Blackrock’s new trading platform (ll)

Blackrock is the largest money manager in the world, with $3.5 trillion under management.  It manages stock, bonds and alternative investments, packaged as either separate accounts, ETFs or mutual funds.  It was built by former brokerage house employees who come from a deeply trading-oriented culture.  So it’s not surprising that the firm has a keen awareness of the value of the trading it does with the rest of the financial world.

Blackrock first announced its intention to create an internal trading platform in 2009.  Recently the Financial Times reports that the firm has begun to hire IT people to have the network up and running sometime in 2011.

the platform

How will the trading platform work?

If I understand Blackrock’s plans correctly, it will be something like this:

1. All buy and sell orders for publicly traded securities anywhere in Blackrock will be  entered into the internal trading system.  Buys and sells that match one another will automatically be executed inside Blackrock, saving the majority of the commission that would otherwise be paid to a third party.  In this respect, the platform will work like an electronic crossing network.

2. Small orders can be aggregated and placed externally at a more favorable commission rate.

3. Minimum levels of order flow can be directed to brokers who will give a better rate in order to get higher volume.  Factors 1-3 would mimic the behavior of discount brokers.

4.  Unlike the case with third parties, portfolio managers will presumably give a true indication of the total intended size of any transaction, rather than feeding orders piecemeal to try to disguise their intentions.  This may allow managers to negotiate more frankly through internal Blackrock traders, and thereby buy and sell in large size much more quickly than they would be able to do otherwise.

Where will the trades come from?

…from ETF share creation/redemption and related hedging, mutual fund inflows and outflows, and the buy/sell decisions of active managers working for Blackrock.

only scratching the surface

When the trading platform is up and running and some record of savings from internal matching is available, Blackrock will likely begin to use the data as a marketing tool for its products.  I presume the marketing pitch will be that part or all of the savings will be returned to clients–producing better performance.  Maybe this will be enough to tilt a hiring decision in favor of Blackrock, maybe not.  But I think this is only the first use Blackrock will make of the platform.  For instance:

–understanding the aggregate patterns of the movement of Blackrock’s $3.5 trillion under management is a powerful source of market intelligence

–it can be a tool for evaluating the decision-making skills of the firm’s managers

–Blackrock can seek other sources of trading flow.

—–it could easily open its trading platform to others as a “dark pool.”

—–it could offer the platform to discount brokers.

—–it could create a discount brokerage operation itself.

What I think is most interesting about Blackrock’s plans is that the firm doesn’t need to make money from its trading operations.  It can even take a loss on trading, if it thought that would enhance the attractiveness of its fee-generating money management business.  This possibility should be very scary to financial firms whose chief/sole business is based on trading, especially for any with Blackrock as a big customer.  But the possibility has wider import.  The canyons of Wall Street are littered with the bones of one-product companies where someone else decided to make that product a loss leader.



Blackrock’s new trading platform as attack on traditional money managers (l): background

I’m going to write two posts about the internal trade order-matching network that Blackrock intends to have up and running next year.  This one will provide background, some of which I’ve written about before.  Tomorrow’s will deal with how the Blackrock network fits as a strategic weapon in the money manager’s arsenal.

three types of commission

For a conventional money manager, commissions paid for trades–or bid-asked spreads, which amount to the same thing–break out into three types, from most expensive to least:

–research commissions, aka “soft dollar” commissions.  These commissions consist of a payment to a broker for executing and recording a trade plus an amount to compensate for research services.  Ten years ago the research service payment was predominantly in return for information from the broker’s own in-house research.  Today, most brokerage house analysts have been laid off and work in independent research boutiques that their former employers act as middlemen for.

The amount paid per trade will depend on the size and trading habits of a given institutional client, by may amount to, say, $.05 per share.

–commissions for execution.  These are paid strictly in accord with the SEC mandate for registered money managers to obtain “best price” and “best execution” when they trade for clients. They might amount to $.03 per share, of which $.015 might be the broker’s cost and the remainder a profit element.

–trades through electronic crossing networks, aka “dark pools” (for fantasy or vampire fans, I guess).  These have become increasingly popular.  One advantage of such networks is their low cost–maybe $.001 over the expense of executing a trade.  The second is their anonymity–you don’t run the risk that your intentions are not only broadcast to your broker’s proprietary trading desk, as they surely are, but also to all the broker’s best customers as well.

attacks on the conventional model

Blackrock’s new trading platform is the latest one.  That’s tomorrow’s story.

