The Securities and Exchange Commission of La Mancha

I’ve long been a critic of the ridiculous regime created by NRSRO legislation, that is, the Rating Agencies, or really, S&P, Moody’s, and Fitch.  There are so many problems from top to bottom, left to right that I’m not even going to begin to list them here.  I will, however, quote what I think is a rather eloquent description of the core problem from a man far smarter than I: David Rowe in a post he wrote on the Kamakura Corporation blog (emphasis mine, as usual).

Currently, the US Securities and Exchange Commission (SEC) is soliciting comments on various proposals to reform the institutional framework of credit ratings. The supervisor wants to ensure effective ratings, as if there is some objective truth that can be discovered as long as the right incentives are in place. In fact, when dealing with innovative, highly complex and historically untested structures, no such objective truth exists. The perceived credit quality of such instruments can be as diverse as views on whether a given company’s shares are a buy or a sell. Imposing a one-size-fits-all rating scheme risks unrealistically homogenising market perceptions that should be highly diverse if adequate information for detailed analysis was widely available. Furthermore, it is just such homogenised perceptions that can lead to herd behaviour and major market dislocations when broadly shared expectations prove to be unfounded.

Trying to reform market structure in search of a non-existent objective measure of credit quality and associated risk amounts to a mission impossible. It is bound to bureaucratise and homogenise ratings, thereby creating an inflexible structure that is vulnerable to a systemic crisis. In fairness, the SEC is only doing what was mandated by the US Congress. Nevertheless, what should be done is to seek a framework that will make all the relevant data underlying such securities readily available in a standard format to a broad community of analysts.

Attacking the independence and objectivity of the ratings agencies due to their business model is easy, but it largely ignores the deeper problem Rowe describes above.  The ratings agency approach to credit analysis is inherently and impossibly broken, and efforts to reform it merely amount to tilting at windmills.

However, while hardly perfect – far from it – I think the equity model and the equity-research-centric approach currently adopted by the SEC would be largely instructive for how to reform the credit research industry.  A not insignificant amount of the information needed to analyze a firm’s credits is already included in the filings publicly-traded firms already make to the SEC.  Why not align the reporting requirements for debt and equity issuers?  Why not incentivize a movement to democratize the credit market just as the equity market was over the past 30 or so years?  Seeds of revolution (or rebellion, depending on your perspective) have long-since been planted with exchange-traded hybrid securities, ETNs, and a myriad of other products and services.

I realize the Herculean (if not downright Sisyphean) effort facing regulators with their current responsibilities from Dodd-Frank, but why not kill several giant birds with one stone instead of ignoring keeping the blinders on until the next inevitable crisis?

Reality vs. Matt Taibbi, Part I

Over the weekend I finally relented and read schmuck “journalist” Matt Taibbi’s most recent allegations against Goldman “Vampire Squid” Sachs.  The plan is to write a longer, more formal response, but in the interim I just want to take a few minutes to address the primary shortcoming of Taibbi’s “work,” namely, that he has no fucking clue what he’s talking about.

Why Levered ETFs Don’t Need to Be Banned

Felix Salmon wrote a post today in response to both my, and Kid Dynamite’s posts in response to his original post, wherein he said the SEC needs to do more to protect retail investors from blowing themselves up with levered ETFs.  I certainly appreciate the open debate (and I hope our readers do as well!), but it seems like Felix is still missing a few things, and making a few factual leaps of faith, which I’d like to discuss here.

He begins by asking how laymen could possibly understand these securities if an (apparently, I’m not familiar  with the gent mentioned) qualified financial journalist doesn’t understand how they ETF’s work:

Except, if you go back a month to when KD last wrote about these things, you’ll find him linking to a column by Dave Kansas — the founding editor of thestreet.com, and about as veteran and admired a markets journalist as it’s possible to find. And he got it wrong, as the correction at the bottom of the column attests.

I’ve read the article, wherein the author said:

Conversely, the ProShares UltraShort S&P 500 (SDS), which makes a double bet against the S&P 500, is down 40% in the past year, which compares to a 13% gain for the S&P 500. That means the “double” bet against the index is doing worse than promised, highlighting another risk for such funds: They often fail to track their stated performance goals.

