Felix Salmon - All posts

Sell-side research isn't inside information

Sat, 19 May 2012 18:25 GMT

Ted Parmigiani, a research analyst, was fired by Lehman Brothers in 2005, after he upgraded a company called Amkor from Sell to Neutral. He discussed his upgrade on the firm-wide squawk box at 10am on June 1, and it seems that he was hoping that his upgrade would move the market. He was disappointed: while Amkor did rise that day, it rose before his 10am call, rather than after it. Convinced that the early-morning move was attributable to Lehman insiders and their clients buying Amkor with foreknowledge of his upgrade, Parmigiani started a series of complaints.

First, Parmigiani complained to Lehman superiors; that just got him fired. So he filed a wrongful-termination suit, which got settled out of court. And with his suit behind him, Parmigiani kept on complaining about what had happened. First he went to the SEC, which looked into his allegations and found no evidence of wrongdoing. After striking out with the SEC, Parmigiani complained to Senator Charles Grassley, and also to Preet Bharara, United States attorney for the Southern District of New York. Again, nothing. Finally, with nowhere left to go, and despite the fact that Lehman went spectacularly bust back in 2008, Parmigiani went to Gretchen Morgenson, some seven years after the events in question happened. And this time, he got results, if by “results” you mean a big 3,000-word article in the New York Times.

I'll let Morgenson explain what Lehman is supposed to have done wrong:

Mr. Parmigiani says traders there were routinely advised of changes in analysts’ company ratings before those changes were made public. That way, Lehman could profit on subsequent market moves. Here is how he describes it: First, research officials tipped off the traders; then Lehman’s proprietary trading desk, which cast bets with the firm’s own money, positioned itself accordingly. Lehman salespeople also alerted favored hedge funds. Only later, he says, were ratings changes made public.

I have to admit that I'm a bit confused with what exactly Morgenson means by the phrase “made public”. I, for one, never had access to Lehman Brothers squawk-box calls, and I've never seen sell-side upgrades or downgrades filed with the SEC or be made subject to Reg FD.

Now it's true that the SEC does consider the news that an investment bank is going to change its rating on a stock to be material nonpublic information, and therefore subject to insider-trading rules. But it's a very weird, grey-area sort of inside information. Let's say Lehman upgrades Amkor: is that inside information about Lehman, or is it inside information about Amkor? The news would be very unlikely to affect Lehman stock, so it's not really the former. But at the same time, no Amkor insiders are involved at all, so it's hard to see how it can be the latter.

There can't and shouldn't be any rule against analysts doing independent analysis on companies, based on publicly-available information. Similarly, once that analysis has been done, the analyst can do what she likes with her analysis. She can trade the stock, she can write it up, she can talk to hedge funds about what she thinks, she can sell it to clients, she can make it public. Or, she can do all of the above, in any order she likes.

The tricky thing happens when that analyst gets a job at an investment bank, and the individual's analysis mutates into being the bank's analysis. There's a kind of invisible special sauce which a bank pours onto its analysts' reports: if Joe Schmo puts out a “buy” rating on XYZ Corp on Seeking Alpha, few people will notice or care. But if Mr Schmo gets a job at Goldman Sachs, then that rating can move XYZ shares. And at that point, the SEC starts getting interested.

Now the SEC does not say that banks need to make their research reports fully public. In its complaint against Goldman Sachs “huddles”, for instance, the SEC has no problem with news of upgrades and downgrades being “disseminated broadly to all clients of the firm”. There's a huge difference, of course, between the set of Goldman Sachs clients and the set of public-company investors, but as far as the SEC is concerned, it seems that if all of Goldman's clients have a certain piece of information, then that piece of information can be considered to be public information.

Similarly, Morgenson and Parmigiani seem to think that once a call has been made on the Lehman Brothers squawk box, that too counts as public information. If something's available — in theory — to any Lehman client, then it's public. If it's only available to select Lehman clients, then it's inside information.

Here's Morgenson:

While insider trading commonly involves nonpublic corporate information, advance warning on research changes can also yield quick, illicit gains. The S.E.C. said as much in a rare research case it filed in 2007 involving an executive at the Swiss banking giant UBS. In that case, eight individuals and three hedge funds were charged with profiting on tips about coming analyst ratings changes — “valuable and material, nonpublic information,” the S.E.C. said. One executive went to jail, and others settled with the S.E.C.

This is disingenuous. The case in question involved individuals, not the bank as a whole: a UBS executive director, Mitchel Guttenberg, was personally tipping off his friends, in return for under-the-table payoffs, about upcoming UBS upgrades and downgrades. In that sense, the case is really about misappropriation rather than about insider trading. As John Carney explains, using the example of Foster Winans:

An employee’s undisclosed and self-serving use of information belonging to his employer to trade securities is a securities fraud. The employee is “misappropriating” the information from his employer and using it for his own personal gain…

If the Wall Street Journal had authorized Winans to leak to his roommate and his stockbroker, no violation would have occurred. In that case, there would be no breach of duty to his employer, which means there’s no misappropriation.

In other words, as far as I can tell, no one has ever been successfully prosecuted for the crime that Morgenson and Parmigiani are so upset about here — the crime of giving information about ratings actions to some clients before other clients. The Goldman huddle case, in particular, seems particularly thin: the SEC is basically shocked — shocked! — that before an analyst upgraded a company, that analyst was bullish on the company in question. Whereas the rest of us would probably be shocked if an analyst wasn't bullish before upgrading a company. And in the end, the Goldman huddle case was more about internal controls than it was about inside information.

The fact is that if no corporate insiders are involved, there's really no good reason at all to prosecute or criminalize anybody using information they've obtained to act in the markets. The markets should be a game of people using independently-obtained information and analysis to make their own determinations about what various securities are worth — that's the best way to maximize the amount of information reflected in the price of those securities.

