Archive for the 'Banks' Category

the Unicredit rights issue

Published January 12, 2012 Banks , Basic Concepts , Current Market Thoughts , Industry Analysis , Recent Market Action , rights issue Leave a Comment
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the Unicredit issue

Unicredit, a major Italian commercial bank, is in the midst of an equity raising aimed at shoring up its finances to meet new capital adequacy standards being set by the Bank for International Settlements.

It’s doing so in the customary European way, through a rights issue (see my post on rights issues for more detail).  The prospectus is available–but not to people in the US–on the company website.

No E-Z bank is eager to raise new equity today.  Their stocks are trading at well below half of the balance sheet carrying value of their net assets (which is the problem in a nutshell–no one believes the carrying values have much basis in reality).  Nevertheless, many are resigned to doing so.  Therefore, the Unicredit issue is attracting a lot of market attention as it proceeds.

Several aspects of the issue are striking:

its large size

Prior to announcement of the issue, Unicredit was trading at around €6.30 a share.  The issue gives existing shareholders the right to buy 2 new shares at €1.93 each for every one they held at the ex rights date.  The new money coming in from the issue amounts to about 60% of the pre-rights market value of Unicredit.

implied change of control possibility

The shares created by the issue will represent two-thirds of the new total.  The issue has the potential to completely rewrite the share register if traditional large shareholders choose not to participate.  That’s certainly an inducement for them to come up with the money.

the low exercise price

Think of rights as being like short-term warrants.  Suppose the existing shareholder doesn’t want to, or can’t afford to, exercise his right to buy new shares.  What happens then?

Usually, and in this case as well, the issue is underwritten.  That is, the investment bank group arranging the issue agrees to buy, at the rights price, any shares that shareholders don’t.  The underwriters, in turn, sub-underwrite part or all of their obligation to other investors–typically portfolio management companies (this is a whole other, semi-sordid, story–but a topic for another day).  No matter what, Unicredit will get the money it wants.

Underwriters don’t want shareholders en masse to refuse to take up their rights.  It’s embarrassing for all parties, for one thing.  The underwriters, or angry customers who act as sub-underwriters, are stuck with the shares on their books, at a loss and tying up capital.

Their solution?  Coercion.

Underwriters always price the new shares at a discount to the prevailing stock price.  The bigger the discount, the bigger the gun to the head of existing shareholders to avoid having their percentage ownership of the company assets diluted by not taking up their rights.  Conversely, the smaller the discount, the more eager underwriters figure existing shareholders are to give company management fresh capital.

In the Unicredit case, the discount is gigantic.  The new shares will be issued a less than a third of the pre-rights share quote.  More like a cannon than a gun.

the issue appears to be succeeding

…at least in the sense that the current share price is comfortably above the €1.93 level.  The stock hasn’t traded below the rights exercise price since it went ex rights and has strengthened each day, as well.

Unicredit is worth watching closely

This is a bellwether rights issue.  If it goes well–and signs are positive so far–other, stronger banks should be able to raise substantial new equity, too.

 

 

the SEC, Citigroup and moral hazard

Published December 1, 2011 Banks , Derivative instruments , Industry Analysis , Investment firms , moral hazard , securities markets , Securities regulation , short selling , Where are the customers' yachts? Leave a Comment
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This is an update and elaboration on my November 11th post about Judge Jed S. Rakoff, the SEC and Citigroup.

moral hazard

Moral hazard in finance is the situation where the existence of an agreement to share risks causes one of the parties to act in an extra-risky manner, to the detriment of the other.   In a sense, the willingness of the party who ultimately gets injured to enter into the agreement causes, or at least allows, the bad behavior by the other to occur.  He inadvertently sets up a situation where the bad behavior is rewarded, not punished.

examples

–Systematically important banks have been able to take very big proprietary trading risks, knowing that they are “too big to fail” and will ultimately be bailed out by the government if their risky bets don’t pan out.  The rewards of such risk-taking go as bonuses to the bankers; the cost of bets gone bad is borne by the general public.

–One of the reasons Germany is so hesitant to bail out Greece is that doing so rewards the latter country’s reckless borrowing behavior over the past decadeand shifts the costs of cleaning up the resulting economic mess onto the citizens of the rest of the EU.

the Rakoff case and moral hazard

Judge Rakoff has just rejected a proposed settlement of a case involving Citigroup and the SEC, on what appear to me to be similar moral hazard grounds.

The settlement involves Citi’s creation and sale of $1 billion in securities ultimately tied to a pool of sub-prime mortgages selected by the bank.  Citi neglected to tell the buyers of the securities that it wasn’t simply an agent.  It was making a $500 million bet that the securities would decline in value sharply–which they subsequently did.  Investors who bought the securities from Citi lost $700 million.