As the correction added after publication (almost) admits, this is an egregious mistake if it was made honestly, and a gross misstatement if not.  Either way, I can’t find any way to excuse such ignorance from the WSJ, The Financial Paper of Record, even with the correction.  Everyone makes mistakes, of course, but this isn’t some casual blog post, or tweet; its THE Wall Street Journal!  Perhaps (some) financial journalists should check with their sources and/or take a few more minutes to learn about what they’re writing before they hit the “publish” button, but that’s neither here nor there…

As both KD and I have explained, the sponsors of these ETFs go to significant lengths to explain they are designed to target 2 or 3x the DAILY return of the index, therefore, comparing returns of the ETF and the index on a longer time period is at best, apples and oranges.   Felix continues:

My point here is that if you want to find out how easy and obvious something is, you don’t first look for someone who understands it and then ask them whether understanding it is easy. Instead, you look at a broad audience of people who ought to understand it, and look to see what percentage of them actually do.

While I agree that you don’t ask your friend who’s a Quantum Physicist to explain how easy classical physics is to understand, if we look at the “broad audience of people who ought to understand it” that Felix mentions, they should, in fact, be able to understand concepts that could be the basis for questions on the TV show “Are You Smarter Than A Fifth Grader?”  If adults with brokerage accounts who can get the approval I mentioned in my last post from their broker to buy levered ETF’s (which usually requires a relatively substantial amount of money and long-ish relationship) can’t understand arithmetic, then we have a MUCH bigger problem to discuss than whether levered ETFs are or are not a good idea!

Felix’s next non-sequitur is equally confusion:

And if you look at the people who are investing in TBT, it’s clear that the vast majority of them do not understand how it works. For all that there are prominent disclaimers in the abbreviated summary prospectus about such things, those disclaimers are not preventing people from making long-term investments in a security which should never be held for longer than one day. They’re not working.

In his initial post, Felix said that since TBT (and thereby all levered ETFs) are “intraday-only” trading instruments, the fact that the average daily volume is only ~1/10th of the shares outstanding, that means 90% of shares are held by people who aren’t using them properly.  This is also a non-sequitur in and of itself, as  example, see this paper on trading leveraged ETF’s from NYU (pdf), which says:

The study also shows that leveraged funds can be used to replicate the returns of the underlying
index, provided we use a dynamic rebalancing strategy. Empirically, we find that rebalancing frequencies required to achieve this goal are moderate, on the order of one week between rebalancings. Nevertheless, this need for dynamic rebalancing leads to the conclusion that leveraged ETFs as currently designed may be unsuitable for buy-and-hold investors.

That’s only from the abstract to the paper, but the point is that while 90% of the fund float may not be turned-over each day, suggesting that is entirely from naive buy-and-hold retail investors is itself incredibly naive.  In a simple regard, an investor can hold levered ETF’s on a greater-than-daily basis to make a longer-term bet on sector volatility, instead of whole-market vol (see VXX, etc).  Levered ETFs also give a trader/investor the ability to get levered returns without having to deal with margin calls, which in volatile markets is a great comfort, to say the least.  One does not need to be a professional trader to put-on such a trades, I promise, as I’m not myself a professional trader (although I suppose a decade+ in/out of markets, BS in Finance, and a few years working does make me slightly more experienced than the average Joe…).  I can’t quantify to what degree these levered ETFs are used by non-amateurs, but I can all but guarantee that it is much greater than 0%, as there are several reasons to hold them for greater than intraday.

Felix then says he’s concerned that ETFs are a problem because the same rules that are applied to stocks – which have a positive social value in that they represent ownership of tangible assets and help firms raise funds – are being applied to ETFs, which have no such implicit value, social or otherwise.  He also says that these vehicles are mathematically guaranteed to go to zero, which is not the case at all, at least not in the way he puts it, which assumes that is the only option (over a long-enough period of time this may very-well be true, but we are not talking years upon years here).

To see how levered ETFs actually behave, recall the graph from my last post of FAZ, the ultra-short financial ETF v. the Financial SPDR, XLF***, which showed as XLF increased over the past two years, FAZ decreased by even more.  If we zoom in on just the first three months of that series, we can see just exactly what it takes for a levered ETF to “go to zero:” relatively large swings and/or a relatively short period of time.

In this case, it was both large swings AND a short period of time.  FAZ lost 47% of its value after just 5 trading days, over which FAZ’s average daily return was 2.7x that of XLF!  You can see that during these three months, there were some relative large corrections in the opposite direction of the trend, for example after the first initial dive to almost -50%, FAZ went up so that it was only -~30%.  Because FAZ was already beaten-down and returns are compounded, smaller decreases in the index resulted in even larger gains for FAZ, driving it back up almost as quickly as it dropped.