As the Facebook IPO demonstrated, pricing securities, especially stocks, is always more of an art than a science. Facebook's underwriters thought they had a pretty good handle on where the demand was for Facebook's stock, but they were wrong: all those investors were deliberately upsizing their orders just because they knew they wouldn't get all the shares they were asking for. And because they also reckoned they could lock in a nice profit by selling some of their shares at the very first tick. By the end of the day, Facebook's banks were being forced to buy back stock, in significant quantities, at the same price they'd sold it.

So let's let brokerages' clients trade what they like, so long as they're not trading on genuinely inside information from the company in question. If we're going to be serious about the Volcker Rule, and prevent the brokerages from trading for their own account, the least we can do is let them monetize their analysts' research as best they can.

Much ado about nothing

Fri, 18 May 2012 15:17 GMT

567 million shares of Facebook changed hands today — that's more than the total number of shares issued — at a volume-weighted average price of just over $40 per share. To put it another way, the whopping move from the IPO price of $38.00 to the closing price of $38.23 came with more than $22 billion of trading activity, and undoubtedly left the underwriting banks with rather more Facebook stock on their books than they had been hoping for. But that's what it means to be an underwriter.

For anybody disappointed that they didn't get their full initial allocation of stock, or who thinks that small retail investors can't buy into IPOs at the same price that large institutional investors can, this is great news: Monday's going to be a do-over, with everybody being able to buy Facebook stock at the IPO price.

This of course helps to point up just how silly all the Facebook IPO hype really was. Yes, Facebook is now a public company, but it's still controlled by Mark Zuckerberg, and the IPO itself was a bit of a farce: delayed at the open, artificially supported by the underwriters at the close, and mainly serving to demonstrate that a brand-new company, which no one knows how to value, trading at a stratospheric valuation, can still somehow end up trading within an incredibly narrow range on enormous daily volume.

For that, you can probably thank the surprisingly old-fashioned book-building process, where a team of investment bankers took Facebook on a classic roadshow, complete with a slick and rather embarrassing video, all for a record-low fee of 1.1% of the proceeds. Still, never mind the low fee: the bankers were paid to do a job, and they did it, providing a rock-solid bid at exactly $38 per share and thereby sending a clear signal to any potential future client: we're never going to let investors lose money on the first day. Frankly, there are worse ways of spending money to try to bolster your reputation.

But while this was an incredibly important deal for people working in equity capital markets, it really wasn't important for the rest of us. Facebook today is the same as Facebook yesterday: a site where we keep in touch with our friends, and a means of staking out a bit of personal identity on the internet. If you think that's a hugely valuable proposition, then there are hundreds of millions of shares available, now, for you to buy on the open market. And I'm quite sure that there's no shortage of big investment banks who would be positively delighted to sell them to you. Ideally, for them, at a price somewhere north of $38.

Counterparties: Facebook's share price is a number

Fri, 18 May 2012 14:56 GMT

Welcome to the Counterparties email. The sign-up page is here, it’s just a matter of checking a box if you’re already registered on the Reuters website. Send suggestions, story tips and complaints to Counterparties.Reuters@gmail.com

Facebook is now a public company. And on its first day of trading, Facebook, well, traded, and investors who bought a $38 stock now own a $38 stock, after Facebook's underwriting banks stepped in.

Here's a great graphic from the NYT that puts Facebook's offering in the context of previous tech IPOs (hint: it was pretty damn big). For stock analysis, here's NYU professor Aswath Damodaran. And for bearish perspective, take a look at Friendster and its nagging investors; MySpace and its “mismanagement, a flawed merger and countless strategic blunders”; and Ning with its wildly overblown notions of “double viral expansion loops.”

Or for counter-programmatic viewing, watch this history of John Baldessari, narrated by Tom Waits. There's no better tonic to a $16 billion equity raise than a short film about a conceptual artist who once cremated his entire body of work. Which is even more drastic than deleting your Facebook account. – Ben Walsh

On to today's links.

JPMorgan
JPMorgan didn't have a treasurer during the five-month period in which its hedges imploded – WSJ
Jamie Dimon's strangely glowing account of Jamie Dimon's response to JPMorgan's massive trading – WSJ

Crisis Retro
“Treasury wants to make banks boring again by selling CDOs of community-bank hybrid capital instruments” – Matt Levine

EU Mess
The best explanation of the chaos that a Greek exit from the euro zone would cause – Martin Wolf
The Greek exit becomes increasingly expensive over time – Sober Look

Facebook
Facebook's secondary market pricing – Secondmarket
How to make $50 million trading Facebook – Felix
Peter Eavis: Facebook's missing risk factor – Dealbook

Wonks
An argument that principal reductions won't help the mortgage mess – Brookings Institution
Divorce rates help explain why Americans work more than Europeans – Vox

Politicking
Learning how to walk through the revolving door: the top lobbyist-producing colleges – Open Secrets

The Speech TED Didn't Like
Why TED passed on the income inequality speech – Chris Anderson

Stuff We're Not Linking To
The real-time Mark Zuckerberg Wealth-o-Meter widget – WSJ
Amity Shlaes: “Unemployment now, yes.” – Bloomberg View
Businessweek goes listicle for its cover: “Five hacks that have changed Silicon Valley forever” – Businessweek

How to make $50 million trading Facebook shares

Fri, 18 May 2012 09:23 GMT

Update: Everything I had here originally is wrong! SecondMarket has just updated its infographic, changing “average transaction size” to “average amount sold”. It seems that the average seller sold to 4.9 buyers, which means that the average transaction size was not 454,565 shares, as SecondMarket originally said, but rather 93,186 shares. And so most of the SecondMarket numbers here need to be divided by 4.9. Here goes:

SecondMarket has published a glossy 8-page horizontal-scrolling infographic, all about the history of Facebook on its platform; they also sent me an accompanying spreadsheet, with the data in slightly more tractable form. We now know that there were 689 transactions in all, at an average transaction size of ~~454,565~~ 93,186 shares — which means that since April 2008, SecondMarket has traded a total of ~~313,195,285~~ 64,205,154 shares of Facebook, adjusted for splits.

