alternative investments, the SEC and Trump

My earliest experience with alternatives was as a rookie analyst in 1979. Among other things, I was covering small oil wildcatters who funded themselves by promoting oil and gas limited partnerships sold through retail brokers. The 1/2″-thick prospectuses laid out terms that were so unfavorable to limited partners that at first I couldn’t understand why anyone would buy them. So I asked the VP Finance of one of my coverage companies. He laughed, and said the offerings were not for people who wanted to make money. They were for people who wanted to tell others at a party that they were wealthy enough to have an income tax problem.

I remember a China-oriented private equity fund whose prospectus touted the promoters’ prowess through their extraordinary history of high returns. The returns were high–but, after fees, they matched almost exactly those of the Hang Seng index. Again, lots of sizzle but…

As part of the financial reform after the financial crisis, and because of widespread improprieties in the alternatives industry–like misstatement of returns, or professional credentials, or size of assets under management …or other stuff I’d call flat-out fraud–many alternatives providers were required to begin filing reports with the SEC, which has since prosecuted a number of high-profile cases of abuse.

Trump is now taking two actions in support of alternatives, both of which seem to me only to be pluses for dubious alternatives promoters. He’s proposing that ordinary investors be allowed to buy alternatives in 401k accounts (they’ve been barred as too opaque and risky). He’s also “solving” the issue of fraudulent reporting by ending the mandate that smaller alternatives firms to file their results with the SEC (removing the threat of Federal prosecution for, say, falsifying returns).

Neither makes any sense to me. Why do this? Maybe the same reason Trump has made no effort to keep his promise to eliminate the carried interest ploy private equity managers use to avoid income tax.

regulating money market funds

In the aftermath of the financial crisis, the government has been considering the risks to financial stability posed, not only be banks but also by asset management firms.  As part of this effort, the SEC is about to set new regulations for money market funds this week.

what money market funds are

One of the most important economic (and stock market) trends of the past half-century has been the emergence of focused single-purpose entities to compete with large conglomerates.  In retail, specialty firms selling jewelry, toys, household goods or electronics have offered an alternative to department stores.

In finance, money market and junk bond mutual funds, have offered alternatives–to borrowers and savers alike–to commercial banks.

Money market funds have several important characteristics:

–they provide short-term, working capital-type loans to borrowers

–as mutual funds, they promise to accept daily subscriptions from savers and allow daily withdrawals in unlimited amounts

–they have typically offered higher yields than bank savings accounts–sometimes far higher yields

–they can offer the ability to write checks against deposits

–they promise, at least implicitly, to maintain net asset value at a stable $1 per share.  In other words, they promise that, like a bank deposit, you won’t lose any of the principal or interest you have in the fund

–because a money market fund is not a bank, its deposits are not government insured.  The “no loss” promise relies solely on the good will and financial strength of the investment company offering the product.

the risks

According to the Investment Company Institute, US money market funds currently hold $2.57 trillion in assets.  That’s a lot of money.

In times of stress, the warts in money market funds begin to show.

They come in two related varieties:

–as a practical matter, many funds are so large that they might not be able to meet redemptions if large numbers of shareholders lost faith in either the industry or a particular fund and headed for the exits,

–because money market funds compete with each other primarily on yield, inevitably someone (or more than one) will hold his nose and make a sketchy loan simply because the interest payments are high.  In a crisis, such loans may not be worth what a fund paid for them; in the worst case, the borrower will default.    In past crises, including 2008-09, there have been times when dud loans are big enough to make it questionable whether the real NAV of a given fund should still be $1.00 and not $.99.  These situations have typically been resolved by the management company that offers the fund buying the securities in question from its money market fund at face value.  But there’s no guarantee this will happen in the future.  And a single fund that “breaks the buck” by writing down assets in a crisis could easily spark an industry-wide panic.

new rules

This week the SEC is expected to issue new money market rules to meet these concerns.  They’ll include:

–many money market funds that don[‘t exclusively own Treasury securities will be required to have a floating NAV, and

–funds will have the ability to suspend redemptions in times of financial stress and/or impose withdrawal fees on those wishing to get their money back.

my take

I think new rules will have their greatest impact on the investment practices of money market funds.  They’re now generally regarded as a utility-like service that requires little investment skill or management oversight to run.  That will change.  No firm will want to be the first to impose withdrawal fees or suspend redemptions.  Certainly, no one will want to destroy their reputation for financial integrity by recording an NAV different from $1.00.  As a result, management oversight will increase and investing practices will become more conservative.

