Friday, January 31, 2014

Fines Are Not Enough: Serial Settlements

Fines Are Not Enough: Serial Settlements

Western Asset Management settled two unrelated matters with the Securities and Exchange Commission and Department of Labor.  The fines and restitution came to $21 million, and as per usual, Western neither admitted nor denied the charges. Normally I wouldn’t write about these settlements, but they illustrate a major weakness in our regulatory system.  This isn’t the first time Western has settled with the SEC, and yet the regulator never mentions or takes into account the prior settlements or improprieties.  Moreover, it doesn’t appear that anyone in a senior position has been held responsible.  In both settlements, the SEC merely “sanctioned” Western.

I wrote about a securities fraud that occurred in a couple of high yield funds advised by Western in “Peering Beneath the Surface: Uncovering A Fraud (October 29, 2012).”  The portfolio manager was barred from the industry (and already had been terminated), and Western was charged with a failure to supervise.  However, no one was held individually accountable for the failure to supervise.  Western’s parent, Legg Mason, paid a $50,000 fine.[1]
Written Down (1999)
During the credit crisis, Western ran into a series of difficulties in its money market funds due to commercial paper investments issued by various structured investments.[2]  Legg Mason arranged financing to backstop the money market fund, and the SEC agreed to forego any enforcement action.[3]

In one of the recent settlements,[4] the SEC charged that Western miscoded a private security that led a trader to invest in an impermissible security on behalf of clients.  Even after Western discovered the mistake, it did not tell clients or reimburse them for the mistake (the security’s price fell sharply in the credit crisis).  The firm interpreted its policy regarding errors narrowly in order to avoid taking action. 

In the second action,[5] the SEC charged that Western inappropriately crossed a security between its clients.  An internal cross involves selling a security in one client’s portfolio and buying it in another portfolio.  While the practice is legal, it requires specific procedures and disclosures because there’s a huge potential conflict of interest involved in trading securities between clients.  On the other hand, if one client should legitimately be selling and another acquiring the security, it can save both clients money by not selling and then buying the security in the market.  For example, if client A only permits investment grade bonds in its account and client B permits non-investment grade investments, it might be perfectly acceptable to sell a bond that has been downgraded from A to B.

Unfortunately, Western made two mistakes.  First, it used the bid price, rather than the average of the bid and ask, so buyers always got the better end of the deal. Second, it crossed a security for a client that prohibited the practice.  In this case, the client was the U.S. Treasury.

Legg Mason’s spokesperson said, “Western Asset has always sought to meet a high standard of client and fiduciary standards and has redoubled its efforts over the past five years to address regulatory compliance and related matters, including the strengthening of controls in the areas covered by the settlements.”[6]

Back in 2001, Western made the same promises to the SEC in settling the securities fraud in the high yield funds.  In my view, these latest transgressions might have been avoided if the SEC held higher up executives responsible for these transgressions instead of simply settling on a fine.  Western will spend a lot of money on consultants and enhanced compliance procedures, but the culture won’t change. 

It’s culture and not compliance procedures that enable money managers to meet a high fiduciary standard.


Thursday, January 30, 2014

Retirement Savings for People Who Can’t Afford to Save: MyRA

Retirement Savings for People Who Can’t Afford to Save: MyRA

Suppose that your employer doesn’t offer retirement benefits. And suppose you don’t have  $1,000 of extra savings to open an IRA.[1]  You are one of those folks President Obama has identified who requires help.  I agree with the President that the working poor face bleak prospects in retirement.  The President has proposed a solution called MyRA.  The program would allow employees to make small contributions of as little $50 via payroll deductions into an account that would be invested in U.S. treasury bonds.    The balance could grow for 30 years or until the investor has a balance of $15,000.  At that point it would be rolled into a traditional IRA.  At present, the returns would be about 1.5% to 2% per year. Contributions wouldn’t be tax deductible, but any gains would eventually be taxed.

The program is entirely voluntary.  Employers don’t have to offer it.  Since the US Treasury will administer the program through a payroll deduction, it won’t cost employers much to participate.  However, this program is aimed at employers who don’t offer much to employees in the first place.

The President’s proposal creates a rosy picture of millions of low-wage workers squirreling away a few dollars until they’ve come up with a nest egg that’s big enough to become a full-fledged IRA.  Strangely, married couples with incomes up to $191,000 are eligible to participate.

MyRA is an idea that’s rather detached from reality.  The folks working in jobs without any retirement benefits are living paycheck to paycheck.  By the time the groceries, rent, and other expenses are paid, there’s no money left over.  Many of these people are already trying to figure out how’ll they manage to pay the subsidized premiums for health insurance under the Affordable Care Act.  While they face a daunting retirement challenge, retirement isn’t on their top ten list of financial problems.