I don’t know precisely how much money Citi made on this transaction.  But I think I can make a good guess.  To make up rough numbers, collecting a 2% fee for creating and selling the issue would bring in $20 million or so.  A 70% gain on its negative bet on the issue would yield $350 million.  If so, the much more compelling reason for creating the issue would be to design it to fail and then short it.  In any event, let’s say Citi cleared $370 million before paying its employees who thought up and executed the total deal.

The proposed settlement?

–fines and penalties totaling $285 million

–Citi doesn’t admit or deny guilt, which means

——the settlement doesn’t create any evidence to support a lawsuit by the investors who lost money, and

——the settlement doesn’t trigger the sanctions against future illegal conduct that are contained in prior settlements with the SEC.

–only low-level Citi employees are reprimanded.

Assume the SEC allegations are all true.

If so, what a deal for Citi!  The SEC “punishment” is that the bank keeps $85 million in profits and gets a slap on the wrist.  Who wouldn’t agree?

What would make this moral hazard is that this is is the worst case outcome for Citi.

And, if you figure that the SEC looks at one suspicious deal out of ten, the situation is even less favorable for investors.  The decision whether to create another issue like this one is a layup.

Would it be so easy if Citi stood a chance of losing money?  …or of triggering clauses in prior settlements prohibiting illegal behavior?

What about the legal team that decided what he minimum disclosure in sales materials should be?  Would they have insisted that Citi must reveal its proprietary trading position in those materials if fines were larger, or if they could be held professionally liable for the information’s exclusion?

What if the Citi executives that okayed everything risked being barred from the securities business for a period of time–would they have acted in the way they did?

grandstanding?

I don’t think critics are correct that Judge Rakoff is trying to raise his public profile by insisting that the SEC either obtain a better settlement or go to trial with its case.  Others are saying that the SEC takes settlements like this because it doesn’t have the legal skill to get anything better.  But these are ad hominem arguments  –like saying the parties are wearing ill-fitting clothes, they’re distracting, but irrelevant.

But it is true that this case comes at a time of growing public anger that bank executives are showing few ill effects from the devastating economic damage they helped cause.

It will be interesting to see what new settlement the SEC and Citi come up with.

Stay tuned.

Citigroup, Jed Rakoff, MF Global and the SEC

Published November 11, 2011 Banks , Derivative instruments , Industry Analysis , Investment firms , Securities regulation , Where are the customers' yachts? 1 Comment
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There’s an odd asymmetry to the way the SEC works.

For example, it put Martha Stewart in jail but ignored Bernie Madoff.   It pursued Michael Milken vigorously after the junk bond market collapsed.   But it has, so far, left the heads of the major commercial and investment banks untouched, despite the fact that the toxic derivative securities they created were much more widespread and–as we continue to see–have damaged the world financial system much more severely than anything Milken did.

Raj Rajaratnam’s insider trading recently drew an 11-year prison sentence and a $93 million fine.

But the other side of the SEC has come to light again recently in the court of gadfly judge Jed Rakoff.  Judge Rakoff is being asked to approve a settlement of a case in which buyers of a Citigroup mortgage product lost $700 million.

The deal the SEC is offering?

–pay back $160 million, plus $30 million in interest and a $95 million fine;

–Citi doesn’t admit it did anything wrong;

–only low-level Citi employees are sanctioned.

–oh  …and the SEC wants to include an admonition to Citi not to do stuff like this again.  But, as Judge Rakoff points out, Citi appears to have violated such orders issued in prior settlements at least twice in the past decade and the SEC has done nothing.

You’d take a deal like that all day long.

A cynic might say that this behavior is related to the fact the current head of the SEC used to be in charge of the brokerage industry trade association.  On the other hand, I believe much of the toxic derivative activity was deliberately organized by the banks out of London because that put them out of the reach of US prosecutors.  So there’s not much the SEC can do.

…which brings me to MF Global.

There’s certainly a danger to generalizing from a small number of instances.  But, to me, what connects Martha Stewart, Michael Milken and Raj Rajaratnam is tha: t the issues are easy to understand, the names are high-profile, none were deeply plugged into the financial industry establishment and, although wealthy, none had the near-infinite resources of the large investment and commercial banks.

One of the issues that the Occupy Wall Street movement gives voice to is that after nearly destroying the world economy and forcing a high-cost financial rescue that all of us will be paying for for many years, no high-level financial commercial bank or brokerage executive has been prosecuted for anything.

