Unilife Releases OrbiMed Loan Covenants: Is Default Imminent?

In May, we explained how UNIS – with the helping hand of the SEC – was able to file the OrbiMed credit agreement and leave out very important details, particularly what financial performance it had to achieve to avoid triggering an event of default/covenant breach:

As far as we know, we are the only observers to find this unacceptable, as it allows UNIS to severely impair analysts’ and investors’ ability to evaluate the firm’s default risk and valuation.
Continue reading

SEC, NASDAQ, NYSE Finally Do, Er, “Something” To Combat Reverse Merger Abuse…

The SEC is a joke, a mockery of a regulatory agency, mandated with (among other things), investor protection and ensuring fair, transparent, and fraud-free capital markets.  It has failed, quite fantastically in these tasks, especially in the (latter part of the) past decade, chronicled by myself and others with great frequency and depth.

Thus, it is little if any surprise that when it came time do something about the fantastic frequency and magnitude of fraud in the (largely Chinese) reverse-merger industry, the “fix” the SEC and the exchanges have come up with to stem RM market abuse really isn’t a fix at all.  Rather, the “solution” to the problem is simply to put a speed bump or two on the road to U.S. reverse-merger listing:

Continue reading

Financial Regulation: One Step Forward, Twelve Steps Back – FINRA’s Bid for More Power

We here at Stone Street Advisors are long-time critics of our Financial Regulatory regime, with little exception, and with the SEC – charged with protecting the interests of investors – being the recipient of the majority of our criticism as a result of their repeated and remarkable failure to do anything even remotely close.

Worse, though, than the SEC is FINRA, the industry’s self-regulatory organization. FINRA (ex NASD) licenses brokers and takes action against them (supposedly). Yet I have personally met licensed brokers who do not understand basic concepts necessary to work in Finance, for instance in one particularly irritating case, that of interest, simple interest, not even compound interest. I’ve met brokers who sell complex structured products to widows without knowing a single damn thing about them. I’ve seen it all, and it makes me sick, but FINRA doesn’t care. Generally, unless the abuse is so widespread and so egregious, neither does the SEC, but at least they sometimes take large, sweeping actions (although its often too little, too late).

FINRA is a dummy regulator, an industry lobbying group masquerading as a regulator looking out for the interests of investors. And that’s putting it as nicely as I possibly can.

So imagine our amusement, nay, disgust, when we read that FINRA wants to take on the added responsibility of overseeing thousands of more investment advisors.

The financial services industry cannot police itself, and while I think most in the business are good, honest people, the reality is that there are some scumbags, some bad seeds, and then there are just the morons, who may out number the former category, who make it necessary for the industry to be subject to harsh yet not overly-strenuous Federal (and other) government regulation. The answer is not to let the industry that has so utterly failed to regulate itself have a shot at doing more of the same. The answer is to cut the bullshit and fix the SEC, which, despite being utterly embarrassed in the wake of (among other things) the Madoff fraud, Chinese reverse mergers, and countless other examples of its institutional ineptitude, remains broken.

As Harry Markopolos – the Madoff whistleblower – clearly shows in his book, “No One Would Listen,” there are clear was the SEC can improve, if only it wasn’t shackled by lack of funds from Congress, a wide swath of responsibilities without the resources to handle them, and an institutional incentive system that does not exactly encourage employees to go above and beyond or stick their necks’ out.

More than three years after (into?) the Financial Crisis little if anything has changed from a Financial Regulatory perspective. We may have Dodd-Frank (kind of), but the industry is broadly the subject of little if any new/additional regulatory burden, excepting some very specific areas. Ultimately, we have the Financial Regulators we deserve, just like we have the politicians we deserve. The problem is The People simply do not understand how bad the regulatory system that is supposed to be protecting them really is, so the politicians don’t care, and thus, the vast majority of them do and have done little to fix the system, while their constituents remain at risk.

There have been some signs of life elsewhere in improving financial regulation, but protecting retail clients – even ultra high net worth ones – is still no one’s priority list.

The Securities and Exchange Commission of La Mancha

I’ve long been a critic of the ridiculous regime created by NRSRO legislation, that is, the Rating Agencies, or really, S&P, Moody’s, and Fitch.  There are so many problems from top to bottom, left to right that I’m not even going to begin to list them here.  I will, however, quote what I think is a rather eloquent description of the core problem from a man far smarter than I: David Rowe in a post he wrote on the Kamakura Corporation blog (emphasis mine, as usual).