Generally speaking, only way for an ultra-long ETF to go to zero is for the index upon which it is based to trend downward over a period of time, with few and small upward corrections relative to the downward ones.  For an ultra-short ETF to go to zero, as is almost the case with FAZ, the underlying index needs to march steadily upward, with little downward corrections relative to the upward ones.

Felix then says that since these securities trade on the same exchanges as stocks, and have symbols like stocks, its easy to confuse the two.  I’m not even going to dignify that bullshit excuse with a response.

Felix’s ultimate concern is that he doesn’t see why these levered ETF’s should exist.  He says:

What purpose do they serve? If you want to make a leveraged bet on a certain asset, you can buy it or short it using borrowed money. These things are obviously harming a lot of people — the investors wielding billions of dollars who are holding them for long periods of times. Who are they benefiting? It seems to me that the cost of leveraged ETFs is greater than the benefit; that’s why I think the SEC should look into them.

Well, as I briefly discussed above, there are legitimate ways to use levered ETF’s as part of a reasonable, well-thought-out trading/investing strategy.  They can also be used for rank speculation, and there is NOTHING WRONG WITH THAT, so long as anyone using them for that purpose understands the possible consequences of so-doing.  Second, I have yet to see any conclusive evidence that any remotely significant and/or widespread damage has been done to Joe & Jane Investor.  Third, I just don’t see any sort of proof that the cost of levered ETFs outweigh their benefit.

The fact of the matter is that retail investors can’t just put on the same trade as a levered ETF without them; Reg T prohibits it by limiting initial leverage.  To (over)simplify, retail accounts must put up at least 50% of the value of purchases in their brokerage account within a certain amount of days, otherwise they will have the position sold-out.  Clients could gain greater leverage by buying options, but I fail to see how that would be a less inappropriate strategy for retail investors, as they have the same potential loss – 100% of the investment – but are even more difficult to understand than ETFs!

So long as levered ETF’s are not being sold by predatory brokers trying to juice their commissions off unsuspecting and unsophisticated clients, I don’t see anything wrong with levered ETFs, which as I said in my previous post, give clients the option to share in the gains – as well as the losses – available to professional traders.  I’m glad Felix is asking these questions because apparently they have not yet been sufficiently addressed, and its clear he is not the only one out there who’d like some answers.  However, just because he – and others – don’t have the answers, that doesn’t make his conclusions logical, let alone right.

I’m all for investor education and protection from both unscrupulous tactics and illegal information asymmetry, but neither of those things are part of Felix’s argument for greater regulation.  Retail investors constantly complain they don’t have the same profit-making opportunities as professional traders and investors, but look what happens when they do (if Felix’s arguments are to be believed); they not only squander and abuse it, but in so doing, shirk responsibility and accountability for the consequences of their actions.

News flash: With great opportunity for profit comes great opportunity for loss.  There is no such thing as a free lunch.  There is no risky return without the risk, etc, etc, you get the idea (I hope!).  If retail wants the opportunity to get rich through “smart” investments and trades, they necessarily must accept the fact that they may very-well get poor the same way.

*** XLF is not the index for FAZ but it is extremely close, so its used as a proxy for the Russel 1000 Financials

SEC investigating structured products: Déjà Vu all over again?

Never let it be said that the denizens at the Securities and Exchange Commission are a stodgy, humorless bunch. A recent WSJ article, Complex bond faces regulators Scrutiny , almost got me. I am not sure if they meant to have an early jump on April Fools, or if some fat fingers at the WSJ was involved.  In any event, well played Schapiro!

The Complex bonds being scrutinized, also known as “reverse convertible notes” falls under the broad investment category of structured products or in the old school vernacular Derivatives, the eleven letter four letter word.

According to the complaint, apparently the bad boys of Wall Street:

“failed to disclose the risks and fees to the investors before they bought the notes.” and possibly failed to disclose “potential conflicts of interests, such as selling a note linked to the stock of a company it is advising.”

Not only have we been down this path before, but with a few well placed directorships, maybe an IPO allocation or two, whatever the legislation and if indeed there is one, it will be tepid and ineffective. I have many reasons for my opinion but I will give three. One is history, two is legislating for greed, stupidity and downright laziness is nigh on impossible and the third I will give you at the end.

Did Mary Schaprio Lie in Her Testimony to Congress?

