is a criminal offense and prosecuted under criminal law. Where tax evasion is a civil offense the ethics issue becomes debatable, since standards of prosecution tend to be much lower – for example, “preponderance of evidence” versus “beyond a reasonable doubt.”
Q. Isn’t poor tax compliance partly a country’s own fault?
A. Sure. Some tax codes are horrible, including the United States – opaque, complex, riddled with exceptions and carve-outs, loopholes and special-interest provisions and viewed by many as not only inefficient but also fundamentally unfair. Couple this with human greed and street smarts - and you have a solid demand for a financial service that extends as far as the eye can see. Switzerland and others have always argued with some justification that it’s not their job to collect other people’s taxes. Too bad. Right now they’re easy targets, a lot easier than sensible tax reform at home.
Q. What impact do anti-terrorist initiatives have on global patterns of tax evasion? 
A. The attacks on New York City in 2001 triggered renewed interest in cross-border financial transfers that are necessary to carry out acts of terrorism. The amounts involved are usually very small but nevertheless crucial in enabling terrorism – the classic “needle in a haystack” problem. Terrorist funding must be kept secret, usually disguised as commercial transactions or personal remittances. There have been systematic efforts by the US and other countries to root-out terrorism-related financial flows and promote cooperation among governments. In the process, investigators inevitably come across substantial financial assets that are unrelated to terrorism but are nevertheless the proceeds of criminal activity – such as organized crime, extortion, human trafficking and the drug trade . Surfacing these kinds of financial flows and assets represent a valuable “bycatch” of efforts to cut off the financial air supply to terrorist groups.
Q. The majority of insider trading scandals uncovered by the US Securities and Exchange Commission involved offshore accounts. Why ? 
A. Insider trading needs secrecy to work. Financial operations to trade on inside information require significant exposures (and sometimes leverage), which have to remain confidential. The proceeds likewise need the protection of secrecy at the time of the illegal transactions and thereafter. Consequently the use of offshore accounts routed through channels for no commercial purpose other than secrecy is virtually ubiquitous. Suspicious trades are usually flagged by brokers to the authorities (in the United States, the Securities and Exchange Commission) which will decide whether an investigation is warranted. If the insider trading ring is large, prosecution may be facilitated by cutting deals with peripheral members in return for leniency – a tactic that can blow up an insider trading ring remarkably quickly - followed by requests to foreign financial authorities for information relevant to a criminal investigation.
Q. Pretend you are the former Finance Minister of Kleptocia, a small developing country with substantial mineral wealth. Back home you are known as “Mr. 5%” - and you have managed to squirrel-away over $700 million in overseas accounts before your government was ousted and you became an ordinary, law abiding private citizen. You have big plans for homes in Cannes and New York, a flat in Mayfair, and maybe even a personal aircraft. How do you get to keep and use the stash you worked so hard to accumulate?
A. This is not an easy question. Increasingly even the most hard-nosed secrecy havens want to stay well clear of clients who are corrupt politicians. Misdeeds will ultimately come out, often involving heinous acts committed on their watch, and this is very bad for the private banking business. Legitimate wealthy clients, and even otherwise respectable tax evaders, want nothing to do with a bank that has aided and abetted political suppression or crimes against humanity. So finding secrecy havens becomes increasingly tough, involving stacks of intermediaries, shell companies, foundations and the use of financial centers that are not too particular about dealing with crooks.
So your hypothetical ex-government official would do best to leave the country post-haste and establish residence and possibly buy citizenship in a country that will sell it in order to impede later extradition. Meanwhile, employ a “secret agent” who is well plugged-in but has flexible integrity. Have him or her construct a secrecy edifice with as many defenses as possible. It would not be surprising if 20% or so of the investable assets (after adjusting for increased risk) get spent in this project. Even then, you are in no position to take your secret agent to court if you’re shortchanged. Will the sleepless nights ever end? But hey! Better than life in a Kleptocian prison with the rats and cockroaches – or worse.

[i] If you want to know more, take a look at my “The Use and Misuse of Financial Secrecy in Global Banking,” Chapter 15 in John Nofsinger (Ed.), Socially Responsible Financial Investing (New York: Wiley, 2012).