Currently, the US Securities and Exchange Commission (SEC) is soliciting comments on various proposals to reform the institutional framework of credit ratings. The supervisor wants to ensure effective ratings, as if there is some objective truth that can be discovered as long as the right incentives are in place. In fact, when dealing with innovative, highly complex and historically untested structures, no such objective truth exists. The perceived credit quality of such instruments can be as diverse as views on whether a given company’s shares are a buy or a sell. Imposing a one-size-fits-all rating scheme risks unrealistically homogenising market perceptions that should be highly diverse if adequate information for detailed analysis was widely available. Furthermore, it is just such homogenised perceptions that can lead to herd behaviour and major market dislocations when broadly shared expectations prove to be unfounded.

Trying to reform market structure in search of a non-existent objective measure of credit quality and associated risk amounts to a mission impossible. It is bound to bureaucratise and homogenise ratings, thereby creating an inflexible structure that is vulnerable to a systemic crisis. In fairness, the SEC is only doing what was mandated by the US Congress. Nevertheless, what should be done is to seek a framework that will make all the relevant data underlying such securities readily available in a standard format to a broad community of analysts.

Attacking the independence and objectivity of the ratings agencies due to their business model is easy, but it largely ignores the deeper problem Rowe describes above.  The ratings agency approach to credit analysis is inherently and impossibly broken, and efforts to reform it merely amount to tilting at windmills.

However, while hardly perfect – far from it – I think the equity model and the equity-research-centric approach currently adopted by the SEC would be largely instructive for how to reform the credit research industry.  A not insignificant amount of the information needed to analyze a firm’s credits is already included in the filings publicly-traded firms already make to the SEC.  Why not align the reporting requirements for debt and equity issuers?  Why not incentivize a movement to democratize the credit market just as the equity market was over the past 30 or so years?  Seeds of revolution (or rebellion, depending on your perspective) have long-since been planted with exchange-traded hybrid securities, ETNs, and a myriad of other products and services.

I realize the Herculean (if not downright Sisyphean) effort facing regulators with their current responsibilities from Dodd-Frank, but why not kill several giant birds with one stone instead of ignoring keeping the blinders on until the next inevitable crisis?

Reality vs. Matt Taibbi, Part I

Over the weekend I finally relented and read schmuck “journalist” Matt Taibbi’s most recent allegations against Goldman “Vampire Squid” Sachs.  The plan is to write a longer, more formal response, but in the interim I just want to take a few minutes to address the primary shortcoming of Taibbi’s “work,” namely, that he has no fucking clue what he’s talking about.

Continue reading

Why Levered ETFs Don't Need to Be Banned

Felix Salmon wrote a post today in response to both my, and Kid Dynamite’s posts in response to his original post, wherein he said the SEC needs to do more to protect retail investors from blowing themselves up with levered ETFs.  I certainly appreciate the open debate (and I hope our readers do as well!), but it seems like Felix is still missing a few things, and making a few factual leaps of faith, which I’d like to discuss here.

He begins by asking how laymen could possibly understand these securities if an (apparently, I’m not familiar  with the gent mentioned) qualified financial journalist doesn’t understand how they ETF’s work:

Except, if you go back a month to when KD last wrote about these things, you’ll find him linking to a column by Dave Kansas — the founding editor of thestreet.com, and about as veteran and admired a markets journalist as it’s possible to find. And he got it wrong, as the correction at the bottom of the column attests.

I’ve read the article, wherein the author said:

Conversely, the ProShares UltraShort S&P 500 (SDS), which makes a double bet against the S&P 500, is down 40% in the past year, which compares to a 13% gain for the S&P 500. That means the “double” bet against the index is doing worse than promised, highlighting another risk for such funds: They often fail to track their stated performance goals.