Those shares weren't always worth as much as they are today. But if we make a few assumptions, we can start getting a first-order approximation for the amount of money that SecondMarket has made off Facebook over the past few years. ~~And it turns out to be significantly larger than the amount of money Facebook is paying its banks to go public.~~

We know how many transactions there were in each quarter from the second quarter of 2008 onwards, and we also know what the share price was in each month that Facebook shares traded. (In April 2009, it was as low as $1.11 per share.) If we assume that the average transaction size has been roughly constant in number-of-shares terms, and take the average of the three months in each quarter as the average price paid in that quarter, then the total volume of Facebook shares traded on SecondMarket comes to ~~$8.5~~ $1.75 billion.

SecondMarket is cagey about how much it charges in commission on Facebook trades, but in general for secondary-market operations it charges between 3% and 5% of the total transaction amount. Let's be conservative and say that for Facebook, SecondMarket charged 3%. Then it seems SecondMarket's total commission on Facebook trades, from April 2008 to date, will have come to roughly 3% of ~~$8.5~~ $1.75 billion, or somewhere on the order of ~~$250~~ $50 million.

~~That helps to put the $200 million valuation for SecondMarket into perspective: there's a decent chance that SecondMarket is actually worth less than its total income from Facebook trading alone.~~

And it also puts into perspective the $177 million being shared between JP Morgan, Morgan Stanley, Goldman Sachs, and a smattering of other banks — they're being paid 1.1% of the money that Facebook is raising today. This is the difference between public, transparent markets and private, over-the-counter markets: the latter are much more lucrative for brokers than the former are. Which is why investment banks don't want derivatives moved to exchanges. And why SecondMarket is moving desperately into weird asset classes like wine, to make up for the fact that it's not going to be trading Facebook shares any more.

Eduardo Saverin joins the stateless billionaires

Thu, 17 May 2012 16:31 GMT

The United States is the only country in the world which applies the same tax regime to all its citizens, regardless of where they live: nowhere else are nonresidents charged the same federal tax rate as residents. And this makes America's plutocrats qualitatively different from every other country's super-rich.

If you wanted to sum up Eduardo Saverin in three words, you could do a lot worse than Very Rich Eurotrash. He didn't become a Facebook billionaire because of his hacking skills or because Mark Zuckerberg happened to be his roommate in college; he became a Facebook billionaire because he had cash, and Zuckerberg needed cash to get Facebook off the ground. Zuckerberg provided the valuable labor which went into creating Facebook; Saverin, for all the ideas he had, was basically needed for his money, and his ideas ended up going nowhere. Today, now that he's dynastically wealthy, he says things like “it’s a misperception, especially the playboy. I do have a Bentley. I do go out.”

Saverin might have more money than the Italian boys with cashmere sweaters draped over their shoulders who flit from one global Cipriani outpost to the next. But when he talks of himself as “a global citizen”, he's not lying: he's just displaying a mindset which he shares with any number of well-heeled international jet-set types. They're easy to find: just get on a plane to Cannes or Sao Paulo, turn left at the first Tyler Brûlé, and you'll find them picking at a $30 salad while wearing shoes which cost substantially more than the waiter's weekly income. They live a pampered and sheltered experience: they even have their own social network, to keep them from being forced to rub digital shoulders with the masses.

In January 2011, after moving to Singapore, Saverin decided that he wanted to give up his US citizenship. He didn't live in the US, he was going to have lots of income going forwards, and he felt that there was no good reason for him — a citoyen du monde — to pay 35% of that income to the USA in particular. Not to mention estate and gift taxes for when he finally passes on his wealth to someone else.

If Saverin hadn't been a US citizen, all of this would have been a non-issue: simply moving to another country suffices to relieve you of most of your tax burden in your country of nationality. But because he was a US citizen, he took the drastic step of renouncing that citizenship; the move became official in September. And then, in a fit of extraordinarily bad timing, from a PR perspective, the news came out just as Facebook was about to go public, and, faster than you can say “press conference”, Chuck Schumer decided that he was going to introduce something called the Ex-PATRIOT Act. (Geddit?) Under the act, people like Saverin renouncing their US citizenship for tax purposes would face fines so huge that they'd be better off not doing so at all.

The rhetoric, here, is that Saverin's success is attributable to his American citizenship, and that therefore America deserves to be able to receive its condign tax revenues. And I half buy it, although frankly there's nothing stopping any rich Brazilian kid from going to Harvard and funding a startup. Saverin didn't need US citizenship to do what he did.

This is an issue which pops up occasionally: it's already very onerous to give up US citizenship. Kathy Kristof had a good overview of the history of such laws in 2008: a 1996 law, for instance, forced former US citizens to continue paying taxes on their worldwide income for at least five years, and in 2004 that was extended to 10 years. In 2008, a new law forced people like Saverin to pay capital gains taxes on the assumption that they liquidated all their property the day before they renounced their citizenship. And indeed, that's what he did.

Still, Saverin can still be considered to be saving taxes here, since Facebook now is worth substantially more than it was worth in September. At the same time, he's facing a nightmare at US immigration — entering the country might well be impossible, and it could be extremely difficult just to change planes here. He's not just another Brazilian any more: he's the lowest of the low as far as US immigration is concerned, and they will never treat him with any respect at all. Since he doesn't have much in the way of rights any more — he gave most of those up with his citizenship — he'd be well advised to avoid the USA pretty much for the rest of his life.

From a public-policy perspective, this is the kind of US exceptionalism I can get behind. There's a corrosive class of global plutocrats, living by choice in tax havens like Singapore or Switzerland, and paying vastly less in taxes than Mitt Romney or any US billionaire. If you're not an American citizen, and you become incredibly wealthy, there's a good chance that you will choose to become a tax exile — thereby depriving your home country of the income taxes it should expect to be able to raise from its richest citizens. It's a country-of-residence tax arbitrage which makes the ultra-rich feel no civic duty at all to their countries. And somehow the US has managed to avoid that problem: American billionaires, as a rule, remain American billionaires, as do their children and their children's children. They — along with the Chinese — are pretty much the only billionaires in the world who don't live a stateless existence. And even the Chinese ultra-rich are rapidly breaking free of their home country.

