Category Archives: Where are the customers' yachts?

TVIX: an expensive lesson about an exotic exchange traded note

March 30, 2012 By in Derivative instruments, ETFs Vs. Mutual Funds, Getting financial advice, short selling, Where are the customers' yachts? Tags: , , , , , , , , Leave a comment

TVIX

TVIX is the ticker symbol for “Velocity Shares Daily 2x VIX Short-Term” ETNs (exchange traded notes), sponsored by Credit Suisse.  What a mouthful!

They’ve been in the news recently because of very big losses some buyers of them have suffered.

what it is (hang onto your hat)

An ETN is something like an ETF, except that what the holder is buying is not an ownership interest in a collection of equity securities but rather a piece of a debt security issued by the investment bank that sponsors the ETN.

In the case of TVIX, the debt instrument in question is a promise by Credit Suisse to pay the holder an amount that’s tied to the performance of futures on the CBOE Volatility Index, or VIX.  Although in form the actual note issued by CS is a debt instrument, in function it’s very much like an OTC derivative contract.

The 2x in the name means the ETN is leveraged.  It’s designed to deliver 2x the return on the VIX.

Daily means it’s re-leveraged each day to deliver 2x the return on the VIX.  The significance of this daily recalibration is that the return over longer periods of time can be significantly different than 2x leverage over that span, depending on the sequence of daily gains and losses.

The VIX is a measure of expected volatility, or movement of the S&P 500 index away from the current level–up or down–over the coming 30 days.  It’s calculated based on the prices of near term puts and calls on the S&P.

what happened

ETFs and ETNs typically act like open-end mutual funds.  When new buyers want the securities, the sponsor satisfies demand by issuing more.  When sellers want to redeem, the sponsor cashes them in.

In the case of TVIX, Credit Suisse hedges the risk it takes in issuing the note by maintaining an offsetting position in the actual VIX futures contract. A month or so ago, however,  CS reached the maximum position size allowed by the Chicago Board of Exchange.  When it did, CS stopped issuing new ETN shares.  At that time the net asset value of TVIX was about $15/share.

Over the ensuing weeks, as the S&P 500 meandered, the VIX fell sharply and the NAV of TVIX plunged to about $7 a share.

And here’s the strange part…

…retail buyers didn’t notice. 

They continued to pay $14-$15 a share for TVIX, despite the plunge in value of the underlying note!.   At the worst point investors were paying over 2x NAV!!!   That’s like going to the bank to get change for $20 and being satisfied with $10 in coins.  Who would do that?  From looking at the charts it appears that at least a million shares or so traded at this level of misvaluation.

Then short sellers appeared and the bottom fell out. TVIX, which is trading a bit below $7.50 now, bottomed around $6.

the lesson(s)?

1.  Unlike mutual funds, ETFs and ETNs don’t trade at net asset value.  They trade at whatever price willing buyers and willing sellers meet.

2.  As far as I’m aware there’s no publicly available data on average bid-asked spreads for any ETFs or ETNs.  But the VIX price is available in real time, so it should have been easy to make a rough guess at NAV–and theefore the premium one would be paying.  It’s hard to believe that no buyer did any homework.  The broker acting as an agent in the transaction certainly knew what net asset value was.

3.  The broker you place the order with is an agent.  He has no obligation to tell you you’re doing something incredibly stupid.  (Caveat emptor.  Welcome to Wall Street.)

4.  I wonder who the short sellers were and how they got the idea to sell TVIX short.

5.  Where do you think the stock the short sellers borrowed to sell came from?   …from the accounts of the retail investors who held TVIX and whose brokerage agreements allowed their firms to led out their holdings, that’s where.  Translation:  from just about any retail holder.

According to the Wall Street Journal, which doesn’t seem to get the misvaluation–which I think is the most interesting part of the story–the SEC is investigating.  Why?   …because the shares plunged just before Credit Suisse announced it would begin to issue new TVIX shares.

the SEC, Citigroup and moral hazard

December 1, 2011 By in Banks, Derivative instruments, Industry Analysis, Investment firms, moral hazard, securities markets, Securities regulation, short selling, Where are the customers' yachts? Tags: , , , , , , , Leave a comment

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

November 11, 2011 By in Banks, Derivative instruments, Industry Analysis, Investment firms, Securities regulation, Where are the customers' yachts? Tags: , , , , , , , 1 Comment

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.

Goldman’s trading “huddles” are back in the news again

May 13, 2011 By in Getting financial advice, Investment firms, Trading, Where are the customers' yachts? Tags: , , , , , , Leave a comment

Reuters reported on Tuesday that the Massachusetts Securities Division is considering administrative proceedings against GS for its conduct in weekly meetings of analysts and traders, called “huddles.”

I wrote about the Goldman huddles when the news first broke a little less than two years ago, so you can read more detail in that post.  It’s not clear whether the meetings still go on, but when the Wall Street Journal revealed their existence, the huddles were weekly get-togethers of GS’s analysts and proprietary traders.  Their purpose was to develop short-term trading ideas involving stocks GS analysts covered.

The issue is how the results, which sometimes ran contrary to the recommendations in GS’s published research, were disseminated.  GS apparently used them in its own trading.  Institutional salesmen privy to the meetings’ output passed the ideas on to a small number of the firms largest clients.  However, GS didn’t inform the rest of its customers, who were left to act on an official “buy” recommendation when favored clients were being told to “sell.”