In her testimony to Congress today, SEC Chair Mary Schapiro appears to have painted an overly-rosy picture of her accomplishments and the changes she’s made at the SEC since taking the helm.  In fact, unless the SEC’s website is simply painfully out-of-date (which is a pretty damn easy fix), it appears she may actually have spoken a un/half-truth, when she said (emphasis mine):

10 Things Wells Fargo Wants You to Ignore

It has been well documented that Warren Buffett is Wells Fargo’s biggest fan – and largest shareholder (through Berkshire Hathaway). In fact, in his annual letter to shareholders he states that WFC is likely to increase its dividend the most among his common stock holdings. Given that WFC cut its dividend after taking TARP money, his prediction should not come as a surprise.

Another interesting comment from the Oracle of Omaha was his take on Black-Scholes. He writes that the model “produces WILDLY inappropriate values when applied to long-dated options” (emphasis mine). Then he wryly states that he “would rather be approximately right than precisely wrong.”

SEC Division of Risk, Strategy, & Financial Innovation Could Use A Few Good Men…

I realize the SEC’s task is a gargantuan one, especially considering the severely constrained resources, but there’s just no excuse for things like this.  The SEC’s Division of Risk, Strategy, and Financial Innovation – the group created in 2009 to supposedly “enhance our capabilities and help identify developing risks and trends in the financial markets” – does not have anyone running the Office of Data & Data Analytics.  How the hell is the Division supposed to do its job if there’s no one analyzing data?!?!?

On The SEC’s ABACUS Case Against Goldman Sachs

Back in Sophomore (maybe Junior) year Finance class, we learn some very basic approaches to investment analysis. Before we ever touch upon analytical methods, we learn high-level stuff, for example, first and foremost you should analyze a potential investment on its merits; extraneous information is, at best, of secondary, tertiary, or just no concern. If I’m considering buying the ABACUS synthetic CDO deal at the heart of the SEC’s case against Goldman, my primary focus is to analyze the RMBS transactions in the reference portfolio selected by ACA (NOT Paulson – ACA could have throw out EVERY/ANY security Paulson suggested if they thought it was a crap bond), the structure of the deal. Once I’ve done the granular analysis of EVERY bond in the reference portfolio – as close to loan-level as possible, especially with the 20+ person diligence team that IKB reportedly employed – and decided everything looked good, then and only then would I get into other considerations. Have we covered all our bases? Are we missing anything? What are other smart people doing with this/similar transactions?

I firmly believe this story pretty cut & dry: IKB/ACA/ABN did their diligence (well, let’s give them the benefit of the doubt they did, at least) and determined they wanted to buy the deal. They had the blessing of the Ratings Agencies (which, with the wisdom of hindsight – key word – we know was not a very bright idea), they had other “smart” people reinforcing their view (long live confirmation bias!), and the financial industry, as a whole, was generally still long housing.

Anyone who claims that the buyers (longs) would have backed-out if they knew some no-name Hedge Fund manager with ZERO mortgage investing experience suggested part of the reference portfolio is material is full of it. The buyers were arrogant, over-confident in their experience and ability to analyze complex structured finance transactions. Hell, if they WERE made explicitly aware of Paulson’s “involvement” they probably would have enjoyed a good, hearty laugh at his expense and quite possibly even bought MORE of the deal when they knew they were up against such a rube, a novice, a guy in WAY over his head.

One person on the other side of this debate says that in order for me to make such a claim I must be either clairvoyant or have worked on IKB’s deal team in 2007. While I think that’s a bit of a non-sequitur, I’ll allow it, and then accuse the SEC of the same apparent psychic abilities. How on Earth do they presume to prove what IKB WOULD have done? How could anyone prove what they WOULD have done in the past? Sure, I WOULD have prepared differently for the GMAT’s if I knew I was going to run out of time on the math section, but I didn’t KNOW that would be the outcome, since I knew the material very well. Similarly, IKB “KNEW” structured finance RMBS investing, they just didn’t know or expect the outcome we know so well with the benefit of hindsight.

That’s it. Everything else is irrelevant. IKB knew the material that was going to be on the test (the composition of the reference portfolio and all other relevant deal information), they had the ability (experienced deal team) to prepare for the test (analyze the deal), they just came to what turned out to be the wrong conclusion, and didn’t do as well as they expected.

Ultimately, whether Paulson’s involvement will be decided in court, and what I have to say is, unfortunately, just words on a page.  I agree there is the possibility that when all of the information is made available (emails, etc), there may have been an intent to deceive, or scienter,but that’s for the courts/lawyers/etc to decide.