A second attack, blunted for a while by the financial crisis, is coming from Fidelity and concerns soft dollars.

When I entered the industry, conventional money management firms typically had large cadres of in-house research analysts who serviced the firm’s portfolio managers and reported to a research director.  This was expensive.  Also, in many cases the firms didn’t have strong enough general management to ensure the in-house research was any good.

As time went on, firms gradually shrank their in-house research efforts.  Instead, they began to increasingly depend on analysis generated by the brokerage houses they traded with–paid for with higher-than-normal commissions.  This “solved” the management problem.  And it had the added benefit of increasing profits by shifting the cost of research away from salaries paid out of the money manager’s fee income to commission expense paid by the client!

How do you justify this, either to the SEC (assuming the agency weren’t clueless) or to clients?  The standard response was that this was normal industry practice.  How so?  …because that’s what the industry giant, Fidelity, does.  The mantra has been that if Fidelity allocates 15% of its commission volume to pay for research, it’s ok for everyone else to do that, too.

Just before the onset of the financial crisis, however, Fidelity, which has a large in-house research staff, decided to change its practice.  It proposed to the major brokers that it pay them a set cash fee for research each year, say, $8 million.

Brokers balked, for two reasons.  The money was been less than they were getting paid before.  It would have forced an internal reallocation of compensation away from the traders who run the firms to the researchers who were specifically identified with the fee income.

For other money managers–to my mind, the true target of the Fidelity initiative–this was a nightmare.  They could no longer use Fidelity as justification for their soft dollar spending.  In addition, their profits would plunge as they either paid out large portions of their management fee income to newly rehired research analysts or to brokers for their research output.  Smaller managers might be forced to close up shop.

The soft dollar issue hasn’t gone away.  Brokers, however, have “solved” their internal profit allocation problem in the short term by firing most of their veteran researchers during the downturn.  And Fidelity seems to have lost interest for the moment in pushing the issue.  …or at least publicizing it.  It may well be striking cash deals with small research boutiques.

I think Blackrock’s trading platform idea has similar elements of using large market size to damage smaller competitors while at the same time making a profit for itself.

net neutrality: one more time

Last week the FCC issued its latest pronouncement on net neutrality, the question of who regulates the internet–and therefore, implicitly, who owns it.  You can find the FCC releases and member commentary here.


Two pieces of background information are necessary to understand the meaning of the FCC statement.

1.  A while ago Comcast deliberately slowed down its service to BitTorrent, a file-sharing service.  Comcast said a small number of BitTorrent users were gobbling up huge amounts of bandwidth and slowing down service on its network for everyone else.  The FCC ordered Comcast to stop doing so.

Comcast successfully sued, arguing in court that the FCC didn’t have this kind of jurisdiction over it.  The case hinged on the FCC’s classification of the internet, not as a communications service, but as an “information” service.

Reading between the lines of subsequent statements by the parties and press coverage, the FCC decided to respond by saying it now realizes the internet is indeed a communications services, like plain old telephone service.  That would remove the internal contradictions in the FCC’s behavior.  But it would also potentially open the door to taxing internet access in the same way that phone service is.

Talk about driving a stake through the heart.  However, after hearing personally from over half of the members of the House of Representatives and a third of the Senate, the FCC changed its mind.

2.  In August, in the midst of the post-Comcast court victory discussion, Google and Verizon issued an internet manifesto (see my post).

what the FCC said

Last week’s FCC statement addresses the GOOG/VZN manifesto point by point.  The highlights:

–wired internet has one set of rules.  An ISP can’t block any content or services.  It also can’t deliberately slow down, or speed up, any particular content or services.  It can, however, offer different speeds of internet access to customers at different prices.

–wireless has another.  Basically, anything is ok, because the greater number of mobile internet service providers means consumers can switch ISPs if they don’t like what their current one is doing.