Massachusetts has long been a leader in sticking up for the rights of ordinary citizens in financial matters, so this is an interesting situation.  I don’t think the case is as open and shut, however, as, say, the Raj Rajaratnam insider trading case was.  Three reasons:

1.  Every GS research report contains several pages of disclosure in small print at the end (I’ve checked).   Sometimes the disclosure section is longer than the report.  But the fact that GS may act against its official recommendations and tell different things to different clients is among them.

2.  According to the WSJ, analysts were “guided” not to utter the words “buy” or “sell” in the meetings.  So while circumlocutions may have made it clear what the conclusions arrived at in the meetings might have been, establishing that in court might be hard.

3.  GS equity research really isn’t that good, in my opinion.  Its strength has always been the collection of large amounts of factual information about companies and industries.  Its weakness is analysts’ judgment.  And the firm has slipped badly in the annual research department rankings by the Institutional Investor magazine, among others, in recent years.  So GIGO might be another defense.

One other note:  the Reuters article refers to the recently-issued GS 10Q.  Footnote 27 to the financial statements mentions in a general way GS discussions with the Massachusetts regulator.  Either the Reuters reporter is incredibly observant, or someone (the regulator?) called her attention to it.  Can it be that what we’re seeing are the first steps in a systematic investigation by regulators of Wall Street behavior before and during the financial crisis?

“Financial Markets 2020”: an IBM study of the investment management industry

April 7, 2011 By in Getting financial advice, hedge funds, Industry Analysis, Investment firms, Where are the customers' yachts? Tags: , , , , , 4 Comments

the survey

Talk about ugly.

In the April 4th issue  of FTfm, its review of the fund management industry, the Financial Times outlines the conclusions of an as yet unpublished study by IBM of the investment management industry, Financial Markets 2020.

the findings

FM2000’s bottom line?  …the worldwide investment management industry loses US$1.3 trillion of its clients’ money every year.  That’s over $100 million during the time it takes a fast reader to reach this point in the post.  Wow!!

The main offenders?  Here they are, in order of the magnitude of client losses:

—$459 billion        credit rating agencies and sell-side research, because the analysis is weak

—$300 billion        fees paid to underperforming portfolio managers

—$250 billion        fees paid for advisory services that underachieve

—$213 billion         excess expenses caused by investment managers’ organizational inefficiency

—$51 billion           fees paid to underperforming hedge funds.

the conclusions

IBM argues that clients are gradually waking up and smelling the coffee  …and firing the offending service providers, as they work out how bad the performance has been.  The computer giant thinks upward of a third of the people involved in today’s fund management industry will be gone before clients are through with their housecleaning.  Among sell-side researchers and credit rating agency analysts, the winnowing will remove closer to half.

my thoughts

First of all, I haven’t seen the study.  I’m assuming that it’s being accurately portrayed in the FT.

In the nitpicking department, the data seem to have come from an internet survey.  If so, its conclusions represent the input of the respondents, and may not be representative of the views of clients as a whole.   In addition, the numbers are overly (maybe “ludicrously” would be a better word) precise, suggesting inexperience on the part of the IBM Institute for Business Value, which wrote the report.  The assertion that credit rating agencies et al lose their clients $459 billion a year implies the figure is not $458 billion or $460 billion.  How could IBM possibly be confident that this is right?

The general direction of the report is doubtless correct, though.  Early in my career as an investor, I remember reading the famous comment by Charles Ellis, the founder of Greenwich Associates, a pension consulting firm, that the average portfolio manager is just that–average.  At the time, I was offended.  Thirty years later, I’d be tempted to amend it to read that the average portfolio manager is just that–a little below average. The credit rating agencies have been notorious for as long as I’ve been in the business for being behind the curve.  And everyone knows, or should know, that brokers make their money by having you trade with them, not by having you achieve superior returns.

I think IBM’s idea that clients will quickly take the axe to many of their investment service providers is much too simplistic.  Yes, chronic underperformance is a big issue.  But there seem to me to be three factors IBM overlooks:

1.  The head of virtually every investment management organization is a highly polished marketer, not an investor.  A big reason for this is that investment firms are not only in the business of selling performance, they also sell intangibles–like feelings of prestige, exclusivity, reliability, safety–especially to individuals.   Some people will hire a hedge fund manager instead of buying a Vanguard index fund (which will likely provide superior returns) for the same reason they buy an $8000 Hermès leather handbag instead of a $50 nylon equivalent, or a $150,000 Porsche instead of a $30,000 Subaru Impreza.  It’s to exhibit their wealth.  Having your yearly performance review in a major city, with dinner and a show and your favorite flowers in the hotel suite your manager provides may be just as important as the performance figures–maybe more so.

2.  Companies typically don’t want to manage their employees pensions money in-house for legal reasons.  Hiring a pension consultant and a series of specialist third-party managers transfers responsibility to them.  Doing so acts as a form of insurance.

3.  Suppose you go ahead and fire all your investment advisors.  What do you do then?  What do you substitute for them?  Maybe losing a trillion dollars a year is good in comparison with the alternatives.