As the correction added after publication (almost) admits, this is an egregious mistake if it was made honestly, and a gross misstatement if not.  Either way, I can’t find any way to excuse such ignorance from the WSJ, The Financial Paper of Record, even with the correction.  Everyone makes mistakes, of course, but this isn’t some casual blog post, or tweet; its THE Wall Street Journal!  Perhaps (some) financial journalists should check with their sources and/or take a few more minutes to learn about what they’re writing before they hit the “publish” button, but that’s neither here nor there…

As both KD and I have explained, the sponsors of these ETFs go to significant lengths to explain they are designed to target 2 or 3x the DAILY return of the index, therefore, comparing returns of the ETF and the index on a longer time period is at best, apples and oranges.   Felix continues:

My point here is that if you want to find out how easy and obvious something is, you don’t first look for someone who understands it and then ask them whether understanding it is easy. Instead, you look at a broad audience of people who ought to understand it, and look to see what percentage of them actually do.

While I agree that you don’t ask your friend who’s a Quantum Physicist to explain how easy classical physics is to understand, if we look at the “broad audience of people who ought to understand it” that Felix mentions, they should, in fact, be able to understand concepts that could be the basis for questions on the TV show “Are You Smarter Than A Fifth Grader?”  If adults with brokerage accounts who can get the approval I mentioned in my last post from their broker to buy levered ETF’s (which usually requires a relatively substantial amount of money and long-ish relationship) can’t understand arithmetic, then we have a MUCH bigger problem to discuss than whether levered ETFs are or are not a good idea!

Felix’s next non-sequitur is equally confusion:

And if you look at the people who are investing in TBT, it’s clear that the vast majority of them do not understand how it works. For all that there are prominent disclaimers in the abbreviated summary prospectus about such things, those disclaimers are not preventing people from making long-term investments in a security which should never be held for longer than one day. They’re not working.

In his initial post, Felix said that since TBT (and thereby all levered ETFs) are “intraday-only” trading instruments, the fact that the average daily volume is only ~1/10th of the shares outstanding, that means 90% of shares are held by people who aren’t using them properly.  This is also a non-sequitur in and of itself, as  example, see this paper on trading leveraged ETF’s from NYU (pdf), which says:

The study also shows that leveraged funds can be used to replicate the returns of the underlying
index, provided we use a dynamic rebalancing strategy. Empirically, we find that rebalancing frequencies required to achieve this goal are moderate, on the order of one week between rebalancings. Nevertheless, this need for dynamic rebalancing leads to the conclusion that leveraged ETFs as currently designed may be unsuitable for buy-and-hold investors.

That’s only from the abstract to the paper, but the point is that while 90% of the fund float may not be turned-over each day, suggesting that is entirely from naive buy-and-hold retail investors is itself incredibly naive.  In a simple regard, an investor can hold levered ETF’s on a greater-than-daily basis to make a longer-term bet on sector volatility, instead of whole-market vol (see VXX, etc).  Levered ETFs also give a trader/investor the ability to get levered returns without having to deal with margin calls, which in volatile markets is a great comfort, to say the least.  One does not need to be a professional trader to put-on such a trades, I promise, as I’m not myself a professional trader (although I suppose a decade+ in/out of markets, BS in Finance, and a few years working does make me slightly more experienced than the average Joe…).  I can’t quantify to what degree these levered ETFs are used by non-amateurs, but I can all but guarantee that it is much greater than 0%, as there are several reasons to hold them for greater than intraday.

Felix then says he’s concerned that ETFs are a problem because the same rules that are applied to stocks – which have a positive social value in that they represent ownership of tangible assets and help firms raise funds – are being applied to ETFs, which have no such implicit value, social or otherwise.  He also says that these vehicles are mathematically guaranteed to go to zero, which is not the case at all, at least not in the way he puts it, which assumes that is the only option (over a long-enough period of time this may very-well be true, but we are not talking years upon years here).

To see how levered ETFs actually behave, recall the graph from my last post of FAZ, the ultra-short financial ETF v. the Financial SPDR, XLF***, which showed as XLF increased over the past two years, FAZ decreased by even more.  If we zoom in on just the first three months of that series, we can see just exactly what it takes for a levered ETF to “go to zero:” relatively large swings and/or a relatively short period of time.

In this case, it was both large swings AND a short period of time.  FAZ lost 47% of its value after just 5 trading days, over which FAZ’s average daily return was 2.7x that of XLF!  You can see that during these three months, there were some relative large corrections in the opposite direction of the trend, for example after the first initial dive to almost -50%, FAZ went up so that it was only -~30%.  Because FAZ was already beaten-down and returns are compounded, smaller decreases in the index resulted in even larger gains for FAZ, driving it back up almost as quickly as it dropped.