So far, this is more or less what GOOG/VZN suggested.  But…

–possible new services.  As I mentioned in my August GOOG/VZN post, I think GOOG wants to use its own money to build an internet service that’s more like the information superhighway that the rest of the developed world has, rather than the rutted country lane that ISPs have created in the US.  But before it invests billions doing so, it wants assurance that its service won’t be regulated as a public utility–that is, as if the network had been created with public money.  What GGOG/VZN got in this statement was just the opposite.

As I read it, the FCC says that a GOOG service would be subject to punitive regulation if it posed any threat to existing wired internet services.  But if a new service can’t be any better than today’s services, what’s the point?


The FCC asserts in its statement that it’s in charge–a reprise of Al Haig’s famous declaration, perhaps?  But the courts have been saying something else.  Congress seems to have the agency on a very short leash, as well.  And the new Congress may well have something more definitive to say.

Stay tuned.

municipal bond defaults (ll): implications

size of the market

Outstanding municipal debt amounts to something over $3 trillion.

I can’t find good figures for the breakout of the state vs. the local government portions of the debt (feel free to comment if you know).  The state portion, however, appears to be $2 trillion+ and the local government part $1 trillion-.

Over the past 15 years, the dollar volume of issuance has been roughly split into 1/3 GO, 2/3 project (revenue bonds).

State and local governments report unfunded deficits of around $1 trillion in the pension plans they offer to employees.  Independent observers suggest that if more conservative (and realistic) assumptions about the growth of assets are used, the underfunding may top $3 trillion.

Annual state revenue amounts to around $1.2 trillion.  Local government intake is about $900 billion.

hair-splitting, or maybe something a little more serious than that

Yes, there are unrated bonds.  Small local governments may find it too expensive to pay for a rating, for example.  Let’s ignore that market and ask:

How likely is it that fifty to one hundred cities or towns, involving hundreds of billions of dollars, default on their debts in 2011, as Meredith Whitney claims?

Eliminate GOs from consideration, since

–tax revenues are rising again,

–governments have lots of money relative to their outstanding debt,

–governments can be legally forced to reallocate funds to repay GOs, and

–GO defaults have been almost non-existent.

That leaves project bonds.

By far, the largest number of the 51 project loan defaults over the past forty years have been in health-care (21 instances) and housing (also 21).  The two currently comprise 6.6% and 10.6% of all rated municipal loans.

As I pointed out in yesterday’s post on municipal bonds, about .5% of the outstanding municipal project bonds have defaulted over the past forty years.  33 of those defaults occurred during the past decade, giving a ten-year default rate of .3%.


–to get $200 billion of defaults from the roughly $2 billion total outstanding of state and local project loans, it would be necessary for 10% of the loans to default, assuming defaulters were of average size.  That would be 333x the average number of yearly defaults over the past ten years.   Is this likely?  Unless municipalities want to default, probably not.

Others have commented that if we’re talking about bankruptcy rather than just default, the pool of possible dud loans shrinks to $600-$700 million.  If so, you can only get to $200 billion of defaults if a third of the outstanding loan amount goes bad.  This, in turn, can only happen if several of the biggest cities in the US, like New York City, or Los Angeles, go under.

My conclusion about the Whitney assertions?  I don’t know enough about the muni market to have an opinion.  My hunch, though, is that she has no case.

there is a problem, though

It’s possible that Ms. Whitney simply said what she thought she needed to say so that she would be endorsed as an expert on municipal bonds by Sixty Minutes–and thereby jump-start her new business. Arguably, she knew, or should have known, that what she was saying had little factual support.  But that doesn’t mean there’s clear sailing for state and local governments.  What got her on Sixty Minutes is the growing awareness of problems in municipal finance.

Two related problems actually.

The first is the size–personally, I believe the $3 trillion figure–of the unfunded pension liability for state and local government workers.

The second is the issue of state and local government budget deficits.  My thumbnail description is that governments are sized for the boom times of 2005-2006, and now are being forced by today’s lower revenues to downsize.

These are not problems of the magnitude of the financial crisis, when world commerce froze and corporations made massive layoffs. But they are significant.  And they’re gradually building, as companies and retiring Baby Boomers increasingly migrate away from high taxes and cold weather in the northeast and the midwest to warmer–and lower-cost–areas elsewhere.

Unattended, the pension problem will grow worse.  Balanced-budget requirements are forcing the second to be addressed.

effect on the stock market

…which is mostly what I’m concerned about.