So yes, it's a little bit unfair to Saverin that he's suffering so much opprobrium right now when he would be getting none of this were it not for the accident of his US citizenship. But I can't really feel sorry for him. And if the US succeeds in making an example of him, it will have managed to pull off something very important — which is to keep its billionaires part of the tax base. Very few other countries can say that.

Counterparties: 1 Pinterest=1.5 Instagrams

Thu, 17 May 2012 16:01 GMT

As Facebook, at eight years of age, prepares for its landmark IPO, two-year-old Pinterest has managed to raise $100 million at a jaw-dropping $1 billion valuation. If you're scoring at home, 1 Pinterest = 1.5 Instagrams.

Both Pinterest and Instagram are perfect examples of the delicate art of valuing companies with little to no revenue. This conundrum also faced investors in Tumblr, Foursquare and Twitter. Of course, when you have zero revenue, current revenue multiples are not the right place to turn to justify an investment. As the WSJ‘s Dennis Berman put it:

@dkberman: Oct. 2011: Pinterest is valued at $200M, roughly infinity times revenue. May 2012: Pinterest valued at $1.5B, roughly infinity times revenue.

If you're looking for a different metric for valuing companies that don't make money, VC Marc Andreessen recently said that he doesn't value startups by their revenue, but instead looks at how much they're worth to a larger company. Sometimes that's active, as in Google finding a way to monetize YouTube, and sometimes it's defensive, as in Facebook buying Instagram to keep it out of the hands of Twitter. Either way, the startup's value is based on being able to sell to someone huge – the kind of exit that VCs in general, and Andreessen in particular, love.

If valuing a no-revenue company remains a challenge, the lead investor Pinterest chose, Japanese e-commerce company Rakuten, seems to have a clear idea of how it wants to earn its return. Pinterest users will be able to buy products they see pinned directly from Rakuten, and the company's shoppers will have their Rakuten IDs integrated into Pinterest. And this is no small matter: Techcrunch notes that 75% of Japanese Internet users, 80 million people, have a Rakuten ID. In fact, there's some evidence that Pinterest users are already buying things they see on the site.

This model, Rakuten hopes, will help it wake up its “sleeping customers,” and it may make Pinterest the rare tech startup that isn't going for acquisition or bust. Pinterest's move to attract a large strategic partner before acquisition is a test case for Andreessen's theory that making money, at least in today's tech world, may not matter. Andreessen, though, wins either way: His firm was a small participant in the round. – Ben Walsh

And on to today's links:

JPMorgan
Mitt Romney's response to JPMorgan's trading loss: “That's the way … America works” – WSJ
JPMorgan's CIO unit trading losses are $1 billion larger – DealBook

EU Mess
Spanish official says $1 billion in withdrawals from Bankia is “not a deposit flight” – Dow Jones
Felix: How Europe's banking crises threaten the eurozone – Reuters
Roubini: “Either this year or next, Greece must exit the eurozone” – Project Syndicate
About that Spanish downgrade… – FT Alphaville

Charts
50 years of government spending, in one graph – NPR

Bubbly
Justin Bieber is now a venture capitalist – Forbes

Wonks
The Fed will actually be able to fill its two open vacancies – Yglesias
“It is with regret that we announce the death of inflation targeting” – Project Syndicate

The Speech TED Didn't Like
“If median household income had kept pace with the economy since 1970, it would now be nearly $92,000, not $50,000″ – BI
Why TED passed on Hanauer's talk – Chris Anderson

Politicking
Swing-state voters resoundingly disapprove of Obama's handling of the housing crisis – Huffington Post

Frightening
“Dental abuse” – Private equity somehow makes dentists even more despised – Bloomberg

Boondoggles
Gouging taxpayers for sport:inside the financing of sports stadiums — The Economist

Regulations
Fitch: Basel III will reduce big banks' return on equity by more than 20% – FT Alphaville
EU regulators are still haggling over bank capital requirements – Bloomberg Businessweek

Investigations
The SEC is (finally) investigating Magnetar over its role in infamous crisis-era CDOs – WSJ
2010: How Magnetar's trades kept the housing bubble going – ProPublica

How to cover Greece

Thu, 17 May 2012 08:58 GMT

You might have heard that Facebook's going public; certainly the editors of Businessweek have, and so they've managed to come up with a listicle (“five hacks that have changed Silicon Valley forever”) to put on their cover this week. The Economist, by contrast, not only has a much better cover; it has also gone with the much more important story. (Which doesn't yet appear to be online.)

Watching the two stories play out in the news media, especially here in the US, has been fascinating. And it's no coincidence that the London-based publication went with Greece while the New York-based publication went with Facebook. Looked at from New York, the Greece story is a horribly complex mess of players and parties and agendas, with no obvious timetable and no chief protagonist. Plus, while it's clearly important from a global perspective, it's perennially impossible to come up with any really good explanation of why a US audience should really care.

On the other side, looked at from across the pond, the Facebook IPO seems like much ado over relatively little: a hot company is managing to raise a large amount of equity at a high valuation. That's fine — but in this case there's really no reason why the average European should care: Facebook is not going to visibly change at all for having gone public, and Europeans in general don't pay nearly as much attention to individual share prices as Americans do.

My guess is that this dynamic is going to stay in place even after Facebook has gone public and the share price has settled down: the European media will cover the Greece story in minute detail, while the US media will largely ignore it, but for the occasional dull-and-worthy piece buried where no one will find it, until such time as it starts causing visible repercussions for US banks or stocks.

