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Category Archives: Derivative instruments
a former MF Global CEO is now managing NYC pension investments
in the Wall Street Journal
In an odd article at the top of the front page of the December 1st Greater New York section of the Wall Street Journal, the newspaper heralds NYC’s hiring of Kevin Davis, a former CEO of MF Global, who was replaced there in late 2008. Mr. Davis has been overseeing commodities investments for the city’s Bureau of Asset Management for about three months. Lawrence Schloss, himself a former director of MF Global, selected Mr. Davis for the job, saying he has 26 years of experience and was the best candidate to apply.
details
The article goes on to to relate, without analysis or comment, that:
–Mr. Davis is earning a salary of $175,000–which is less than 1% of his compensation during his last full year at MF
–MF Global’s stock lost over 90% of it value during his tenure
–MF was subsequently sued by pension funds for misrepresenting its risk management practices, a case that MF recently settled by paying $90 million.
any significance?
There’s nothing in the article, other than its prominent placement, to indicate that there’s anything amiss with the hire. And the placement may be more the result of political differences between the city Comptroller and News Corp than of anything else.
Two things strike me, however:
1. NYC, like many government bodies, seems to be an advocate of the penny-wise-pound-foolish school of investment manager compensation. A competent commodities person would make many times what the city is offering. Mr. Davis may have been the only candidate to apply.
2. The event that ultimately led to Mr. Davis’s demise at MF was discovery of $141 million in losses from unauthorized wheat trading by a broker in MF’s Memphis, Tennessee office. According to theFinancial Times, the trader wasn’t a “rogue” who evaded management controls; the company’s computer systems weren’t programmed correctly.
Two years later, we’re finding again that MF Global’s computer recordkeeping systems are inadequate. In fact, the records are in such a shambles that no one has been able to figure out how much customer money is missing from the firm–other than it’s a lot–or where it went. I doubt Jon Corzine found top-notch recordkeeping systems when he arrived at MF and dismantled them (for what it’s worth, he doesn’t strike me as the kind of guy who would have looked in the first place). My hunch is that they’ve been inadequate for a long time and that no one investigated properly, or extensively enough, after the 2008 trading losses. There may well be much more to the MF Global story today than deficient computers. But I think anyone using the in-house systems should have immediately realized their inadequacies and at least insisted they be fixed.
the SEC, Citigroup and moral hazard
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
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
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.