I think the major effect will be to slow improvement in the unemployment rate, as state and local government layoffs offset private sector hiring to some degree.

I think it’s also possible that some municipalities will take the occasion of dealing with a budget deficit as an opportunity to address the pension issue by entering Chapter 9 and hoping to renegotiate contracts with employees.  That would doubtless make headlines and depress stock prices.  The process of change would also be long and arduous.  My guess, though, is that such events will be small enough that they’d represent buying opportunities rather than causing permanent damage to the market.

That leaves the states.  I think it’s telling that high-tax dysfunctional states like California, New Jersey and New York have recently elected governors who have run on platforms of fiscal responsibility.  As an equity investor, I find it impossible to handicap the chances of a material negative change in the financial situation of places like this.  I think Wall Street’s default option in such a case is to assume that the entities will muddle through.  Therefore, a sudden change in sentiment that had bond investors denying a state access to new financing could easily clip 5% off the S&P’s market cap.





municipal bond defaults (l): general

I’m finally trying seriously to formulate a detailed strategy statement for 2011.  As usual, I’ve waited to the absolute last minute.  In thinking about what might go wrong on a macro level, two issues stand out:

–possible EU sovereign debt problems and

–potential municipal financing difficulties in the US.

So I started doing research on municipal bankruptcies.

the slapstick

I learned there’s been a media firestorm over this topic during the past week, with real slapstick comedy overtones.  Putative municipal credit rater Meredith Whitney appeared on Sixty Minutes last week to predict that 50-100 cities in the US will declare bankruptcy next year, defaulting on “hundreds of billions of dollars” in debt.  This compares with the current record default year of 2008, during which cities stopped paying on about $8 billion of their obligations.  Muni experts were not amused.  They point out that the figure mentioned would imply just about every large city in the US going belly up.

Ms. Whitney is probably best known for being the spouse of former professional wrestling “champion,” John Layfield,  who performed under the nommes de guerre of “Hawk”  (a member of the Undertaker’s “Ministry of Darkness”), “Bradshaw,”  and “JBL.”  He is now a seller of herbal potions, as well as a financial commentator for Fox.  Whitney, also a financial commentator for Fox, gained fame while a bank analyst at Oppenheimer for her well-publicized (and correct) opinion that the financial crisis would be far worse than the consensus expected.

Though widely criticized for her non-consensus views on municipal finance, Whitney has found defenders, including Henry Blodget, a former Oppenheimer analyst himself, who is now barred from the securities industry as part of his agreement to settle securities fraud charges brought against him by the SEC.

the rationale

It’s not clear that Ms. Whitney has any deep knowledge of the municipal markets.  She does “get” the value of publicity, however.  And she has already been a big winner from understanding and exploiting two aspects of the traditional for-sale information business on Wall Street:

1.  Industry analysts depend for their livelihood on the viability and importance of the industry they cover.  As a result, they tend to gradually become like home-town sports announcers, that is, industry apologists.  They screen out any negative information.  That allows someone like Ms. Whitney to play the role of the boy who shouted out that the emperor wasn’t wearing any clothes.

2.  Sell-side analysts get noticed by staking out positions that are unusual and controversial, not by clinging to the consensus.  If radical positions prove wrong, customers quickly forget.  If the ideas are right, they’re the ticket to fame and fortune.  So a junior analyst has nothing to lose by getting as far away from the consensus as possible.

So not only is there a good chance that long-time observers of a section of the capital markets like municipals will ignore seemly obvious problems, but trying to point them out is a no-lose proposition.  So Ms. Whitney’s strategy of going out on a limb makes a lot of business sense.

the facts about municipals

two types of bonds

Municipal bonds are generally classified either as:

general obligation bonds, which means that the full faith and credit of the issuing government stands behind the issue, or

project bonds, or revenue bonds, which is basically everything else.  These bonds are backed by the revenue-generating power of some specific government-related endeavor.  They can range from a power plant or a road, to a nursing home or some more dubious private enterprise that uses municipal finance as a “conduit” or wrapper.

default rates are extremely low

According to data complied by Moody’s about issues rated by the agency, defaults on municipal bonds have been relatively rare.  Moody’s latest study covers the forty years from 1970-2009.  Of the 18,400 issues considered, 47% were GO issues, 53% project bonds.