Sunday, April 20, 2014

Thoughts on Reputation and Governance in Banking

Ingo Walter
The epic financial crisis of a few years ago inflicted immense damage on the process of financial intermediation, the fabric of the real economy, and the reputation of banks and bankers. Even today, some five years later, little has happened to restore financial firms to their former glory near the top of the reputational food-chain in most countries.  For reasons of their own, many boards and managers in the banking industry have little good to say about the taxpayer bailouts and the inevitable regulatory tightening. In the words for former Barclays CEO Bob Diamond, "There was a period of remorse and apology for banks. I think that period is over. Frankly, the biggest issue is how do we put some of the blame game behind us? There's been apologies and remorse, now we need to build some confidence.”[1]
          There have been some notable exceptions, of course. In the middle of the crisis Josef Ackermann, former CEO of Deutsche Bank and Chairman of the International Institute of Finance (the preeminent lobbying organization for the world’s largest banks), noted in 2008 that the industry as a whole was guilty of poor risk management, with serious overreliance on flawed models, inadequate stress-testing of portfolios, recurring conflicts of interest, and lack of common sense, as well as irrational compensation practices not linked to long-term profitability – with a growing perception by the public that banking was the playground of “clever crooks and greedy fools.” Ackermann concluded that the banking industry had a great deal of work to do to regain its reputation, and hoped that this could preempt damaging regulation. It was already too late for that.
          Crisis-driven reputational damage at the firm level can also be inferred from remarks by Peter Kurer, former Supervisory Board Chairman of UBS AG, who noted at the bank’s annual general meeting in April 2008 that “We shouldn’t fool ourselves. We can’t pretend that there has been no reputational damage. Experience says it goes away after two or three years.”[2] Perhaps it does, perhaps not. But the hemorrhage of UBS private client withdrawals at the height of the crisis and immediately thereafter suggests severe reputational damage to what was then the world’s largest private bank.
          The number of financial firms -- ranging from Santander in Spain to Citigroup in the US and Union Bancaire Privée in Switzerland -- that have reimbursed client losses from the sale of toxic Lehman mini-bonds, collapsed auction-rate securities, and investments in Bernard Madoff’s Ponzi scheme suggests the importance of reputational capital and the lengths to which financial firms must go to try to restore it. And at the personal level the world is full of disgraced and sidelined bankers whose hard work, career ambitions and future prospects lie in tatters.  
          Whether at the industry, firm or personal level, the reputational costs of the financial crisis five years ago were enormous. So it’s all the more curious that banks have run into an even greater firestorm of reputational losses more recently. Consider the following questions:
       Is it acceptable to mis-sell worthless payment protection insurance to retail mortgage and credit card customers?
       Push in-house products to investor clients against superior (better-performing or cheaper) third-party products?
       Invade segregated customer accounts and borrow the money for your
          own operations?
        Facilitate clients’ evasion of taxes legally payable in their countries of residence?
       Launder money for drug dealers and arms traffickers and facilitate violations of bilateral and multilateral trade and financial sanctions?
       Sell securities to institutional clients which you know will collapse in value – and then use your proprietary trading platform to speculate against them?
       Use an investment advisory relationship to earn kickbacks from product vendors?
        Design off-balance-sheet structures for clients solely for purposes
           of financial misrepresentation?
        Exceed your internal or regulatory risk exposure limits and cover your tracks?
        Submit false Libor numbers and trade against them – and work in cahoots with other banks and money brokers to implement the scheme?
        Redefine a bank’s central exposure hedging platform as a profit center and
 circumvent established risk controls to generate additional earnings?