What this adds up to, I think, is that the SEC will be scrutinizing the role Jon Corzine played in the demise of MF Global very carefully.  He’s a former head of Goldman Sachs but no longer an industry insider;  he’s an ex-senator and ex-governor; he’s wealthy–but not Bill Gates.   And, the question of whether the firm illegally took money out of customer accounts and used it to stave off margin calls is pretty clear-cut.  It may also be hard to say you didn’t notice an extra $600 million plopping into a portfolio you manage–especially so if you really needed it.

It will be interesting to see what happens–both whether the SEC finds a reason to prosecute and whether that will satisfy OWS.  My guess on the second count is that it won’t.

risk controls at UBS: the case of trader Kweku Adoboli

Published September 20, 2011 Banks , Current Market Thoughts , Derivative instruments , ETFs Vs. Mutual Funds , Industry Analysis , Recent Market Action , Trading Leave a Comment
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Kweku Adoboli is the UBS trader who ran up losses of $3.2 billion through unauthorized trading in stock index futures over a three-month period without being discovered.  Both the Financial Times and the Wall Street Journal have extensive accounts of what Mr. Adoboli did.

Here are my observations:

background

Legally, traders act as agents for the institution they work for.  Once an employer introduces an employee to counterparties as being authorized to trade for the firm, the counterparties have no obligation to try to figure out what the trader is doing.  Until the employer informs them otherwise, the counterparty’s job is simply to execute the orders they receive.

Mr. Adoboli worked on a small trading desk called Delta One, that processed buy and sell orders that UBS received for ETFs.  For this story, the most important characterisitics of ETFs (see my posts on ETFs vs mutual funds for more information) are that:

–ETFs trade continuously throughout the day, in large aggregate amounts but typically in many small orders

–firms that run ETFs have no direct dealings with the investing public.  They keep their costs low by having brokers do virtually all trade processing and record keeping for them.

Brokers recoup the administrative expenses they incur through the commissions and bid-asked spreads they charge customers.  Once they amass a large net position in a given ETF, they can close their exposure out by transacting with the firm that runs the ETF.  They may also attempt to make additional gains through the timing of these transactions.

Brokers routinely hedge part or all of their ETF exposure through derivatives markets.  The name of Mr. Adoboli’s unit, Delta One, signifies that the trading desk “delta,” or the change in value of the hedges for a given change in the underlying position UBS held, should be “one.”  That is, the two should match exactly; there should be no net exposure.

Mr. Adoboli

Mr. Adoboli’s initial job at UBS appears to have been in the back office, as one of the administrative employees processing and recording the activities of the Delta One desk.  One of his unit’s jobs would have been to reconcile the desk’s accounts of the trades it made each day with the confirmation notices sent by counterparties. 

Mr. Adoboli was a good enough employee to be promoted to the much higher status job of trader.  One key fact that he learned from his back office time was, surprisingly to  me, that for a whole class of plain vanilla short-term derivative contracts, counterparty banks never sent confirmations on the day of the trade.  Apparently, standard procedure was to only to send settlement instructions a few days before the contract came due.

on the Delta One desk

Despite the name, the Delta One desk had to take risk.  And, from Mr. Adoboli’s behavior we can conclude that the desk rewarded traders for successfully taking risk.  But these risks would have been small, like:

–widening the bid-asked spread slightly, or

–delaying making a hedging transcation by five or ten minutes in hopes of getting a higher price, or maybe even

–by “anticipatory hedging,” over-hedging at a favorable price, figuring that new orders would soon come in.

three months ago

That’s when Mr. Adoboli exceeded the risk limits specified by his desk.  Who knows what happened?  He may have accidentally added an extra zero to a trade.  More likely, he may have decided he wanted to quickly make enough trading profit to get a higher bonus, or to be recognized as an astute trader and promoted to a “prop trading” desk whose principal job is to try to make trading profit (“prop” is short for proprietary, meaning it trades with the firm’s own money).

In any event, at some point Mr. Adoboli’s trading went badly and he began to make substantial losses.  Rather than reporting what he’d done to his boss, he used his back office knowledge to record fake trades that offset his losses.  He selected instruments where he knew no confirmations would be sent–buying him time until close to settlement day for him to recoup his losses and enter more, counterbalancing, fake trades to erase them from the records.

Apparently, toward the end, Mr. Adoboli was making speculative trades covering as much as $5 billion in securities, all without being detected.