Over that time period, 54 issues, or .3% of the total, defaulted.  Three of them were GOs, implying a default rate of .03% for GOs.  The project bond default rate was about .5%.

There has been some acceleration in the default rate, though.  36 issues, including all three GOs, have defaulted since the turn of the century.

In the defaults, investors’ recoveries have averaged 67% of principal.  The median recovery has been 85%.  The difference is caused by a few real clunkers of project financings where investors lost 95% of their money.

municipal bankruptcy isn’t easy to do

States can’t go into bankruptcy, period.

Cities and towns can go into Chapter 9 of the bankruptcy code, but require the permission of their states to file.  In a little fewer than half the states municipalities are simply prohibited from doing so.  In others, the process may be a lot more complicated–and time-consuming–than simply throwing a switch.

Chapter 9

Chapter 9 differs from the corporate Chapter 7 (liquidation) or Chapter 11 (reorganization), in that:

–the municipality must elect to enter Chapter 9.  Creditors can’t compel them to, as they can with corporate debtors

–Chapter 9 provides only for renegotiation of debt terms, not for liquidation

–the municipality continues to be in charge of operations, not a bankruptcy judge

–the municipality can’t enter Chapter 9 in anticipation of running out of money or even if it has decided to default on loans by simply not paying.  It has to be actually unable to pay.

In the case of a GO, if a municipality stops paying creditors can get a court order telling the municipality to raise taxes or do whatever else is necessary to raise the money need to cure the default.

Some commentators have observed that in the case of states, even those in the worst financial conditions, raising taxes by 2% would wipe out the budget deficits.  I don’t know if this is true or not.  I do think that matters are not that simple.  Higher taxes may increase non-compliance.  They may also hasten migration to areas (in the South or West) that don’t have income taxes.  As a practical matter, it’s entirely possible that raising taxes may result in a government getting in less revenue than before.

I’ve read, but been unable to confirm from the agency website, that the federal Government Accountability Office has recommended that municipalities use Chapter 9 as a vehicle for renegotiating employee pension obligations that they have previously agreed to but now find they aren’t able to afford.  In the few cases where this has been tried, however, the process is–as you might imagine–protracted and very contentious.

(In all this, remember that I’m an investor, not a lawyer.  My main point is that this area is much, much more complicated than it might seem at first.)

That’s it for today.  Tomorrow:  the scope of the problem and what effect it might have on the stock market.

2011 S&P profits

I usually don’t read Barron’s. Early in my career–and that was a long time ago–I combed through it carefully every weekend.  But I found that any time I relied on an idea that appeared in the magazine I lost money.  Of course, I was much less experienced then, and I had done what I considered careful research in every case.  But I concluded that, although I didn’t know why reading Barron’s did me no good, I knew that for me its ideas were toxic.  So I stopped.

Yesterday morning, I found complimentary copies of the Wall Street Journal and Barron’s on my front lawn.  So I brought both inside and paged through Barron’s for the first time in years.

It seems a lot more superficial than I remember it.  The Market Week section still has a ton of statistics, but the rest of the magazine struck me as a mere shadow of its former self.  It could just be me, but it may also be the effect of the change of ownership of the magazine that put it in the Rupert Murdoch empire.  After all, that same move clearly resulted in a sharp decline in the quality of the business information in the Journal.

Still, one column in the main section, Profit Growth:  From Great to Good, caught my eye (it also appeared online as: Yearning for Earnings in 2011).  It contained advice that didn’t exactly square with the evidence advanced for it, but the interesting part was a table from ThomsonReuters that aggregated the consensus earnings estimates of Wall Street brokerage firms for the S&P in 2010 and 2011.

In my earliest posts (I began writing this blog just before the market bottom in 2009), I’ve written extensively about what happens in the early days of a market rebound from recession. But we’re now 5 quarters from the low point in S&P profits, 6 quarters since the official end of recession and 7 quarters from the bottom in the stock market.  In other words, we’re no longer in the early days of recovery.  In a typical up cycle, lasting maybe three years, investor emphasis gradually shifts from value stocks that benefit from the overall economic rebound to growth stocks that are capable of generating their own earnings momentum internally, with only a mild tailwind from the economy aiding them.