For a world which supposedly globalized decades ago, the crucial and central importance of the Greece story to Europe, and its decidedly peripheral status in the US, is telling. If you were launching a new publication aimed at the “global business elite” right now, which of these stories would you consider more important? You'd try to cover them both, of course. But if you spent too much time on Facebook, your non-US audience would consider you frivolous, and if you spent too much time on Greece, your US audience (and, crucially, your US advertisers) would consider you wonky and worthy and boring. Maybe the answer is to just stick with shiny photos of a major global city at night. That always works.

How Bruno Iksil lost $2 billion

Wed, 16 May 2012 15:46 GMT

In February 2009, Deutsche Bank announced that its Credit Trading desk had managed to lose €3.4 billion in the fourth quarter of 2008, with €1 billion of those losses directly attributable to the bank's prop desk.

The losses in the Credit Proprietary Trading business were mainly driven by losses on long positions in the U.S. Automotive sector and by falling corporate and convertible bond prices and basis widening versus the Credit Default Swaps (CDS) established to hedge them.

In English, Deutsche Bank had put on a basis trade: it owned credit instruments, like bonds, and it also owned credit default swaps designed to hedge against those loans. And then the trade blew up.

The Deutsche trader responsible for the monster losses was Boaz Weinstein, who eventually left the bank to start his own hedge fund, Saba Capital. His first job, obviously, was to make sure he didn't blow up a second time. But his second job, it seems, was to use his experience at Deutsche to be able to notice when someone else was about to blow up on a massive basis trade. In this case, JP Morgan.

Go back to early February, long before the articles about the “London Whale” came out in Bloomberg and the WSJ, and you'll find Weinstein revealing his biggest trade at the Harbor Investment Conference:

The derivatives trader and legendary hedge fund manager said his trade idea is to buy Investment Grade Series 9 10-Year Index CDS (maturing on 12/20/2017).

“They are very attractive,” he explained adding that they can be bought at a “very good discount.”

At the time, Weinstein didn't know — or necessarily even suspect — that his big trade would involve a zero-sum bet with one of the biggest hedge funds in the world, JP Morgan's Chief Investment Office. But over time, as he bought more and more protection but the price stubbornly refused to rise, he began to learn just how big the other size of the trade was. Whale big.

Tracy Alloway and Sam Jones have pieced together the best account yet of what exactly JP Morgan was up to. Yet again, it was a basis trade, although this one was horribly complex even by basis-trade standards. Essentially, that CDX.NA.IG.9 position was a second-order hedge, designed to offset volatility in JP Morgan's first-order hedge, which was designed to offset credit risk in the rest of the bank's portfolio.

The first-order hedge itself doesn't make a great deal of sense — Iksil seems to have bought “tranches” of CDS indices, which would pay off if some (but not all) credits suddenly got into trouble. For a bank which had broad economic exposure to European meltdown and/or a US double dip, that seems like a pretty narrow hedge.

But if the first-order hedge is weird, the second-order hedge is downright scary. Do you remember the notorious Howie Hubler trade at Morgan Stanley, where he made a smart bet against dangerous subprime securities, but then put on a much larger “hedge” which ended up costing him $9 billion? Iksil's trade seems a bit like that:

Because of the mechanics of the trade, in order to achieve a “market neutral” position, whereby JPMorgan hedged the bet against volatility as best it could and offset the cost of its short positions, the bank had to sell far more units of cheap protection on the IG.9 as a whole than it bought on short, more expensive tranches.

Inevitably things started to go wrong. There are two things you can do when something starts to go wrong in the markets. You can unwind your position at a loss. Or you can try to fix it. Iksil, and Drew, chose the latter:

The two legs of JPMorgan’s trade did not move according to the relationship the bank had expected, meaning the position became imperfectly hedged. Like many credit models before it, JPMorgan appeared to misjudge correlation – one of the hardest market phenomena to accurately capture in mathematics.

In order to try and stay risk neutral, the dynamic hedge required even more long protection to be sold. The bank continued to write swaps on the IG.9, causing a pricing distortion that was spotted by more and more hedge funds seeking profit.

The rest, pretty much, is history.

Iksil, we're told, is going to leave JP Morgan, while taking his own sweet time doing so: “although a spokeswoman for the bank said Mr. Iksil is still employed, he is no longer trading on behalf on the bank and is expected to be gone by the end of the year”. I'm sure he'll use the intervening months to feel out his chances of being able to raise a few billion dollars for a hedge fund of his own, and weigh them up against simply joining a fund like Saba. Iksil's now learned a $2 billion lesson — and as Boaz Weinstein can attest, once learned, those lessons can be surprisingly valuable.

Counterparties: Are you sick of Facebook yet?

Wed, 16 May 2012 13:43 GMT

Never mind the important stuff going on in the world, all that anybody wants to talk about today and tomorrow and Friday is the “spectacle, media event and cultural moment” (Max Wolff) known as the Facebook IPO. We want to know who's buying! We want to know who's selling! We want to know what advertisers are thinking! We want to know what old people are thinking! We want to parse the relationship between IPO investors and brand-name puppets!

Should you buy FB? All the media advice – even Jim Cramer – says no, but an impressive 18% of Felix's readers say that they're seriously considering it. And surely Felix's readers are smarter than Jim Cramer! If you try to value Facebook, you'll never end up at $35 per share, but that just proves that this isn't a trade for DCF jockeys. Besides, speculating on Facebook is much less boring than buying an index fund. When was the last time you saw an ETF valued in Whoppers? One thing's for sure: If you're half as sick of Facebook as we are, at this point, just don't consume any media for the next three days. It's only going to get worse.

On to today's links.