What appears to have tripped Mr. Adoboli up was that the back office noticed it was not receiving settlement instructions for fake trades set to settle on September 22nd.

observations

In the mid-1980s as I was beginning to learn about bank stocks, a colleague who was an excellent bank analyst told me she had one main criterion for separating good banks from bad.  In a good bank, when someone makes a mistake and reports it, he’s rewarded; in a bad bank, mistakes are punished, so employees hide them.

It’s hard for me to believe that Mr. Adoboli was able to conceal his unauthorized trading from his direct supervisor–in a five- or six-person section–for so long.  That person must have been asleep at the switch.

It’s also surprising that there was such an unaddressed loophole in UBS’s trade reconciliation procedures–and that no one noticed that one person was doing so much unreconciled trading.

Juergen Stark quits the European Central Bank and stocks sag: why?

Published September 12, 2011 Banks , Current Market Thoughts , Industry Analysis , Recent Market Action , Strategy Leave a Comment
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resignation last Friday

Jürgen Stark, a respected and politically-connected economist representing Germany on the ECB, resigned from that body’s board on Friday at about the time US markets opened for trading last Friday.  You can see the sharp drop in stocks that followed the announcement of this news.  Why?

some background

1.  Deeply scarred by the hyperinflation of the Weimar years after WWI, Germany has always been the strongest advocate of price stability (i.e., no inflation) in modern Europe.  Unlike the US, which is willing to accept a moderate amount of inflation (currently the upper bound is 2% or less–and we wish it could get that high) in return for faster GDP growth, Germany is willing to sacrifice almost any amount of growth to maintain stable prices.

As a result, Germany has traditionally acted as the economic “policeman” of Europe, enforcing sound fiscal and money policy rules and acting as a lightning rod to deflect local political criticism in the rest of the EU for governments taking unpopular but necessary economic actions.

Mr. Stark’s resignation from the ECB for “personal reasons” –but apparently in protest over the ECB’s decision to prop up the finances of weaker EU member states by buying their bonds–suggests the ECB is deciding/has decided to break with the traditional no-inflation-first policy stance.

2.  Mr. Stark is the second German official to resign from the ECB in recent months.  In February, Axel Weber resigned as head of the German central bank and withdrew from consideration to head the ECB–apparently with similar concerns to Mr. Stark’s.

3.  The Stark resignation may cause enough political fallout inside Germany to force the Merkel government to say openly whether it approves of ECB actions.  So far, Germany has been pretending it doesn’t see the drift away from the traditional German policy stance and just, little by little, letting the drift continue.  I’m not an expert on internal German politics.  But it doesn’t seem clear whether Germany would back Ms. Merkel vowing unconditional support for a Greek bailout–meaning German taxpayers would foot a large part of the bill.

stock market reaction

World financial markets are acting as if the Stark resignation is the tipping point that will force the EU to stop hoping the problem disappears and confront the fact that Greece can’t service the large amount of euro-denominated sovereign debt it has amassed since joining the EU.

possible solutions

In general terms, two approaches to resolution are possible:

–the German price stability mentality holds.  If so,

Greece will be allowed to default.  Holders of Greek sovereign debt, including big EU banks which are stuffed to the gills with these bonds, will suffer large losses.  The problem with this solution is that the markets will just turn to the next country with wobbly finances–Portugal or Spain–and the whole destabilizing question of bailout or not arises anew.  Look at the Asian debt crisis of 1997 if you don’t think so.

–the EU as a whole assumes responsibility for the sovereign debt of weaker members.  There’d have to be some mechanism for ensuring that a repeat of their debt expansion doesn’t happen.  To the stronger countries’ eyes–and certainly to Germany’s–this has to look like a rerun of the reunification of the two Germanies after the fall of the Berlin Wall.  A decade of economic stagnation followed.  So this solution (which I think is more likely) probably also entails a bias toward a weaker euro and tolerance of a bit of inflation.

what do investors do?

Solution 1 is bad for Greece, and bad for banks and other financials that hold Greek debt.  It might just shift the focus of worry away from Greece to Portugal or Spain.

Solution 2 is bad for the less-indebted EU members and bad for the euro.

The intersection of the bad-ness is the financial companies in the less-indebted EU countries.  So for traders, selling them is a no-brainer.  Even if these stocks are the epicenter of weakness–and they have been so far–arbitrage tends to drag everything down.  So just selling anything in the EU is a close second choice.

If there’s any silver lining to the selling, it’s that it may force a resolution to the Greek debt issue.  A sharp market decline may provide the political cover EU authorities feel they need before they act in a way that could threaten their ability to be reelected.  Also, as the selling exhausts itself, there may be an opportunity to pick up the stocks of well-run EU-based multinationals at a cheap price.

 

 

 

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