The table illustrates the point or maturing recovery pretty sharply.  It shows that S&P earnings will likely have grown by 32% year on year in the fourth quarter.  That will cap off four quarters in which S&P profits will have expanded by 38% vs. the prior year.

Prospects for 2011?  A 13% advance, or only about a third of the rate of 2010.  A glance at value- and growth-oriented market indices suggests the corresponding shift from value to growth began to take place in early September.

The chart also breaks out growth prospects by industry, as follows:

–on the low-growth side of ledger:  utilities, health care, technology and staples

–on the high-growth side:  materials, financials, industrials, consumer discretionary and energy.

I’m not sure these figures are enough to base an investment strategy on.  On second thought, they may be useful in delineating the underperforming industries, the ones like health care and utilities that have persistently slow earnings growth.  So they show you the areas to avoid.

But this part of the market cycle typically also favors smaller capitalization names, so in an industry undergoing rapid structural change, like technology, the sub-par overall growth rate may mostly reflect the fact that newer, smaller companies are eating the lunch of older-generation giants.

Overall, the chart has two messages:  2011 offers the possibility of being another 10%+ year for stock prices, but it will be harder to achieve outperformance than 2010 has been.

fixing mistakes: psychological barriers

Merry Christmas!!

One of my first bosses used to say that it takes three good stocks to offset the negative effects of one clunker.  Today, I’m not sure that’s the right ratio–a lot depends on investment style.  Also, I think the number is bigger than that in bear markets, where bad news is discounted heavily and good news is ignored, and smaller in bull markets.  But the ratio is certainly greater than 1 at all times.  That’s why it’s catching mistakes early is crucial to investment success.

Recently I’ve been reading books on decision-making.  I got the first, Jonah Lehrer’s How We Decide, from one of my sons.  I saw a review of the second, The Art of Choosing, by Sheena Iyengar, and bought it myself.  Both cover a lot of the same material, and in the same order.  This may be due to the Columbia connection between the authors.  Lehrer was an undergraduate there; Iyengar teaches there.  How We Decide is more readable and refers to a much larger number of experimental results.  The Art of Choosing focuses more on research Ms. Iyengar has done herself, and emphasizes that the psychological picture we create of ourselves for ourselves will be internally consistent–but won’t always correspond with reality.

Both books highlight the fact that we all tend to hold beliefs that we come to on a non-scientific basis.  For example, we all tend to think that we’re above average at just about everything we do.  Once we’ve made a decision, we tend to defend it by searching only for information that reinforces our opinion.  We also tend to ignore or screen out any data that calls our initial decision into question.  In fact, if we have believed something different in the past, we also gradually rewrite our memories (shades of Orwell) so that we come to believe we’ve always thought what we think now.

Even worse than all this, the more important the initial belief, the more likely we are to do this.

While this tendency may be relatively harmless if I think I’m handsome or witty or a good dancer, it’s an absolute disaster for an investor.  It’s a very great difficulty for professionals, who need very strong egos to withstand two aspects of the job:  many of the economic factors that influence the portfolio are outside the manager’s control, and at least 40% of the decisions managers make turn out to be wrong.

The professional manager has to keep his confidence from shattering, but at the same time be open enough to reality to stop his mistakes from destroying his portfolio performance.

How do you do this?

Two ways:


You have to be aware of the tendency to need to be right all the time, and resist it.  You have to actively scan news sources to look for negative information about your investment ideas.   A professional has to make it clear to sellers of research that you don’t regard a negative opinion or negative information as insulting or a reason to stop associating with them.


In my experience, every portfolio has its dark corners where underperforming stocks fester. Periodic performance measurement and stock-by-stock attribution analysis are the only cures.

Some investors–I’m not one of them–will also have mechanical rules that compel them to immediately sell a stock if, for example, it drops by 15% from its purchase price or earnings results fall short of internal/external analysts’ estimates.  The first rule seems to me to work better for value investors than their growth counterparts.  The second appeals to me more, but–at the risk of succumbing to the self-deception I’m writing about–I don’t subscribe to it.  My issue:  the risk of missing an AAPL or a MON or a COH because of a temporary earnings disappointment is too high.