Plutocracy Now
How Chief Justice John Roberts orchestrated the return of corporate money to politics – New Yorker

Facebook
At $67 million, Eduardo Saverin thinks his U.S. citizenship is overvalued – Bloomberg

JPMorgan
One controversial JPMorgan unit sold risky derivatives and another bought them – DealBook
JPMorgan's risk management unit had looser risk controls than the rest of the bank – International Financing Review
Hedge fund manager in February: “Buy CDX.NA.IG.9″ – FT
A sad Jamie Dimon Pinterest board – Kevin Roose

Politicking
Never let a fiasco go to waste: John Boehner threatens a debt ceiling do-over – WashPo
Ezra: This time around, it'll be much more than just a debt ceiling crisis – WashPo
States decide to use mortgage settlement aid meant for homeowners for things that won't help homeowners – NYT

EU Mess
There's not yet a run on Greek banks, but it's getting awfully close – Reuters

Chesapeake
Aubrey McClendon may also be distorting ticket prices at the Oklahoma City Thunder – CNBC

Boondoggles
New data shows Google+ is basically a ghost town – Fast Company

Stuff We're Not Linking To
For the rich who don't want to be confused for the smart, diamonds are the new stocks – CNBC
President Obama has a JPMorgan Chase checking account with money in it – Politico

Why JP Morgan's CIO found it so easy to make money

Wed, 16 May 2012 10:29 GMT

You want proof that JP Morgan was — is — using its Chief Investment Office to gamble with taxpayer-backstopped funds?

The CIO unit also had a lower cost of capital than other parts of the bank, an artificial advantage that gave it an incentive to take more risk and behave in a less disciplined way, people familiar with the unit said.

“It was very large, but was never very transparent, and it wasn’t clear that they had an appropriate funding cost,” said the source with direct knowledge of the CIO.

In any unit of any bank, one of the key drivers of profit and loss is the internal cost of funds. If you're paying 1% for your funds and earning 3%, then you can claim profits of the difference, 2%. But if your cost of funds is increased to 2%, then your profit is halved at a stroke. For someone like Ina Drew, who was charged with turning hedges into profitable trades, the easiest way to do that would always have been to simply get Jamie Dimon to decrease the CIO's cost of funds.

And at JP Morgan, just like at any other bank, the cheapest cost of funds is always deposits. JP Morgan has hundreds of billions of dollars in excess deposits just because it's too big to fail, and has an implicit government backstop. It's bonkers that it should then be able to take the resulting ultra-low cost of funds, and turn it into eight-figure bonuses to people like Drew, all for taking that money and playing on derivatives indices in London.

As John Macaskill points out, the CIO, by its own faulty measurements, had for the past two quarters more money at risk than JP Morgan's entire investment bank — and that was with a more lenient risk measurement and with a lower cost of capital. In reality, the CIO's risk levels were vastly greater than those at the investment bank, as we discovered after the blow-up.

If JP Morgan wants the CIO to be taking that kind of risk, it has to significantly increase the CIO's internal cost of funds. The CIO is at heart a hedge fund (it's designed to put on hedges), and JP Morgan should extend it billions on the same kind of terms that it would extend money to top prime-brokerage clients. The CIO's secret weapon, all these years, has been its artificially low cost of funds. If that number were more realistic, maybe JP Morgan wouldn't have ended up parking such an insanely enormous amount of money there.

How Europe's banking crises threaten the eurozone

Wed, 16 May 2012 09:38 GMT

The size of the run on Greek banks is not at all clear: while it seems that something on the order of €1 billion has left the banks of late, it's less obvious whether that was over the course of one day, three days, or two weeks. The big picture, though, is unambiguous:

What you're seeing here is Greece down to its last €165 billion or so in deposits, and at the margin the rate of decrease is probably accelerating, despite the fact that most sensible Greeks will have already stashed their hard-earned euros safely outside the country a long time ago. I don't know what the minimum amount is that Greeks need on deposit just to serve their near-term liquidity requirements, but we're not there yet: Greece's total population is only 11 million. So there's a long way further this number can fall — especially since the Greek banking system isn't receiving the support it needs from the ECB.

The more realistic constraint is simply that many Greeks lack the education and sophistication and language skills needed to move their money out of the country. This, for instance, is telling:

A 60-year-old textiles store owner who gave his name only as Nasos said he had transferred 10,000 euros over the phone to a bank in fellow euro zone state Cyprus on Tuesday afternoon.

If Greece exits the euro, there's no doubt that there will be a massive banking crisis in Cyprus — it's pretty much the least safe haven conceivable for someone looking to move their money from Greece. The only reason to move money to Cyprus rather than, say, Luxembourg is that they speak Greek there, and the logistics of moving money to Cyprus are easier than the logistics of moving money to any other country.

Meanwhile, in the rest of the eurozone periphery, foreigners are already pulling their deposits from Italian banks, while the Spanish banking system is only getting increasingly precarious:

All of which is to say that the causal relationship between sovereign crises and banking crises is rather more complicated than one causing the other: in reality, they cause each other, in a vicious cycle which clearly isn't close to being broken in any of the southern European states. Greece is further along in the cycle than Spain or Portugal or Italy, but they're all still moving in the wrong direction.

Greece's banks, remember, are the mechanism by which the rest of Europe will force Grexit. Banks are the circulatory system of any economy: if they stop pumping money, the country dies. And so, in extremis, Greece will need to do a complete blood transfusion, replacing all euros with drachmas, if the only alternative is to see the flow of euros dry up entirely.

In the meantime, however, expect to see deposits continue to leave Greece — and the rest of the European periphery as well. Even if your euros are reasonably safe in a big Italian bank, they're surely safer in a big German bank. And the first thing that all depositors want is safety. Now that questions have been raised about the solvency of various southern European banking systems, it's going to be very hard to reconstitute the eurozone in a robust fashion. The Eurozone was never designed to cope with millions of Spaniards moving their money out of the country, behaving like middle-class Venezuelans with offshore accounts in Miami. And it also was never designed to cope with capital controls. But increasingly, it looks like we're going to end up with one or the other. Or both.

Facebook: The smart money exits

Wed, 16 May 2012 07:34 GMT

The Facebook IPO is now set to raise an absolutely astonishing amount of money — as much as $18 billion, if the greenshoe is exercised and the offering prices at the top of the indicated range. As a result, it's certain to be the single largest technology IPO of all time. (Most companies don't even have a valuation of $18 billion when they IPO, let alone have $18 billion worth of stock for sale to the public.)

