Felix Salmon

Idiotic online brokerage of the day, April fool edition

Felix Salmon
Apr 6, 2009 11:29 UTC

I hope the SIPC is looking into this:

Online brokerage site Zecco somehow failed to predict that surprising customers with multi-million dollar trading balances for April Fools would encourage their customers to make actual trades with their newfound riches. When Zecco realized what was happening, they responded by panic-selling the purchased stocks at a loss and charging the balance to customers, along with a $19.99 broker-assisted trading fee. One poor schmo bought $1 million worth of shares that were later sold for less than the purchase price.

Sometimes a bone-headed April Fool transcends mere stupidity to become outright fraud: this is one of those cases. A reputable brokerage doesn’t tell people they have millions of dollars in their account, and then allow them to trade it, and then charge them any losses they make. I’m not sure what sanctions the SIPC has available to it, but I hope they throw the book at Zecco.

(It’s not clear that this was a deliberate April’s Fool; it might have been an online cock-up which coincidentally took place on April 1. Either way, it’s unforgivable. And if this weekend’s Barron’s story has you tempted to use Zecco to trade forex, just don’t do it.)

Update: Zecco has now released a statement:

On April 1, 2009, one of our vendors provided Zecco Trading with an incorrect data feed which caused some customers to see erroneously high buying power. This error was quickly corrected, but about 1% of our customers were impacted. All positions in excess of our customers’ true buying power have since been closed. Except in a very small number of egregious and fraudulent cases, customers will not be responsible for losses (or gains) incurred for trades in excess of their buying power.

Additionally, we want to make it clear that contrary to some reports, this was not in any way intentional and was not an April Fool’s joke. We take the integrity of our customers’ accounts very seriously and we have taken measures to ensure this does not happen again. We sincerely apologize to our customers if this caused any confusion.

I’ve talked to Zecco’s CIO, Michael Raneri, and I do believe that this was a cock-up rather than an April fool or anything deliberate. Essentially the system was erroneously telling people that they had a huge amount of “buying power” — which is Zecco’s term for margin — and because Zecco’s customers have three days to meet margin calls, their orders were allowed to go through. It’s not the kind of thing you ever want to see at an online brokerage, but it’s not malign, just a nasty mistake which was magnified by the fact that it took place on April 1.


Let Occam’s Razor be your friend – surely the simplest explanation of this is merely a disgruntled former employee?

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How stock-market indices underperform

Felix Salmon
Apr 6, 2009 10:49 UTC

One frequent complaint made about stock-market indices is that they’re not truly representative of the stock market as a whole, since they exhibit what’s known as “survivorship bias”. If a company is failing it drops out of the index, to be replaced by a more successful firm. In turn, that should boost the index’s return, right?

Wrong. It’s wrong for the S&P 500, and, says Henry Blodget, quoting John Mauldin, it’s wrong for the Dow, too:

If Dow Jones hadn’t tinkered with the index, the 30 companies would have merged or failed their way down to just 9 survivors. Of the 21 companies in the original 30 that are now gone, 20 disappeared through M&A, some were replaced by successor firms and others not, and only one (Bethlehem Steel) failed outright.

But this no-fiddling index would have topped out at just over 30,000 in October 2007 and would have finished 2008 at 14,600…

With the Dow 30, your $100 would have grown to $96,993 as of December 2008, but the Original 30 would have grown to $161,603…

[T]here is an even bigger differential if you simply equal-weight the components rather than use a price-weighting methodology. Your $100 grows at a 10.4% clip and becomes $272,554, or almost three times the actual Dow 30.

Maybe this is the best possible reason for not investing in index funds: indexes underperform. Instead, just pick a basket of stocks, and hold them forever, reinvesting dividends. Some will go to zero. But you’ll still be significantly better off than holding the index, assuming you can reinvest dividends cost-free.


Presumably the reason for this is that for companies dropping out and coming into the index an index fund is basically forced to buy dear and sell cheap.

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Stanford’s receiver war

Felix Salmon
Apr 6, 2009 10:27 UTC

Alex Dalmady, who first revealed to the public that Stanford International Bank was a Ponzi scheme, has a very handy post up about what he’s calling the “receiver war” between Antigua and the US.