          There are many others. Each has the name of a major bank attached to it, sometimes several banks. Most of the offenses seem to intentionally violate established regulations and legal statutes -  or just defy common-sense definitions of what is fair, appropriate and ethical.
          Banks and bankers, some would argue, have lost their way in carrying out their key role as efficient allocators of capital and creators of improved social welfare. They seem more like wealth-redistributors, from their clients to bank employees and shareholders, all the while privatizing returns and socializing risks on the back of taxpayers when things go badly wrong.  Fair assessment or not, it’s no wonder the industry as a whole and individual banks have seen their reputational capital erode.
          What might explain this? After all, some of the best educated, most highly talented and morally upright people in the world work for banks and do their best to serve clients, owners and other stakeholders well.
          It could be the changed competitive market structure in global banking, in which more intense competitive pressure and heavily commoditized markets have made it increasingly difficult to deliver ambitious promised returns to shareholders and attractive bonus pools to employees. This creates incentives to migrate banking activities to less open and less transparent markets, where transaction costs and profit margins are higher. These are markets that have become increasingly problematic as a result of greater product complexity and erosion of transparency, with efforts to reform them often resisted furiously by banks and their advocates.
          It could also be that, in such an environment, the definition of “fiduciary obligation” - the duty of care and loyalty that has traditionally been the benchmark of trust between banker and client - has morphed into redefining the client as a “trading counterparty,” to whom the bank owes nothing more than acceptable disclosure of price, quantity and product. A deal is a deal, and what happens later is only of limited concern in a world where the “long term” is after lunch.
          Compounding the effects of the market is the changing nature of the banks themselves, which might be considered both a cause and a consequence of crisis-related and subsequent reputational issues. If bank size, complexity, imbedded conflicts of interest, and the ability to manage and govern themselves were contributory factors leading to the recent crisis, then these issues are even more problematic today – if only as a result of still bigger and broader financial conglomerates emerging from governments’ efforts to stabilize the system. In the ensuing restructuring process some important things can easily get lost, with thousands of people from competing institutions newly hired and others dropped from the team. Whatever affirmative culture and perspective once existed can easily get washed-away in the tide.
          Such factors are sometimes complemented by banks’ underinvestment in risk management and compliance (the “defense”) and its perennial disadvantage in questions of judgment and engagement against revenue- and earnings-generation (the “offense”). Usually this “tilt” is compounded by levels and systems of compensation designed to emphasize bonus against malus. Reputational capital is lost by people, acting individually and collectively. So what drives people carries big consequences.
          Nor can boards of directors be let off the hook. They are supposed to set the tone that dominates everything a bank does, and how that is projected into the marketplace. In some cases factors like poor industry knowledge or lack of technical background of directors, dominant or “imperial” chairmen, and a boardroom sociology that puts a premium on “teamwork” can be at fault. And who is supposed to control boards? Presumably it’s individual investors and fiduciaries, which control share voting rights. Perhaps most important are institutional investors who fail to use the power of the proxy to challenge errant boardroom behavior – possibly because they themselves face conflicts of interest and do business with the same banks in which they exercise voting rights.
          And not least, banking regulators seem to have plenty of problems understanding and approving conventional risk indicators and management practices in large, complex banks. Understanding the specific reputation-sensitivity of activities in the firms they regulate at the business-line level just may be too much to ask.