MyRA may serve one useful purpose.  Workers can withdraw funds from a MyRa without penalty (although the gains would then be taxed), so the account might serve as a  small rainy day fund when the car breaks down or the kids need new shoes.  Unless there’s some kind of fundamental improvement in wages, the only one who might feel better about retirement security among the working poor will be the President.

[1] The minimum initial contribution is $1,000 at Schwab and Vanguard and $2,000 at Fidelity.

Wednesday, January 29, 2014

Emerging Market Noise: Turkey Raises Rates

Emerging Market Noise: Turkey Raises Rates

Last night the Turkish Central Bank raised interest rates dramatically.  For example, the one week REPO was increased from 4.5% to 10%.  Within minutes the Turkish Lira strengthened relative to major currencies.  As I went to bed, Asian stocks were rallying and various news services were reporting that the emerging market crisis might be abating.  While most of us were sleeping in the United States, European markets jumped and the headlines and market commentaries remained optimistic.  However, the Lira rally faded, and with it the gains in many stock markets.  By eight o’clock this morning, the headlines and commentaries had turned cautious again.

This is yet another example of trying to create a narrative out of noise.  Because the currency and equity markets reacted to the Central Bank’s move, we needed to have a story.  By the time strategists and commentators had put out their sound bites on Erdim Basci’s bold move to raise Turkish interest rates, traders were already taking profits.  Nothing else had changed.  Argentina, South Africa, Ukraine, and a bunch of other worries were still festering.  As the Turkish Lira comes under renewed pressure this morning, we are looking for new stories to help explain the noise.

We will hear about the handful of few traders who made a tidy profit in about three hours time during the night.  However, we won’t hear about the traders who were caught on the wrong side of the Lira blip.  At best, trading on noise is a zero sum game.   It is particularly dangerous for those who think there really is a story behind the market’s hour-to-hour gyrations.

Tuesday, January 28, 2014

This is Your Strategist Speaking

This is Your Strategist Speaking

When an airplane hits turbulence, many passengers are comforted when the pilot gets on the public address system.  Most often he’ll tell us its nothing to worry about and promise to look for smoother air at another altitude.  We’ve got good reason to be calmed by his explanation because most turbulence is completely harmless, and the pilot has a great deal of control over the aircraft.

As the prices of developing market currencies, stocks, and bond have swooned, the knuckles of many investors are turning white as they grip their arm rests while peering at their computers screens. The 570-point drop in the Dow Jones Industrial Average over the past week has unsettled more than a few stomachs, even though it only represents a 3.5% drop.

At the moment you can’t watch a financial report or read a newspaper without some strategist sagely informing you of the reasons for this bit of financial turbulence.  The differences between the pilot and the strategist are two-fold.  First, the pilot knows what he’s talking about, while the strategist is grasping at straws.  Second, the pilot may be able to do something about the unpleasant bumps, while the strategist is as helpless as you are.

Three weeks ago as 2014 began, most strategists were rather upbeat, and very few had much to say about the Argentine devaluation, Turkish instability, moderating Chinese manufacturing, strikes in South Africa, or the slowing of the Fed’s quantitative easing.   Many emerging currencies have been falling for months, Turkey has been firing and reassigning police officers and judges for awhile, South Africa has had labor unrest for quite some time, and the Fed’s modest cut back in its bond buying program has been well known for months.  It’s hard to imagine that Fed purchases of $75 billion worth of bonds a month was okay for financial markets, but $65 billion is some kind of financial calamity.  Nonetheless, strategists suddenly have the charts, words, and wisdom to explain the market’s recent bout of agita.

There’s so much speculative money chasing stocks, bonds and currencies, it shouldn’t come as any surprise that markets can become unstable without much warning.  There’s probably more psychology than fundamentals buffeting the market.  We like it when those traders drive up prices and make us feel richer, but it’s not so pleasant when they all head for the exit at the same time and drive prices down.

In due course we’ll find put that one or more factors contributed to these unpleasant markets, and some strategists will look prescient. Meanwhile we’re at the mercy of traders and hedge funds who will be looking to make money from the financial turbulence.