So what is Facebook going to do with all that money? Well, it turns out that in upsizing the size of the IPO, Facebook has not actually increased the number of shares it's selling to the public. Instead, most of the new shares being sold are coming from Mark Zuckerberg ~~personally~~. He's now going to sell 126 million shares in the IPO, and other early investors, including James Breyer and Peter Thiel, are cashing out too.

I'll do the math for you: 126 million shares, at $38 a piece, comes to almost $5 billion. That's a lot of money to raise in one day. When Facebook first filed for an IPO, Zuckerberg was only selling enough shares to allow him to pay what will probably be the single largest individual tax bill the IRS has ever seen. ~~But now, Zuckerberg's going to be a billionaire excluding his Facebook stake.~~*

More generally, this seems to be the point at which the smart money is getting out of Facebook. Accel Partners is now selling 49 million shares in the IPO (think $1.8 billion), while DST and Mail.Ru will sell some $2.5 billion of stock in total.

Capital markets are not particularly efficient, but one thing nearly always holds true: when stock prices are high, companies issue more stock, and when stock prices are low, they issue less stock. In general, we're not seeing a huge number of primary or secondary offerings right now: it's still cheaper for companies to issue debt rather than equity. The exception, of course, is in technology companies, where it's clearly possible to go public at frothy multiples — even if those IPO valuations don't last long.

The Facebook strategy is an interesting one: a lot of the time, in technology IPOs, you see companies issuing a pretty tiny number of shares, and using artificial scarcity to boost the price. That's definitely not happening here — Facebook stock is going to be a highly-liquid price discovery tool from day one. And if there are lots of institutional investors out there wanting to own a piece of Facebook at a $100 billion valuation, then frankly you can't blame Zuckerberg and Accel and DST for taking them up on their offer.

But it's worth remembering, here, that the main reason that Facebook is going public at all is that it has more than 500 shareholders — and the reason it has more than 500 shareholders is because early investors, including Accel and DST, have been selling down their stakes in private markets for some years now. The main difference between the public markets and the private markets is not the valuations available — $100 billion is very much in line with where Facebook stock has been trading privately — but rather in the sheer volume of stock that can be efficiently sold at one time.

When this IPO is over, Zuckerberg will still have complete control over the company, with more than 50% of the voting rights. But his new shareholders will look very different from his old shareholders, even if the board remains the same. And by far the biggest difference is that while the old shareholders were all sitting on monster paper profits, on their Facebook stock, the new shareholders won't be. They're going to want to see the share price — and Facebook's valuation — go up, substantially. Which means that they're going to want Zuckerberg to come up with a plan to make Facebook worth $200 billion, or $300 billion, or more.

In order to do that, it's not going to be enough for Zuckerberg to build a platform: he's going to have to monetize it, to the tune of way more than a billion dollars a year in advertising profits. Facebook, right now, is trading on its potential for making future profits. At some point, and it's not all that far away, Zuckerberg's going to have to realize that potential. Or face some extremely angry shareholders asking whether he played them for suckers when he sold those 126 million shares.

*Update: It now seems that the extra shares being sold by Mark Zuckerberg are not shares he owns, but rather shares he doesn't own. Zuckerberg has an “irrevocable proxy” over certain shares, which means that he controls them without owning them. He seems to be selling those shares, not shares he owns pesrsonally. So he won't personally receive the extra billions.

Counterparties: The ‘hunt for a government' in Greece

Tue, 15 May 2012 16:01 GMT

At a time when it's facing an ultimatum from Europe, Greece has given up its “nine-day hunt for a government.” New elections are on the way in June, and Greece's anti-austerity left is expected to win.

For now, Greece's lame-duck transition government can't respond to Germany's open threats to accept crippling budget cuts or leave the euro zone. This is happening as Greece's deputy prime minister is warning that his country could run out money in six weeks, the Greek stock market fell 4.5% in seconds – and have we mentioned a Greek leader is now warning about civil war?

Quite suddenly, we're back to last summer: pondering the implications of (another) Greek default and dealing with (another) potential debt-ceiling standoff in America.

This time, in Europe at least, is actually a bit different. After days of speculation about euro officials pondering a Grexit, IMF chief Christine Lagarde admitted that an “orderly” Greek exit from the euro zone is a possibility. “It is something that would be extremely expensive and would pose great risks but it is part of options that we must technically consider,” she told France24. (Lagarde left the door open to examining “the details” of Greece's bailout program.)

There are also some very specific ideas of the costs involved if Greece exits the euro. Losses for French banks could reach $25 billion; German banks could see a $6 billion loss, according to one estimate. JPMorgan estimates the immediate costs for Europe could be $513 billion. UBS figures that leaving the euro zone could cost a country like Greece $12,000 to $14,000 per citizen and lead to a 50% drop in its volume of trade.

Much harder to tabulate is the longer-term domino effect a Grexit could have. James Bianco, building on Paul Krugman's reasoning, pictures a bleak scenario: freaked-out bank depositors moving their money from Greece, then from Spain and Italy, raising these countries' borrowing costs and necessitating more bailouts.

All of which makes it somehow fitting that new French President François Hollande's plane was struck by lightning today. Hollande was on his way to discuss Europe's economic governance with Germany's Angela Merkel; he'd just been sworn into office. – Ryan McCarthy

On to today's links.