While most of the press coverage of the Stanford case has concentrated on the goings-on in the US, the fact remains that Stanford International Bank is an Antiguan entity, and the Antiguan authorities and receivers therefore have most of the real ability to get things done. It’s improbable that Stanford himself is going to be tried in Antigua: when the criminal complaint finally comes down, he will be arrested and tried in the US. But if Stanford’s depositors (including, it is rumored, Libya) are looking for money rather than justice, they should be looking to Antigua rather than the US.

And that’s not just because the CDs were in Antigua; it’s also because the IRS is senior to other claimants in the US. Stanford owes the IRS $227 million, which likely represents the bulk of Stanford International Bank’s recoverable funds. If those funds stay in Antigua, they can be distributed to the bank’s depositors. But if they go to the US, then they’re likely to disappear into the maw of the taxman.


Nigel-Smith of Vantis has never published the amount of money found/frozen in the Allen Stanford accounts.Why?He is alleged to be worth $2.2billion dollars.SEC claims he was given a loan of $1.6billion from the CD’s of SIB.As sole stockholder of SFG,where’s the money.He owns 250 acres in Antigua,1500 acres in St.Croix,who controls them?Stanford has dual citizenship,85-90%of American assets have been released,the CD’s are frozen until Apr.27,then what.As owner of CD’s I am penniless yet Peter Madoff gets $10,000/mo for expenses.

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Default is easier when you have practice

Felix Salmon
Apr 6, 2009 09:09 UTC

OneEyedMan, in the comments, makes a good point about the cost of default:

If you have less outstanding debt, even after a bankruptcy discharges it, then you are immediately less likely to default. However, in comparison with another firm that doesn’t default, if at some future date you have the same financials, expect the debt markets to charge you more to borrow money. That’s how the UK was able to beat up France time and again. By not defaulting on their debt they had lower borrow costs so they borrowed more. Borrowing more funded bigger wars.

This is a very good encapsulation of one of the big theses of James Macdonald’s excellent book A Free Nation Deep in Debt: The Financial Roots of Democracy. And it has an interesting implication about the cost of default: it’s much higher for entities which have never defaulted before than it is for those who have defaulted in the past. Or, to put it another way, the cost of a second default is a lot lower than the cost of a first default, and the cost of a third default is lower still.

Maybe this means that in times of global upheaval, like today, it makes sense to look to countries like Colombia if you want to minimize credit risk. And indeed, Colombia is trading at a spread of 445bp over Treasuries, which is pretty good, these days: Hungary is at 567bp over, for instance, despite being a member of the EU.

On the other hand, Peru has not only defaulted in the relatively recent past, but even did so under its current president, Alan Garcia. And it’s trading at an enviable 393bp over. So clearly the stigma of having defaulted can be overcome.

Is it harder to borrow after you’ve defaulted?

Felix Salmon
Apr 5, 2009 23:52 UTC

There are lots of things a company spokesman can say to reassure reporters and investors that his firm is in good financial shape. This is not one of them:

In early March, the rating agency Moody’s included OSI Restaurant Partners on its list of “bottom-rung” companies that are most likely to default on debt payments. A company spokesman, Michael Fox, said the company had recently significantly improved its financial position by retiring $300 million of debt at a discounted cost of $85 million.

If you’re a bond investor who has sold out at 28 cents on the dollar, you are most likely extremely unhappy. When you bought the bond, you reckoned there was a small but significant chance of default — but you also reckoned that if the company did default, your recovery value would probably be 40 cents or so. If you end up selling for 28 cents, that’s worse than a default.

Which brings me to the latest declaration by Moody’s, over at Zero Hedge:

Exchanges made by distressed issuers at discounts to par which have the effect of allowing the issuer to avoid a bankruptcy filing or a payment default (i.e., “distressed exchanges”) are considered default events under Moody’s definition of default.

What this means, says Tyler, is much less room for maneuver at leveraged companies:

CFOs of highly leveraged companies that still have substantial cash amounts on their books, will now have to sweat the trade off of purchasing their cheap debt in the open market, since any tax benefit of doing so will be eliminated by the threat that Moody’s may assume the company merits a Hovnanian-like treatment and downgrade it to Limited Default, this making it impossible for the company to even have hope of accessing the capital markets in the future.