Update: Since I published this in haste (my bad), I should have rephrased the bolded text three paragraphs up, to ask “How does the SEC believe they can use the ‘reasonable person’ test in this situation?”  That is, this is a market, which by definition necessarily includes two parties both of whom believe themselves to be reasonable with different, nay, opposing views.   Thanks to @_phlox for the legal edit.

On The Goldman Sachs Fraud Charges

I’ve been painfully busy this week so I was only able to get out my thoughts in a few tweets and comments on other blogs, forgive me.  Felix Salmon, Kid Dynamite, Henry Blodget and others have all beat me to the punch, and largely, I share many of their thoughts, especially Dynamite’s most recent take (wherein he quotes Blodget).

I won’t rehash the charges as they’ve already been beaten to death by everyone else, however, I will say after reading the SEC’s complaint, the Abacus pitchbook, and Goldman’s defense, I’ve come to the following conclusions (I’m neither a lawyer or structured finance professional, so keep that in mind):

Not only do I not see how/why GS was under any obligation to disclose the party (parties) on the other side of the Abacus synthetic CDO transaction (see page 8 of the pitchbook), I can’t figure out how it’d matter if they had (more on this below).  I also haven’t seen anything yet that explicitly says whether Paulson & Co. did or did not buy into the equity tranche of the deal.  The SEC complaint seems to imply that they did not, however if that is, in fact, the case, I’m very curious why they danced around saying so clearly…

Also, as KD wrote (emphasis mine):

Note that no one is arguing the merits of GS’s disclosure (or lack thereof) here, but I am absolutely arguing that the disclosure shouldn’t have mattered IF ACA HAD DONE THEIR JOB. The underlying securities in the synthetic CDO are what they are, regardless of who put them on the list, or who takes the other side of the trade.  They need to be evaluated based on risk metrics, cash flows, etc.  The real issue is that ACA didn’t do this work to the level that they needed.

GS may be guilty of insufficient disclosure – let’s just pretend they are.  My point is that even given this failure to disclose, the buyers of the securities in question were grossly negligent in failing to properly assess the values and prospects of the synthetic CDOs, and they are trying to remedy their bad trade by diverting blame.

Again, while I’m not a lawyer, from what we’ve seen so far, it looks like the investors’ shareholders may have merits to file suit against the firm’s management for breach of fiduciary duty, since its seems pretty clear that both ACA and IKB (and/or others) didn’t come anywhere close to conducting the kind of diligence required prior to undertaking such a transaction.  They were given a list of all the underlying RMBS and could have easily done the same research Paulson & Co. apparently did, but it seems that either they did – and simply had a rosier outlook for MBS/over-reliance on Ratings – and/or didn’t, in which case they have no one else to blame but themselves.

At best, Goldman’s role(s) in this Abacus transaction teeter(s) on the edge of what most would call ethical business practices, however, I’m not sure the SEC – especially up against the all-star legal team GS is likely to bring – will be able to prove fraud on any meaningful scale.  Given the emails involving “Fab” Tourre the SEC complaint cites, I wouldn’t be surprised if he gets thrown under the bus here by his squid overlords to save their butts.  If that happens, I also wouldn’t be surprised if he tries to shift the blame onto one or two of his higher-ups, an action which GS senior management may deem necessary to protect the firm as a whole.  Ultimately, my guess at this point is that Goldman ends up paying a $50-$100 million fine -tops – after a year or two of courtroom haggling, while “neither admitting or denying any wrongdoing.”  My friend, The Reformed Broker explains what’ll likely come of this in it far better detail, here.

As far as the bigger picture goes, I’m glad the SEC looks like they may finally be getting their shit together.  Unfortunately, unless they have an ace up their sleeve, I doubt this case is the slam dunk they likely thought it was.

Mary Schaprio: Computers? We Don’t Need No Stinkin’ Computers!

All I’m saying is that if I ran the SEC, my desk would look nothing like that of current SEC Chairwoman Mary Shapiro (pic via dealbreaker).

NO COMPUTER?!  No dual + monitor setup with streaming level III quotes, Bloomberg, etc?   Sure, Mary’s a bureaucrat and all, but WHAT THE HELL?!  Fellow Finance professionals, tell me, if you were at the helm of the SEC your desk wouldn’t look something like Adam Sender’s:

Hell, if I ran the SEC my office would look like the freaking Nasdaq market site!

Sure, the SEC has plenty more to worry about than high-tech global trading markets (not to mention there’s allegedly a division to handle such things), but hell, I had more computing power and information access on my desktop in the mid 1990′s, 18.8 baud modem and all!