For all practical purposes, NAVs will remain stable at $1.00.

For savers, the FDIC insurance offered by bank deposits will become a bit more attractive.  Since, however, 2/3 of money market shares are held by institutions, I don’t think there will be a massive shift away from money market funds when the new rules take effect.

the “dark pool” investigation

Someone with a Dungeons and Dragons background must have named them “dark pools.”  But they’re neither mysterious nor scary.  Dark pools are just off-exchange automated trading networks for stocks.

They exist for two reasons:

–the old school method of having a trader in a money management firm call up a broker and place a buy or sell order by phone is expensive.  And money managers have a legal obligation to obtain the lowest cost execution of their orders on behalf of clients.  So they have a positive obligation to seek out cheaper ways of doing business–which automated networks are.

–brokerage house traders won’t keep a money manager’s order secret unless the manager is exceptionally diligent.  This is a real hassle, and very time-consuming for the  money manager’s trading room.  But if you don’t pay extraordinary attention, your secret trading plans–which, after all, are your stock in trade–will be all over Wall Street in a nanosecond.

Automated trading networks have one–no, make that two–defects:

–they can be relatively illiquid, so that very large positions may not be able to be moved quickly, and

–many of the biggest of them are run by investment banks/brokerage houses.

This second characteristic is the reason for the current SEC investigation.

In a recent post, I wrote that Fidelity was exploring the possibility of forming its own automated trading network with other money managers, cutting out brokers altogether.  Its reason, I thought, was that computer=based high frequency traders were able to deduce Fidelity’s trading plans by analyzing dark pool data–and that Fidelity wanted to create a venue where they’d be banned.

It appears I may have been too high-tech in my approach.  The SEC investigation appears to focus on two possibilities, both of which are decidedly old-school brokerage behavior and both of which would violate the guarantees the automated network operators give to clients:

–the first is that the operators may have taken undisclosed fees from high-speed traders to allow their buys and sells to have priority over other order–essentially letting them front-run or scalp other participants

–the second is that operators may have taken the supposedly anonymous trading activity of high-profile participants and sold its details to others.  I say “sold” but in my experience, the compensation for such information would normally not be in cash but either in increased trading volume or higher per-trade fees.

Personally, I don’t think dark pools themselves are the issue.  I view them as part of the solution to a problem with how traditional brokerage/investment banks are run.  And the fact that the old system is breaking down makes these firms even less willing than normal to give clients an even shake.

It will be interesting to see how the SEC investigation progresses.

 

 

Madoff and JPMorgan Chase

another JP Morgan legal settlement

Yesterday JP Morgan and the federal government announced a deal.  The bank has agreed to pay fines of $2.6 billion and to reform its operating practices, in return for not being prosecuted for offenses relating to the Bernie Madoff Ponzi scheme.

Although the press reports are a bit confusing, the offenses seem to fall into two areas:

–Madoff routinely made transfers in and out of his accounts in excess of $10,000 a day.  Chase did not report these to the government as required by anti- money laundering statutes.  At least some of these transfers were rapid-fire movements from bank to bank, designed to allow Madoff to illegally collect interest on the deposits from more than one institution (“check kiting”).

–Parts of JP Morgan refused to invest the bank’s money with Madoff on the grounds that he was running a Ponzi scheme.  Other parts of JP Morgan happily continued to service Madoff, to buy his products, and to help sell them to others. Also, In the days just before Madoff’s arrest, JP Morgan withdrew most of its own money from Madoff, apparently because of fears of fraud.  The bank notified the UK government of this, but, oddly, not the US.

my take

To me, the plea deal is more evidence of a sea change in the attitude of regulators toward the financial industry since Mary Jo White became head of the SEC.  Long overdue.