          Frederick the Great of Prussia has often been quoted as pronouncing that “Banking is a very special business which should be the province of very special people.” By “special” he presumably meant people who were honest and trustworthy to a fault, with a keen eye to their fiduciary obligations in handling other people’s money, and to do so in confidence.
          Maybe banking today attracts some rather un-special people who liberally use terms like “share of wallet,” “asset gathering,” “guaranteed bonus,” “caveat emptor” and “Muppets” in connection with the work they do every day. Dynamic, fast-moving businesses where these characteristics are highly valued have become increasingly important in banks over the years. So the bacterium gradually infests larger parts of the organization, and the reputational erosion that follows gets to be viewed as an inevitable consequence of the new world of banking. Meantime, educational institutions enthusiastically churn out more young talent with much the same mind-set. Unfair? Probably. But it doesn’t take too many bad apples.
          Anyway, who cares? Reputational losses occur from time to time in any business, no matter what the industry. They eventually go away. And they are usually much less problematic when pretty much all of the players are doing the same thing.
          One would like to believe that market discipline transmitted through the share price can be a powerful deterrent. But this depends critically on the efficiency and effectiveness of corporate governance, and we observe that banks continue to encounter serious reputation losses due to misconduct despite their impact on the value of the business.
          If market discipline fails, the alternatives include civil litigation and external regulation aimed at avoiding or remedying damage created by unacceptable financial practices. Yet civil litigation seems ineffective in changing bank behavior despite “deferred prosecution” agreements not to repeat offenses. This again suggests continued material lapses in the governance and management process.
Dealing with operational and reputational risk can be an expensive business, with compliance systems that are costly to set up and maintain, and various types of walls between business units and functions that impose opportunity costs on banks due to inefficient use of information and capital within the organization. And intractable conflicts of interest may defy sustainable control, and possibly require structural remediation involving withdrawal from activities that are too problematic to keep under the same roof. These are not popular topics among bankers. Nonetheless, it seems that operational, compliance and reputational issues contribute to market valuations among the world’s major financial conglomerates that fall well below valuations of simpler, more specialized financial services businesses.
As demonstrated by the kinds reputation-sensitive “accidents” that seem to occur repeatedly in the financial services industry, neither good corporate governance or stakeholder legal recourse or more intrusive regulation seems to be particularly effective in stanching reputational losses in banking. Maybe they just “a cost of doing business” in this industry? One would hope not. The same argument in the pharmaceutical, petroleum or food industries would be considered appalling by most people.
          Bottom line? Managements and boards of financial intermediaries need to be convinced that a good defense is as important as a good offense in determining sustainable competitive performance. The also need to walk the talk. Admittedly this is extraordinarily difficult to put into practice in a highly competitive environment for both financial services firms and for the highly skilled professionals that comprise the industry. A good defense requires an unusual degree of senior management attention and commitment. Internally, there have to be mechanisms that reinforce the loyalty and professional conduct of employees. Externally, there has to be careful and sustained attention to reputation, perspective and balance, in addition to ongoing competitive performance.
          In the end, it is probably leadership more than anything else that separates winners from losers over the long term – the notion that appropriate professional behavior reinforced by a sense of belonging to a quality franchise constitutes a decisive competitive advantage.