Generally speaking, only way for an ultra-long ETF to go to zero is for the index upon which it is based to trend downward over a period of time, with few and small upward corrections relative to the downward ones.  For an ultra-short ETF to go to zero, as is almost the case with FAZ, the underlying index needs to march steadily upward, with little downward corrections relative to the upward ones.

Felix then says that since these securities trade on the same exchanges as stocks, and have symbols like stocks, its easy to confuse the two.  I’m not even going to dignify that bullshit excuse with a response.

Felix’s ultimate concern is that he doesn’t see why these levered ETF’s should exist.  He says:

What purpose do they serve? If you want to make a leveraged bet on a certain asset, you can buy it or short it using borrowed money. These things are obviously harming a lot of people — the investors wielding billions of dollars who are holding them for long periods of times. Who are they benefiting? It seems to me that the cost of leveraged ETFs is greater than the benefit; that’s why I think the SEC should look into them.

Well, as I briefly discussed above, there are legitimate ways to use levered ETF’s as part of a reasonable, well-thought-out trading/investing strategy.  They can also be used for rank speculation, and there is NOTHING WRONG WITH THAT, so long as anyone using them for that purpose understands the possible consequences of so-doing.  Second, I have yet to see any conclusive evidence that any remotely significant and/or widespread damage has been done to Joe & Jane Investor.  Third, I just don’t see any sort of proof that the cost of levered ETFs outweigh their benefit.

The fact of the matter is that retail investors can’t just put on the same trade as a levered ETF without them; Reg T prohibits it by limiting initial leverage.  To (over)simplify, retail accounts must put up at least 50% of the value of purchases in their brokerage account within a certain amount of days, otherwise they will have the position sold-out.  Clients could gain greater leverage by buying options, but I fail to see how that would be a less inappropriate strategy for retail investors, as they have the same potential loss – 100% of the investment – but are even more difficult to understand than ETFs!

So long as levered ETF’s are not being sold by predatory brokers trying to juice their commissions off unsuspecting and unsophisticated clients, I don’t see anything wrong with levered ETFs, which as I said in my previous post, give clients the option to share in the gains – as well as the losses – available to professional traders.  I’m glad Felix is asking these questions because apparently they have not yet been sufficiently addressed, and its clear he is not the only one out there who’d like some answers.  However, just because he – and others – don’t have the answers, that doesn’t make his conclusions logical, let alone right.

I’m all for investor education and protection from both unscrupulous tactics and illegal information asymmetry, but neither of those things are part of Felix’s argument for greater regulation.  Retail investors constantly complain they don’t have the same profit-making opportunities as professional traders and investors, but look what happens when they do (if Felix’s arguments are to be believed); they not only squander and abuse it, but in so doing, shirk responsibility and accountability for the consequences of their actions.

News flash: With great opportunity for profit comes great opportunity for loss.  There is no such thing as a free lunch.  There is no risky return without the risk, etc, etc, you get the idea (I hope!).  If retail wants the opportunity to get rich through “smart” investments and trades, they necessarily must accept the fact that they may very-well get poor the same way.

*** XLF is not the index for FAZ but it is extremely close, so its used as a proxy for the Russel 1000 Financials

SEC investigating structured products: Déjà Vu all over again?

Never let it be said that the denizens at the Securities and Exchange Commission are a stodgy, humorless bunch. A recent WSJ article, Complex bond faces regulators Scrutiny , almost got me. I am not sure if they meant to have an early jump on April Fools, or if some fat fingers at the WSJ was involved.  In any event, well played Schapiro!
The Complex bonds being scrutinized, also known as “reverse convertible notes” falls under the broad investment category of structured products or in the old school vernacular Derivatives, the eleven letter four letter word.
According to the complaint, apparently the bad boys of Wall Street:
“failed to disclose the risks and fees to the investors before they bought the notes.” and possibly failed to disclose “potential conflicts of interests, such as selling a note linked to the stock of a company it is advising.”
Not only have we been down this path before, but with a few well placed directorships, maybe an IPO allocation or two, whatever the legislation and if indeed there is one, it will be tepid and ineffective. I have many reasons for my opinion but I will give three. One is history, two is legislating for greed, stupidity and downright laziness is nigh on impossible and the third I will give you at the end.

Did Mary Schaprio Lie in Her Testimony to Congress?