In my experience, in every company there’s a tension between politically powerful senior managers who are identified with, and benefit from, the revenues generated by someone like Madoff and the relatively junior researchers who understand the facts better and are more aware of what the law requires.  The former can put up immense resistance to fixing problems.  Their allies can simply refuse to act on, or even to read, the case for a different course of action.

I’ve seen some of the Madoff sales materials.  They assert that phenomenally high returns are to be had with virtually no risk.  No explanation of how this is possible, just a simple appeal to greed.

Current media coverage is highly favorable to government investigators.  What seems to be forgotten is that Harry Markopolos, a financial analyst whistleblower with very detailed evidence of the Madoff Ponzi scheme, repeatedly showed up at SEC offices from 2000 onward to present his case.  He was ignored every time.  (Markopolos was asked by his boss to create a clone of Madoff.  He soon realized that there were periods where no assets delivered the returns Madoff claimed.)

The most elementary checks of the phony documentation Madoff prepared would have revealed the fraud.  But in their periodic inspections, the SEC appears to have checked virtually nothing.  Madoff himself commented on how easy the SEC was to fool.

accredited investors and the JOBS Act

“accredited” investors

When you open a brokerage account in the US, you fill out a form that requests information about your income, risk tolerances and investment knowledge.  From what I can see, it gets only superficial scrutiny.  But saying that you have some money and understand the risks of investing in various types of publicly traded securities does two things.  It gets you a seat at the table and it protects your broker from customer lawsuits claiming they lost money because they didn’t understand what they were getting into.  In a sense, passing this vetting process makes you accredited–but that’s not what the term “accredited” usually means.

Instead, it refers to the same kind of vetting process, but for private placements–purchases of securities not registered with the SEC and not sold through the traditional (expensive and time-consuming) IPO process carried out by the big brokerage houses.

For individuals, “accredited” means you have $1 million in assets, not including your principal residence, or you earn at least $200,000 a year.  (There’s a different criterion for institutional investors who want to trade in non-registered–usually foreign–securities.  To be accredited in that sense means having $100 million in investable funds under management.)

The bottom line:  “accredited” means either you’re in the top 1% or pretty close.

not good enough for the 21st century

In the pre-internet, pre-JOBS Act, pre-Mary Jo White world, that was ok.  Private placements were restricted to a very small number of individuals, whose main characteristic is that they can afford losses they might incur in buying risky securities.  The wealth criterion also effectively preserved the near-monopoly on public issuance of securities of the big brokerage houses on Wall Street.

That’s all changing.

the new order

There are already special rules to allow crowdfunding sales of securities.

For the JOBS Act (which allows smaller, early stage companies to raise funds with only limited disclosure) to be truly effective as a  capital raising vehicle for business startups, the pool of investors has got to be larger than just the usual “accredited” suspects.

Interestingly, at the same time as the newly active SEC is saying it sees some merit in things like bitcoin, the agency is also preparing to overhaul the definition of what an accredited investor is.

The new emphasis appears to be on accrediting people who have knowledge, training or experience that gives them insight into the risks and rewards of investing in a startup rather than just being able to take their lumps if an investment goes south.

I don’t know whether this is a good thing or not.

But Washington passed the JOBS Act last year to make it much easier for startups to raise money.  And, contrary to Mary Shapiro’s foot dragging, Mary Jo White is certainly going to set rules of procedure to allow the Act to function.  And that means opening this class of investments to more potential buyers.

do think, however, that this will turn out to be another instance of a new internet-based business model undermining an older higher-cost pre-internet one.  It will be interesting to see how–and if traditional brokerage/investment banking firms will adapt.  I suspect that this change will have far greater ripple effects than anyone now expects–maybe even momentous ones.

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