[1] Appearing before the Treasury Select Committee, UK Parliament, 11 January 2011.
[2] See

Friday, April 11, 2014

Greek Lessons for Putin

by Roy C. Smith

After the “cram-down” restructuring of Greek private sector debt in 2012 that forced a 75% haircut, in a transaction officially scored as a default, financial markets resounded with cries of “never again.”
But Greece’s oversubscribed €3 billion 5-year bond issued on April 10th with a coupon of 4.75%, 50 basis points below its expected level, shows yet again that markets have short memories, and that “opportunities” changes.
True, the bond was rated a barely breathing Caa3 by Moody’s and the Greek economy continues to be a mess after six years of recession with 26% unemployment, a still sky-high debt burden, and continued political unrest, there is a bright side -- especially if you are a “trader” as opposed to a traditional “long-term investor.”
Traders who bought Greek 10-year bonds a year ago have enjoyed market gains of 33%. They will tell you that the expectation of a near-term default of private sector debt is very unlikely. After all the struggle within the Eurozone to determine whether and how to bail out Greece, the country is back in the euro fold and the continuing support of the EU and its agencies can be assumed. With their help, and after the 2012 restructuring, Greek debt service is reasonably assured for about 10 years, whereas the new bonds mature in five.
The traders will also tell you that €3 billion is a tiny fraction of the €320 billion of Greek debt outstanding before the issue, 85% of which is owned by the IMF, ECB and similar government bodies. The new bonds are issued under UK law, which means a default would be accompanied by lots of messy litigation with collateral grabbing of the sort Argentina has been experiencing.
Besides, the traders might add, we’re getting a much higher yield on these 5-year bonds than on Portuguese (2.5%) or Irish (1.4%) bonds issued within the last year. Fixed-income investors are desperate for yield in the current European low inflation environment.
Traders, of course, are not your traditional, stodgy, hold-until-maturity bond investors. They are a different breed altogether, comprising proprietary traders, hedge funds, high-yield bond funds, and ETFs. Most manage large amounts of money for pension funds, endowments and wealthy families. They think opportunistically with time horizons of six-months to a year and move into and out of things quickly. Such traders are the ones behind the apparent bubble in the low-grade sovereign and corporate bond markets that has been inflating for the last couple of years.
Traders are in equity markets too, as followers of social media stocks will confirm. Facebook recently announced it would pay $19 billion to acquire WhatsApp, an incredible amount for a company with few revenues and no earnings. Facebook, with a market capitalization of $170 billion, will pay for the deal with stock trading at over 100 times earnings, something it can continue to do as long as it retains market support.
Indeed, traders buy and sell a lot more often than long-term investors, so they tend to be the ones setting prices in the markets. Often they pursue the same market opportunity (e.g., tech stocks in the 1990s, mortgage-backed securities from 2003-2007) and turn them into bubbles. But they can also abandon markets suddenly as they did in 2000 to the tech stocks, and in 2008 for mortgage backed securities, turning these events into crashes.
After the euro was introduced in 1999, the differences between German government bond yields and those of all the other EuroZone countries (including Greece) were negligible, despite major differences in their financial and economic positions and outlooks. Traders assumed that the system would underwrite any troubled members, but in 2010, when the European banking crisis contaminated sovereign credits, they rushed for the exits. Greek 10-year yields reached 30% before the crisis was resolved and markets relaxed.
So the real Greek lesson is that, for countries plugged into the global financial system, markets forces can be extremely helpful when they are going in the right direction -- lowering interest rates, providing access to easy credit, encouraging foreign direct investment and higher stock prices -- but equally, when market forces are in opposition, they deny access to credit, sink stock markets and block inward direct investment.
Market forces make a huge difference to growth and stability in all economies, but especially in developing and emerging market countries. Thus, governments must align their economic policies to gain the support – not the opposition – of market forces.
Maybe Mr. Putin should sign up for a Greek lesson. Though Russia’s 10-year sovereign debt reached a peak yield of 16% during the financial crisis, it recovered to a low of 6.24% in 2011. The yield was 7.2% last October, before the Ukrainian crisis began, and is now 9% (a 25% increase).
By comparison, Greek government 10-year bonds are now yielding 5.9%.  Russia has also seen a 20% decline in stock prices, a 15% decline in the value of the Ruble, and a capital outflow estimated at $100 billion since the crisis began.
As powerful as Mr. Putin may see himself to be, he is nowhere near as powerful as financial markets. Unlike the times of his Soviet predecessors, Russia is now part of the global financial system and must endure its reaction to Russian policies and actions.
Russia has benefitted greatly from positive market forces since its independence in 1991, but as these forces reverse, things start to look much worse. The IMF is now estimating Russian GDP growth for 2014 at -1.6% (it was 4.5% in 2011 and 2012).
But if the Ukrainian situation gets worse, especially if major sanctions are involved, the combined impact on the Russian economy of negative market forces could more than equal those that buried Greece in economic misery for six years.

