The Devil Is in the Details

“We need to pass the bill to see what’s in the bill.” Nancy Pelosi lobbying members of Congress why we needed to pass ObamaCare.

“You can read the Obama Trade bill after we pass it.” Paul Ryan commenting to the press on why they have not seen the details of the bill.

imagesCA27GPLZWe are all stressed. We all have too much to do. Life is so complicated that we don’t even have time to do the basics of our jobs….like Congressional Representatives actually reading the bills they plan to pass.

I get it. I used to sell new issues to my clients without reading the prospectus. (a prospectus is the document that governs the new issue).  In reality, nobody reads them and anybody who works on Wall Street will tell you that nobody reads them. I used to be  a salesperson at a bank and relied on the capital markets team to make sure that our governmental compliance was correct and accurate.

However, just as there is reason for Congress to read bills before they make them law, there is reason for traders and investors to read a prospectus before issuing or investing: there is money to be made by reading a prospectus.

Whenever a company issues a stock or a bond, a “prospectus” is attached that explains everything about the issue. These documents are thick with tiny print, boring, dull and obtuse. No one bothers to pore over the detail in them.  That is, until a deal goes bad. Then the prospectus become required reading for the professional speculator. When I worked on a trading desk, I would often have to price three deals per week. Doing a new deal is time consuming and entails the following actions:

  • Going on road shows;
  • Doing conference calls;
  • Talking to the different analysts;
  • Talking to portfolio managers;
  • Calling clients;
  • Looking at the financials;
  • Coordinating with the syndicate desk;
  • Pricing and trading the deal.

Its a lot of work and the whole structure of the deal is encapsulated in the prospectus.

The capital markets team, which brought the deals together, would be responsible for negotiating the terms and getting the legal documents together to build the prospectus. Given that the capital markets team was also overworked and pitching tons of deals, they would often use standard documentation forms from prior transactions to get the prospectus done. Think of a high-end “cut and paste” job.

If the deals were from the U.S that approach might present less of a problem. However, I worked in emerging markets where bonds were issued by different countries, in different languages, with different governing laws and an assortment of legal jurisdictions that governed the deal.

As long as the company paid its interest and principal no one would read the prospectus. But if the company fell in arrears, the first call we would get would be from the owners of the bonds requesting a copy of the prospectus. Suddenly, the fund managers, lawyers and traders found time to look at the intricate details of the issue they owned. They did so as a matter of protection.

Once a company was behind in its payments, vulture funds would circle around to see how they could pick at the carcass. Vulture funds were always looking at ways to buy assets on the cheap. For example, a typical prospectus might contain a clause stating that all the assets had to be sold to pay off all their bondholders. If the bonds were trading at 20 cents on the dollar, and the company could be liquidated for 30 cents on the dollar, a vulture fund might buy as many bonds as they could to make a quick profit.

To give you an idea as to what type of person and mindset you need to read prospectuses, take a look at a great book by Michael Lewis called “The Big Short.Lewis goes into great detail about how Michael Burry, an ex-neurologist with Aspergers Syndrome, would pour over the prospectus of arcane real estate structures. He locked himself in a room for hours on end for six months to understand what these issues were about. Only by doing so was he able to fully understand how these deals worked.

After reading the prospectus, he formed a fund and sold short many of the real estate instruments that were being issued by Wall Street banks. Many of his colleagues, peers and the bank themselves, thought he was crazy. The irony was that he had read the prospectus in its totality and knew more about the instruments than the banks that were issuing them!  The end result? Burry made millions of dollars.

He knew that the business of the banks is more transactional in nature and more orientated towards generating commissions. The salespeople were overwhelmed by the amount of deals they were doing and did not have the time to look at the minutia of the deals. Part of the reason that many salespeople did not understand the products is because the financial instruments were never fully explained to the professionals who sold them.

How does this happen?

Money is made in the financial markets by possessing knowledge that others don’t have. Even employees at the same firms will withhold information from each other. To the extent one trader can make more money than another trader, he will do so knowing that his take home pay will be greater. Because of this, employees at the same firm are not keen to share their trade secrets with their co-workers.

I have been in meetings where a firm would try to sell massive issues yet only give the barest minimum of information. Never were any of the intricacies of the deal  offered up. The presentation would be filled with acronyms and code language that made it virtually impossible for anyone to decipher.  If anyone asked a question, often times that person would be ridiculed for being stupid and not understanding what had just been explained and “clearly” understood by everybody else in the room.

Maybe that is why, in the end, all of the banks went under. They had no idea what they were selling. If the banks knew what they were selling, people like Michael Burry could not have made his millions.

Which gets me back to the quotes from Nancy Pelosi and Paul Ryan. Congress passes bills into law without even reading them. This is no different than what happened, and still happens, on Wall Street. It was only through one thoughtful man taking the time to actually do the research that was there for all to see that caused change to come to Wall Street.

If we don’t start taking the time to read the bills we’re passing, it won’t be a bank that goes under. It will be the whole country.

Trust as a Business

There was a great piece on 60 minutes last night with Michael Lewis about the financial markets. It is well worth the 14 minutes to watch it and you can see it here:

Michael LewisThe topic was about how high frequency equity trading was destroying the financial markets. The solution to solve the problem, as outlined in the interview, is fascinating…creating a platform were people can trust to trade.

Although as we sit here in 2014 the markets are at an all time high, confidence in the financial institutions is at an all time low. Stock ownership has declined dramatically and given that we live in a capitalistic society this should shock many people. The underpinnings of what makes our society tick… free enterprise, risk taking, entrepreneurship… are being taken advantage of and corrupted by the financial marketplace; these risk takers are shunning the market where capital is being allocated.

Over the last 20 years or so stock exchanges have traded humans for machines. I would venture to say that over 90% of all stock exchanges are now electronic. So, now, when you place an order to purchase a stock that order is being handled by a computer not a person.

As this transformation has taken place, pure computer power and the speed of the fiber network has taken precedent over the ability to allocate capital efficiently. High frequency traders over the last 5 years have built these highly complex algorithms to trade and can now execute trades in milliseconds for fractions of a penny. So by the time “Joe Investor” can execute a trade, the high frequency trader can buy and sell that same stock to “Joe Investor” at a slightly higher price and make money off of his order.

Here is an example in practical terms: Say that you wanted to go to the Dolphins game in Florida and saw 4 tickets on stub hub for $20 each each. You decided to buy the 4 tickets but were only successful at buying 2 tickets at $20.00 each. The remaining two tickets, those same additional 2 tickets that you tried to buy minutes before, are now trading at $25.00 each. Why? Because the system recognized your order and filled only 1/2. Then, it raised the price on the other 2 tickets. Since you really need the 2 extra tickets, you buy the last 2 tickets for $10.00 more per ticket.

This example is the same thing that’s happening on Wall Street. High frequency traders can see your order before it gets executed.  Then they buy that same stock and sell it back to you for a slightly higher price. The practice is called “front running.” Normally front running is illegal. However, on Wall Street, the way that high frequency traders are doing it…its legal.

A trader from Royal Bank of Canada spent the last 5 years uncovering the problem, detailing it and alerting investors to the pitfall. He subsequently started a new exchange, which brilliantly circumvents the high frequency trader’s edge by way of new software and complicated data routing. With his new exchange, people can trade stocks without the impact of high frequency traders there to rip them off. So far business has been good.

When asked why his business is doing so well he said “trust.”  Really that is all that he’s selling. People trade on his system because they know that aren’t going to be ripped off. What a beautiful way to run a business. Do what you say you are going to do and people will come.


Steven Clark