In her testimony to Congress today, SEC Chair Mary Schapiro appears to have painted an overly-rosy picture of her accomplishments and the changes she’s made at the SEC since taking the helm.  In fact, unless the SEC’s website is simply painfully out-of-date (which is a pretty damn easy fix), it appears she may actually have spoken a un/half-truth, when she said (emphasis mine):

Continue reading

SEC Division of Risk, Strategy, & Financial Innovation Could Use A Few Good Men…

I realize the SEC’s task is a gargantuan one, especially considering the severely constrained resources, but there’s just no excuse for things like this.  The SEC’s Division of Risk, Strategy, and Financial Innovation – the group created in 2009 to supposedly “enhance our capabilities and help identify developing risks and trends in the financial markets” – does not have anyone running the Office of Data & Data Analytics.  How the hell is the Division supposed to do its job if there’s no one analyzing data?!?!?

Continue reading

On The SEC's ABACUS Case Against Goldman Sachs

Back in Sophomore (maybe Junior) year Finance class, we learn some very basic approaches to investment analysis. Before we ever touch upon analytical methods, we learn high-level stuff, for example, first and foremost you should analyze a potential investment on its merits; extraneous information is, at best, of secondary, tertiary, or just no concern. If I’m considering buying the ABACUS synthetic CDO deal at the heart of the SEC’s case against Goldman, my primary focus is to analyze the RMBS transactions in the reference portfolio selected by ACA (NOT Paulson – ACA could have throw out EVERY/ANY security Paulson suggested if they thought it was a crap bond), the structure of the deal. Once I’ve done the granular analysis of EVERY bond in the reference portfolio – as close to loan-level as possible, especially with the 20+ person diligence team that IKB reportedly employed – and decided everything looked good, then and only then would I get into other considerations. Have we covered all our bases? Are we missing anything? What are other smart people doing with this/similar transactions?

I firmly believe this story pretty cut & dry: IKB/ACA/ABN did their diligence (well, let’s give them the benefit of the doubt they did, at least) and determined they wanted to buy the deal. They had the blessing of the Ratings Agencies (which, with the wisdom of hindsight – key word – we know was not a very bright idea), they had other “smart” people reinforcing their view (long live confirmation bias!), and the financial industry, as a whole, was generally still long housing.

Anyone who claims that the buyers (longs) would have backed-out if they knew some no-name Hedge Fund manager with ZERO mortgage investing experience suggested part of the reference portfolio is material is full of it. The buyers were arrogant, over-confident in their experience and ability to analyze complex structured finance transactions. Hell, if they WERE made explicitly aware of Paulson’s “involvement” they probably would have enjoyed a good, hearty laugh at his expense and quite possibly even bought MORE of the deal when they knew they were up against such a rube, a novice, a guy in WAY over his head.

One person on the other side of this debate says that in order for me to make such a claim I must be either clairvoyant or have worked on IKB’s deal team in 2007. While I think that’s a bit of a non-sequitur, I’ll allow it, and then accuse the SEC of the same apparent psychic abilities. How on Earth do they presume to prove what IKB WOULD have done? How could anyone prove what they WOULD have done in the past? Sure, I WOULD have prepared differently for the GMAT’s if I knew I was going to run out of time on the math section, but I didn’t KNOW that would be the outcome, since I knew the material very well. Similarly, IKB “KNEW” structured finance RMBS investing, they just didn’t know or expect the outcome we know so well with the benefit of hindsight.

That’s it. Everything else is irrelevant. IKB knew the material that was going to be on the test (the composition of the reference portfolio and all other relevant deal information), they had the ability (experienced deal team) to prepare for the test (analyze the deal), they just came to what turned out to be the wrong conclusion, and didn’t do as well as they expected.

Ultimately, whether Paulson’s involvement will be decided in court, and what I have to say is, unfortunately, just words on a page.  I agree there is the possibility that when all of the information is made available (emails, etc), there may have been an intent to deceive, or scienter,but that’s for the courts/lawyers/etc to decide.

Update: Since I published this in haste (my bad), I should have rephrased the bolded text three paragraphs up, to ask “How does the SEC believe they can use the ‘reasonable person’ test in this situation?”  That is, this is a market, which by definition necessarily includes two parties both of whom believe themselves to be reasonable with different, nay, opposing views.   Thanks to @_phlox for the legal edit.