Monday, January 27, 2014

Three Stops on the ‘Business as Usual’ Circuit

Three Stops on the ‘Business as Usual’ Circuit

Most American’s will be lucky to get a raise in 2014.  Not Jamie Dimon.  Most of us have to suffer our investment losses.  Not William Ackman.  Most of us will be thrilled if we can sneak off to the beach for a long weekend.  Not the attendees of the World Economic Forum.  The Friday edition of The New Time’s Deal Book captured a world that is ever more distant from reality of most people’s lives.
Work Teams I (1996)
From the Board Room: We begin our tour with the Board of Directors of JP Morgan.  Despite settling one case after another, Jamie Dimon is going to receive an increase in his compensation this year.  In 2012 his compensation was cut in half to only $11.5 million.  While Mr. Dimon was forced to survive on half pay, the rest of his senior management team didn’t take any hit at all and split $54 million among four executives.  Amazingly Mary Erdoes, the CEO of Asset Management where the large trading losses occurred, was given a $500,000 raise to $15 million in 2012.[1]

Mr. Dimon’s backers cite the bank’s strong performance in 2013, excluding the settlements, as evidence that Mr. Dimon deserves a raise.  With borrowing costs at nearly zero courtesy of the Federal Reserve and an ebullient stock market, JP Morgan had the winds at their backs.  Fixed income trading was probably the only business that was disappointing in 2013.

The Times reported the followings positions on Mr. Dimon’s compensation.  These views are only sustainable in the upper reaches of corporate America.

Leaving his compensation unchanged could have sent a symbolic message of contrition to authorities.

Yet cutting Mr. Dimon’s pay would, some board members feared, alienate the chief executive.

Mr. Dimon is also benefiting, the people say, from a view among some board members that the government’s assault on JPMorgan is driven less by the bank’s actual transgressions and more by a desire, stoked by anti-bank sentiment, to appear tough against Wall Street, the people said.[2]

Mr. Dimon owns about $425 million worth of stock in JP Morgan, and he’s going to receive more shares.  Whatever his compensation, I don’t think it will send a message of contrition.  Whatever his compensation, I don’t think he should feel alienated.  Whatever his compensation, it is hard to feel sympathy for the powerful and wealthy when they attempt to cast themselves as helpless victims.  In any event, Mr. Dimon made his feelings clear about the government’s investigation of JP Morgan when he said in an interview in Davos, “I think a lot of it was unfair.”  In the end, the board raised his compensation to $20 million, a 74% increase over 2012.

From Capitol Hill: Senator Edward Markey has asked the Federal Trade Commission and Securities and Exchange Commission to look into the business practices of Herbalife (NYSE: HLF), the nutrition company whose sales practices have been questioned by William J. Ackman.  Mr. Ackman runs Pershing Square, which has a big short position in the stock and has lost a great deal of money.  There isn’t an obvious and direct connection between Senator Markey and Mr. Ackman.  The New York Times notes that Sen. Markey is certainly aware of Mr. Ackman’s views on Herbalife and his short position.  Moreover, the paper notes that Mr. Ackman is a significant contributor to the Democratic Party and the Democratic Senate Campaign Committee in particular.  Senator Markey was a recipient of money from the DSCC.  Since 2000, Mr. Ackman and his wife have donated $414,000 to various candidates and PACs.

In defending Mr. Ackman, The Times quotes Martin H. Peretz, the former editor of The New Republic and a friend of and investor with Mr. Ackman, as follows:

Political contributions don’t necessarily come with strings attached.  [C]ompared with the vast wealth of Mr. Ackman, who is a billionaire, the contribution to the senatorial campaign committee last year was small.[3]

While Mr. Ackman’s $32,400 contribution to the DSCC may be small in the hedge fund world, it is the maximum allowed under campaign finance laws.  I’m sure the Democrats were glad to get the money, because Mr. Ackman made the maximum contribution in 2007, 2008, 2009, and 2010 before contributing $20,000 each to the Republican Senate and Congressional Committees in 2012.[4]   Mr. Ackman, like many other money managers, backed away from President Obama and the Democrats in 2012.  

Campaign contributions, especially the big ones, always have strings attached.  For billionaires like Mr. Ackman, the price of influence is simply cheap.

From Davos:  After a day exploring the plight of Syrian refugees, the causes of extreme poverty, and the fallout from global warming, it is time to party.  Here’s a description of the scene from Dealbook:

A run-down bar on the ski resort’s main drag was completely transformed with stuffed animal trophies, including heads of buffalo shooting laser beams from their eyes. Wine and cocktails flowed. John Legend sang and played the piano. And the guests included Ms. Mayer of Yahoo, Lloyd C. Blankfein of Goldman Sachs and a crown prince or two.[5]

One of the hot invitations this year is from Google, which planned to return to the party scene on Thursday night. Ms. Blige was indeed scheduled to perform, and food was to be prepared by a Michelin-starred London chef, Tom Aikens.

Many critics would ascribe these three scenes to income inequality.  The social inequality and entitlement represented by these stories is even more damaging.