Why Shareholder Rescue Never Comes to end Too Big to Fail Banks

In his ProPublica article, Jesse Eisinger looks at why shareholders don't end the problem of Too Big to Fail banks.

Mr. Eisinger had hoped that shareholders would put pressure on bank management because of low share prices to break up these institutions.

He considered the possibility that because of opacity, shareholders were worried about how the risk would be distributed if they forced a break-up.  So this restrained the shareholders forcing a break-up.

Then, leaving opacity behind, he settled on the idea that shareholders actually prefer banks to take on risk as they have capped downside and unlimited upside.

Mr. Eisinger is on the right track.  However, he failed to see the link between opacity and the type of shareholders that banks attract.

As regular readers know, under the FDR Framework, there is a three step investment process:

1. Investor independently assesses all the useful, relevant information to determine the risk of and value of the investment;
2. Investor solicits bids from Wall Street to buy or sell the investment.
3. Investor compares the price shown by Wall Street to independent valuation to make buy, hold or sell decision.

When there is opacity, as is the case with banks, investors do not have access to all the useful, relevant information and therefore they cannot independently assess the risk or value the investment.  As a result, investors cannot go through the investment process.

So buying or selling shares in a bank is not investing, but rather something else entirely.

As the Bank of England's Andrew Haldane says, banks are "black boxes".  Nobody other than the bank regulators knows what risks are inside these boxes.  This has important implications for the types of shareholders that banks attract.

Investors are not attracted to banks because investors cannot go through the investment process.  They recognize that buying or selling bank shares is nothing more than gambling on the contents of a black box.

Naturally, the shareholders who are attracted to the big banks are not investors who would exert discipline on management, but rather gamblers.  By definition, these gamblers want bank management to take on risk because as Mr. Eisinger noted their downside is capped and their upside is unlimited.

SEC's Jesse Litvak case shows the value of opacity to Wall Street

In a must read post, ZeroHedge looks at the SEC's case against Jesse Litvak and his conduct in selling mortgage-backed securities.  What ZeroHedge reveals is just how much money Wall Street makes from  opacity.  Specifically, opacity as it applies to both the securities and trading in the Over the Counter (OTC) market.

Regular readers know that since before the financial crisis even began, your humble blogger has been trying to bring transparency to the opaque structured finance market.

My focus has been on bringing 'valuation' transparency as oppose to 'price' transparency as price transparency without valuation transparency is worthless.

The reason that valuation transparency is critically important is that it is valuation transparency that makes it possible for an investor to go through the three step investment process:

1. Independently assess all the useful, relevant information to assess the risk and value the security.  This independent assessment can be done by the investor or an expert third party (think fund manager or an expert hired by the fund manager) hired by the investor.
2. Find out what price Wall Street will buy or sell the security at.
3. Make a decision to buy, hold or sell the security based on the difference between the price shown by Wall Street and the independent valuation.  If a decision is made to buy, limit the purchase to what the investor can afford to lose given the assessment of the risk of the security.

It is under valuation transparency that an investor is provided with access to all the useful, relevant information in an appropriate, timely manner so that the independent assessment of this information can take place.

Without valuation transparency, it is impossible to complete step one of the investment process.

If a buyer or seller of a security cannot complete step one of the investment process, they are reduced to gambling when they buy, hold or sell a security.  Specifically, the buyer or seller is gambling that the price shown by Wall Street reflects the fair value of the investment.

What the Jesse Litvak case shows is how Wall Street uses the simple fact that the buyer or seller is gambling and doesn't know what the fair value of the investment is to profit.  This profit goes away if there is valuation transparency as the buyer or seller knows what the fair value of the investment is and won't transact if the price doesn't reflect this value.

For many years one of the best jobs on Wall Street in terms of a mix of job safety and compensation, was to be a fixed income trader-cum-salesman working for a major bank with a deep balance sheet, which could hold illiquid securities on its prop account, to dispose of as the "flow" (or clients) required, and on unsupervised and unregulated terms that were simply a verbal arrangement between the bank trader and the end client, usually a counterparty trader working for a major institutional buyside shop, including mutual or hedge funds. 

Since for the most part, the buyside traders operated with other people's money, they were largely indiscriminate on the fine pricing nuances of the acquisition (or disposition) of the securities at hand, and while to the "other people's money" under management whether a given bond was bought for 55 or 55.75, or a given MBS was sold for 72-6 or 72-16 meant little (after all the trade was driven by a big picture view that the security would go up or down much more and certainly enough to cover the bid/ask spread, resulting in much larger profits upon unwind), the transaction price had a huge impact for the bank traders-cum-salesmen arranging said deals. 

Because when one is selling a $40 million MBS block, a 1 point price swing equals a difference of $400,000. Make 15 such deals per year, and one's $1,000,000 bonus (assuming a ~15% cut on the profits) is in the bag....

Bottom line:  the lack of valuation transparency allows Wall Street to extract a significant amount of profits as the buy-side is only gambling when it buys opaque structured finance securities ('trade was driven by the big picture view that the security would go up or down ... resulting in much larger profits upon unwind').

When there is valuation transparency, buy-side firms have a fiduciary duty to use this information.  This immediately ends Wall Street's ability to skim the bid/ask spread.

In short: the highly lucrative and extremely profitable bid/ask skimming that every bond trader engaged in for years has been impossible in equities for the simple reason that the bid/ask spread on most equity-related securities is minute and the market is far deeper and (at least used to be) far more liquid.

And the reason that the equity markets are far more liquid has to do with the ready availability of valuation transparency for most firms ('black box' banks are the exception).

It also explains why 4 years after the Great Financial Crisis, there is still no centralized, computerized trading portal for OTC trades, including corps, CDS, loans, etc. 

Doing so would mean that the banks would give up billions in additional commissions that they could charge if all such trades were facilitiated by the kind of sales coverage middlemen described above. 

Because while a salesman was incentivized to peel as much as they could of a given trade, they would at best pocket some 10-15% of the total spread. The rest went to the bank, and thus to management in the form a massive bonuses: comp at banks is not 40% of revenue for nothing, with some money left over for "retained earnings."

Please note, ZeroHedge has laid out why Wall Street is fighting to protect opacity.

But there is no reason to worry about Wall Street's profitability as it has shown itself to being equally adept at making money where there is valuation transparency (see the end of fixed commissions on stock trades for example).

With opacity, Wall Street makes a lot of money on each transaction, but there are very few transactions.  With valuation transparency, Wall Street makes a little money on each transaction, but the volume of trades is significantly higher.  As a result, Wall Street firms actually ends up making more money when there is valuation transparency.  They just have to work harder to make their money.