My feeling is that the capital markets have no morals. All they care about is the chance that you will default in the future, not whether or not you’ve defaulted in the past. Indeed, I remember at one point that Colombia complained regularly that it was being punished for never having defaulted: all the other Latin nations had defaulted, and therefore had lower debt burdens, after renegotiating their debt under the Brady Plan. While Colombia, which did the right thing all along, had more debt and therefore higher spreads.

A lot of Americans are surprised, after they declare bankruptcy, to find the credit offers rolling in almost immediately — they thought that filing would destroy their credit rating and render them incapable of borrowing anything for years. But of course that’s not how it works: having discharged their debts, they’re now free to rack up new ones, at interest rates which make such deals extremely profitable for the lenders.

Bond investors are similar. The less debt that a company has, the more attractive it is. Sure, there are lots of investors who aren’t allowed to invest in a company carrying a “Limited Default” rating. But there are even more investors who are allowed to invest in such companies — indeed, who pride themselves on lending to such companies and making lots of money by doing so.

So by all means let’s have a debate about when a distressed debt buyback constitutes an event of default for CDS purposes. But I’m not sure that Moody’s is really relevant any more.


If defaulting carried no costs then everyone would do it. Why pay your debt otherwise?

Why hedge fund managers shouldn’t lever up

Felix Salmon
Apr 5, 2009 23:09 UTC

Howard Marks of Oaktree Capital, whatever his merits as a hedge-fund manager, is a spectacularly good memo-writer. And his latest makes a particularly germane point:

Once you decide to lever a fund, “risk management” becomes more important than “portfolio management.” Many more people know how to pick securities than know how to restrict a levered fund’s risk to the amount that can be withstood. And the ability to pick securities for an unlevered fund isn’t nearly as critical as the ability to manage risk in a levered fund.

Leverage should, by rights, be orthogonal to fund-manager selection. Investors should choose the asset-pickers they want, and then, if they want leverage, invest borrowed money in the fund. As Marks says, embedding leverage in the fund only serves to make the fund manager’s life massively more difficult, for little obvious benefit. You want your fund manager out there finding the best possible investments, not faffing around with margin agreements.

(HT: Manham)

Andy Beal shows how bankers should gamble

Felix Salmon
Apr 5, 2009 22:48 UTC

I love the Forbes profile of Andy Beal, the Texas banker who — much more than say Warren Buffett — is an expert at making billions by zagging when everybody else zigs.

By September 2004 Beal Bank’s assets had climbed to $7.7 billion. Then Beal stopped buying, letting his loans run off. By September 2007 assets had shriveled to $2.9 billion, one-fifth of which was cold cash. He was worried that consumers had taken on too much debt and money was being lent to companies for next to nothing. “Every deal done since 2004 is just stupid,” Beal says…
Beal started coming to work at 10:30 and leaving at 2:30. He challenged colleagues to backgammon games and took hour-long lunches, complaining of being “bored stiff,” recalls one frequent meal companion, real estate investor Steven Houghton…
The credit rating agencies started pestering him about his dwindling loan portfolio. They never downgraded him but scolded him for seeming not to have a “sustainable” business model.

Beal’s assets are back up to $7 billion now, and he sees them going as high as $30 billion before this is all over. He’s the sole shareholder of his bank, and could end up the single biggest winner of what he sees as a “depression, without bread lines this time, thanks to the government safety net, but with equal cost to society.”

The article is almost embarrassingly laudatory: there’s not a hint that people might demonize Beal for profiting from the misfortune of others. I’m a fan of vulture investors — I think they perform an important service, and are crucial providers of liquidity — but I know that I’m in the minority. And Beal is one of the biggest vulture investors in the world right now.

Incidentally, Beal is also living proof of why it can be a good idea to play the lottery. He does it with a lot more money than most of us have, of course: an entire book was writen on how he lost millions in Vegas playing poker. But it seems that whenever he wanted to gamble, he went to Vegas. When he wanted to bank, on the other hand, he looked carefully at the loans he was offered, did his due diligence, and came to a professional conclusion about whether the yield justified the risks. With all his gambling desires being taken care of in Vegas, he didn’t sublimate them into the hope that cheap loans would turn out to be good.