Wednesday, April 9, 2014

Flash Boys May be Yesterday’s Story

by Roy C. Smith

Michael Lewis’ newest Wall Street bestseller, Flash Boys, claims that equity markets are “rigged” by high frequency traders who invested millions in fiber optic cables that enabled them to shave microseconds from the time it takes to trade stocks. Launched just a week ago in a blizzard of TV interviews with unknowing, uncritical journalists, it is the latest bomb to drop on an industry still struggling to regain its balance after the financial crisis of 2008.
Like his two other very popular books about financial firms and markets (Liar’s Poker and The Big Short), Flash Boys, tells a compelling, if improbable story of how a few really smart tech guys, investing millions in their own high speed cables, have outwitted the usual bunch of dull institutional investors by hijacking billions of dollars of other people’s trades.
After Lewis’ launch, the US Attorney General, Eric Holder, announced he has directed the Justice Department to investigate high frequency traders for insider trading violations. He joins the SEC, the CFTC and the FBI, which say they are also investigating the market-rigging allegation.
Few people know enough about High Frequency Trading (HFT) to be able to take Lewis’ book apart, but many of those who do have chimed in to complain, about his conclusions.
Academics who have followed HFT as an innovation in market microstructure generally seem to believe that (a) it increases competition and has contributed to lowering trading costs, (b) the innovation was enabled by continuous deregulation in financial markets over the past 20 years that has increased transparency and forced traders to search among various market makers for the best execution price, and (c) HFT probably adds to market liquidity, but not necessarily under especially stressful conditions.
Competition has eroded away much of the big profits that HFT operators made in the past, and that are featured in Flash Boys. According to Larry Tabb, a securities market consultant, revenues from HTF that were $7.2 billion in 2009 will be only a little more than $1 billion in 2014.
Such a revenue swing is typical of disruptive technologies – the first ones in with the new idea benefit disproportionately until competition catches up.
Trading technologies have been very disruptive in Wall Street, especially to large broker-dealers that act as intermediaries between clients. A surge in trading volume in the late 1960s forced brokers to computerize back offices, and many that didn’t manage the transition well failed. NASDAQ, an electronic over-the-counter marketplace was established as an alternative to the NYSE in 1971, and has been the second largest trading venue in the US ever since. Michael Bloomberg introduced his computerized black box for comparing bond prices in 1982, and forced the entire industry to adopt trading practices based on the new technology.
In the 1980s and 1990s, enhanced data processing capabilities led to the development of securitized mortgages, to a variety of hedging tools using futures, options and other derivative instruments, and to trading strategies using solely quantitative analytical processes. These innovations were enormously important to the development of efficient, low cost financial markets, and very profitable for the firms that first introduced them. But Wall Street is famous for being able to copy new ideas quickly and erode profits from them.
In 2000, Goldman Sachs acquired Speer, Leeds & Kellogg for $6.5 billion to improve its equity market making capabilities, which it did for a while but even these improved capabilities were later overtaken by technology developments in the industry. Goldman recently announced it was selling the firm for virtually nothing.
In  2001, Liquidnet was formed as an alternative institutional marketplace, now one of several so-called “dark pools” that allow institutional investors to trade directly with each other. Between them, the dozen or so dark pools now account for 36% of the global equities trading market.  Liquidnet operates in 41 markets on behalf of 700 asset managers with $12.5 trillion under management. The New York Stock and Exchange and NASDAQ between them now comprise only 33% of the market, according to Thomson Reuters.
And in 2002 Virtu Financial was formed as a “technology enabled market maker and liquidity provider.” In 2013 it had revenues of $624 million from trading 10,000 different securities on 210 exchanges in 30 countries, and profits of $243 million, a margin of 39%. It is hard to see how all this activity could be based simply on laying down their own fiber optic lines, or buying trading information from the dark pools as Lewis alleges.
Virtu, which has been staked by Silver Lake, a tech oriented venture capital firm, is one is 20-30 privately owned HFTs in the US and Europe. Virtu had made a preliminary filing for an IPO later this year, the first for this industry niche, but has since postponed it due to the controversy surrounding Flash Boys.
Lewis based Flash Boys on a story that began in 2009. It may already be out of date. Things change fast in technology, and in financial markets where every trader is looking for an edge. Sometimes the edge is in quicker hardware, or in better software, or in newer mathematical algorithms that reveal arbitrage opportunities. Sometimes it’s in an ability to get around rules that moves transactions into territory previously unchartered by regulation.
Several Wall Street banks set up HFT operations in its early days, but most of these have been since shut down or phased out. Goldman Sachs was reported recently to be also considering closing down the sizeable dark pool operation it established in 2006. The economics of these business made be changing, but even if they are not, it may be that they are too technologically sophisticated (and error prone), too expensive to carry on the books of a bank with heavy capital requirements, or too out of step with their public relations message to want to hang on to them. So, in this case anyway, the big boys move on, leaving the field to the less visible smaller guys who compete fiercely with each other for as long as their trading edges last.
Even so, the powerful reaction to Lewis’ book demonstrates that exotic new things like flash trading (or derivatives, or CDOs) are suspect, and the more difficult they are for the public to understand, the more certain people are that their purpose is to rig markets or otherwise take advantage of others.
It is very difficult to actually rig markets when they are as large and competitive as global markets are today. Holder and the regulators will be trying to find what rigging they can, and if they succeed, the regulators will have to tighten up the rules. But HFT, an opportunistic innovation that has improved markets, will no doubt continue -- at least until the next innovation.