JPMorgan
Dept. of Justice and FBI open criminal investigation into JPMorgan trading losses – Bloomberg
A modest proposal: Put Jamie Dimon on televised trial hosted by Judge Judy – Alex Pareene

Must Read
Absolutely outrageous report on a government-subsidized non-profit that collects on student debt – Bloomberg

Hackgate
Rebekah Brooks charged over concealing evidence in phone-hacking case – The Guardian

Right On
The economic case for same-sex marriage – Bloomberg

UGH
Healthcare costs for family of four with insurance exceed $20,000 per year – Huffington Post

You Say That Now
High returns on equity in banking are a sign of trouble – Sallie Krawcheck

Awesome
A nerdtastic breakdown of NYC's bikeshare locations – Spatiality

Video
Nations get states: A time lapse of European borders – YouTube

EU Mess
Default now or later? Greece's four options – FT

New Normal
California's governor is calling for a 4-day workweek to close a $16 billion deficit – Bloomberg

Facebook
Facebook ups the price of its IPO, may stop accepting orders today – DealBook

Bikeshare pricing charts of the day

Tue, 15 May 2012 14:47 GMT

When I wrote about New York's expensive bikeshare scheme last week, I got a lot of pushback from people saying that I was missing the point. These bikes are designed for short trips around town, at a marginal price of zero: the large sums you pay if you keep them checked out for an hour or more are a deliberate attempt to discourage that behavior.

OK, fair enough — but in that case, if you're charging high variable costs, the converse should be that you should charge low fixed costs. Most bike schemes work in much the same way: you pay a certain amount up front for membership, be it for a day or a week or a month or a year, and then the variable per-hour costs on top of that. If New York's bikeshare scheme is indeed quite cheap, then one would expect the variable costs to be low.

But they're not.

Ben Walsh put together some numbers for me, for various cities around the world with bikeshare schemes. Not all cities work in exactly the same way, and some have no direct comparison points with New York at all: in Chicago, for instance, the membership options are 1 month, 2 months, and 3 months. In any case, here's what we managed to find, for New York's three options:

It's pretty clear that New York is at the top end of the range, here: only Frankfurt rivals it in price. To have access to New York's bikes for one day, you need to spend $9.95 — that's more than six times the £1 one-day membership in London, and it's significantly more, too, than you'd pay in Washington or Toronto or Paris.

The first reaction of New Yorkers, when they hear this, is surprisingly positive: they think of it as a tax on tourists, and everybody likes taxes on tourists. Let the tourists pay through the nose for their one-day memberships, and we locals will save loads of money, through an implicit cross-subsidy, on our one-year memberships.

But that doesn't seem to be the case, either. Look at the cost of one-year memberships, and New York is still top of the league table, at $95. That's the same as Toronto, and more than seven times what Romans pay. (Indeed, the one-time membership fee in Rome, at €10, is barely more than a daily membership in New York.)

New Yorkers, then, are being asked to spend much more money per year than bikeshare users in just about any other major city — even if they never take out a bike for more than 45 minutes. And what worries me is the deterrent effect that these prices will have.

The first trip you take, on one of the new New York bikes, will cost you at least $10, and possibly as much as $95. Cab rides don't cost much more than that, and you can fit four people in a cab. Experienced urban cyclists like me will definitely cough up the $95, even if that hurts a little, because we know how convenient it can be to be able to take one-way bike trips in Manhattan, especially if it's going to rain later, or if you don't like biking back in the dark, or if you got in to work on the subway but then just need to go a mile or so to your lunch meeting.

But the great promise of the bikeshare scheme is that it will get people onto bikes who have never biked before — people who are generally very nervous about biking at all on busy urban streets. Those people are going to want to try before they buy, and the $10 cost of a trial one-day membership is high enough to give them a good excuse not to bother.

The East River Ferry is a great example of the benefits of low entry costs and the opportunity the city's bikeshare program is missing. When the ferry was reintroduced last June, it was free for the first 12 days. Passengers flocked and even once full fares kicked in, it remained far more popular than planners projected.

That said, from a user's perspective there are two costs worth considering before you opt into one of these schemes, and the dollar cost is only one of them. The other one is convenience — and on that front, New York's 10,000 bikes look as though they're going to be everywhere you might want one, so long as you stay south of 60th Street; there are even a few docking stations in Queens! In that respect, getting on a bike is (fingers crossed) going to be much easier in New York than in most other cities — and I can definitely see how that convenience might be worth paying for.

I don't think the pricing for these bikes is going to cause the plan to fail: New Yorkers are used to paying lots of money for convenience. I just wish there were some cheaper way of getting New Yorkers to try these things out. Because $95 is enough money — roughly the same as an unlimited monthly transit pass — that a lot of people will simply not bother.

Are you seriously thinking of buying Facebook shares?

Tue, 15 May 2012 07:44 GMT

I'm well aware that I live in something of a bubble, here in Manhattan: the people I hang out with tend to be college-educated white liberals, and I'm racking my brain trying to think of someone I spend any real time with who might object to gay marriage. So clearly I don't live in anything approaching a representative sample of Americans. But still, I'm confused by the endless parade of stories about people who want to buy Facebook shares, and whether it's a good idea to buy Facebook shares, and how to buy Facebook shares, and so on and so forth. A classic example, running at 2,300 words, is in the WSJ today:

Late Monday, the social network raised the price range for its IPO to $34 to $38 a share…

Those numbers have created high hopes for both individual and professional investors. The excitement has drawn in fledgling stock buyers such as 11-year-old Jade Supple of Rockville Centre, N.Y., whose father plans to bet money saved to put his daughter through college on Facebook shares, although he has doubts about the price.

My gut feeling, here, is that what we're seeing is nine parts lazy editors commissioning these pieces on autopilot, to one part a real-world phenomenon of huge retail demand for Facebook stock. The press loves IPOs, because they're one of the few occasions when the stock market delivers a significant news event which can be prepared for in advance. But the public? The whole investing-in-IPOs thing just feels so late-90s to me, and the performance of stocks like Groupon and Pandora is hardly likely to spark another feeding frenzy.

So when Henry Blodget describes the Facebook IPO as muppet bait, I do wonder who the muppets really are. Is it a genuine horde of individual investors, all clamoring to get in on the hot new stock offering of the decade? Or is it the muppets on CNBC, following Mark Zuckerberg's every move like he's the Pied Piper of Hamelin, only with a hoodie instead of a magic pipe?

Still, I might be wrong on this. So here's a quick, unscientific poll. Or, just have at it in the comments.

poll by twiigs.com