Maybe this is the real reason why bankers should go to Vegas. Not because junkets are good for the economy, as Ben Stein might have it, but rather because it gets the gamble out of their system, leaving them sober when they get back to work in the real world.

Can the administration control the dollar?

Felix Salmon
Apr 5, 2009 00:44 UTC

On the Brian Lehrer show Friday, I talked about the G20 meeting and the way that the US is taking a more mulilateral, as opposed to unilateral, approach to global leadership. What I didn’t mention is another huge difference between the beginning of the Obama administration and the end of the Bush administration: the strong dollar. Which is something exercising Andy Harless:

That old mantra, “A strong dollar is in our national interest,” still echoes through the air in the District of Columbia. Never mind that the strong dollar was largely responsible for the housing boom that led to the current bust. It was: the strong dollar encouraged Americans to buy from abroad and discouraged those abroad from buying from the US; as a result, the only way the Fed could induce a recovery was by cutting interest rates to levels that sparked a boom in housing. The rest, unfortunately, is history.

A strong dollar is not in our national interest. It is not in the world’s interest. It is not in the interest of justice. It is just wrong.

I disagree. I think that the strong dollar is very much in the national interest when we’re running trillion-dollar deficits: that flow of money into the country is helping to make the cost of that money a great deal lower than, by rights, it should be. Which in turn is saving the US taxpayer tens if not hundreds of billions of dollars.

And clearly a strong dollar is in the world’s interest: we’re still the consumer of last resort, and if the dollar weakened substantially, we’d import even less than we’re importing right now — which would benefit no one.

But more to the point, this whole debate is stunningly academic. The FX markets love to believe that the Treasury secretary has real control over the level of the dollar, but he doesn’t. If we wanted a weaker dollar, what would we do? Cut interest rates? We’ve done that already, and we’ve hit the zero bound, so that’s not an option. Simply print money? Well, we’re trying that too. In effect, US monetary policy is trying its hardest to send the dollar south, and is failing miserably.

So long as the generalized global level of fear remains high, the flight-to-quality trade will remain, and like it or not, when the whole world is falling apart, the US dollar tends to look like the least worst option. Sooner or later, I suspect it’s going to weaken, as a few bold hedge funds rediscover the carry trade, and as the Fed’s monetary policy starts to show up in the inflation figures. But I’m not holding my breath.


Having the world’s most trusted reserve currency is a blessing in the same way having large reserves of oil or diamonds is a blessing to an emerging nation. The elites get fabulously wealthy, everyone else stays poor and oppressed. Democracy is subverted at every turn by the oligarchy that controls the most precious national resource.

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Annals of unjustifiable government subsidy, kraft process edition

Felix Salmon
Apr 4, 2009 22:49 UTC

Christopher Hayes has the astonishing story of how a well-intentioned tax provision, designed to get the transportation industry to add alternative fuels to their gasoline and diesel, has turned into an $8 billion subsidy for the US paper industry, which is needlessly adding diesel to its “black liquor” — a byproduct of the paper-manufacturing process which is burned for fuel. The unintended windfall for the paper industry is massive:

This past fall the Joint Committee on Taxation computed the cost of extending the tax credit for three months and projected it would cost a manageable $61 million. It now appears that the extension (which was passed as part of the TARP) could cost as much as $2 billion before the credits expire at the end of this calendar year.

This will be a very interesting test case of whether change has really come to Washington or not. There’s zero justification for this subsidy, but, says Hayes:

So far, though, to the surprise of McClay and others, there’s been not a peep from Capitol Hill. Allen Hershkowitz, a senior scientist at the Natural Resources Defense Council and director of its paper industry reform project, told me the industry wields significant clout in Washington and has benefited from myriad federal subsidies throughout its history, but that “this is really a perverse exploitation at the expense of the environment.”

The Obama administration seems to have done a reasonably good job of minimizing the old version of pork, where government billions went to the pet projects of powerful legislators. It remains to be seen whether the new version — where random industries suddenly find themselves having won the stimulus-package lottery — will be harder to eradicate.

(HT: Rortybomb)