Felix Salmon

Should ETFs be allowed to include illiquid stocks?

Felix Salmon
Aug 23, 2010 18:56 UTC

I had a fascinating conversation on Friday with Harold Bradley, the CIO of the Kauffman foundation. He’s something of an expert on high-frequency trading, quantitative strategies, and the like, and he raised an interesting question: why isn’t the SEC banning ETFs which include small, illiquid stocks?

The question arises in the context of a stock market which is demonstrating more lockstep than ever: stocks are ever more correlated with each other, and instead of broad indices aggregating lots of different moves in different directions, as they did in the past, increasingly it’s the other way round, and stocks just move up or down depending on what the broader market is doing.

The rise of ETFs, especially in the day-trading space, surely exacerbates this syndrome. As ETFs tied to the S&P 500 get bought and sold in enormous volumes, arbitrageurs, many of them high-frequency automated algos, jump in to buy and sell the underlying stocks. It’s something that some people are worrying about, in that it cuts against the idea that the stock market is meant to allocate money efficiently between companies.

But when ETFs include small, illiquid stocks, the situation is even worse. Right now, the SEC says that 70% of securities in an ETF must be “actively traded”, or 50% if the ETF includes 200 or more securities. Which means that ETFs can have up to 50% illiquid stocks, which are relatively easy to manipulate.

Let’s say that you’re a predatory algo and you’re looking at activity in these ETFs with substantial holdings of small-cap stocks. When people are buying, you quickly load up on the underlyings; when they’re selling, you go short. Your activity will eat into the returns of the ETF, since you’re making it more expensive for the ETF to buy the stocks, and getting it a worse price when it sells. But more to the point, it will maximize volatility and room for manipulation in the underlying stocks, as well, while minimizing the useful information to be gleaned from their share price. If you buy straddles on these small companies — equity derivatives which pay off when volatility is high — then it’s easy to imagine how you can trigger payouts by playing around in the ETF space.

“We have a lithium battery ETF“, says Bradley. “These are designed for manipulation. What we’ve done is create derivative packages that give people the illusion they can trade small-cap stocks for cheap. Just because they’re in an ETF doesn’t make them liquid.”

I do think that a lot of investors like ETFs precisely because they have a certain degree of liquidity which is often missing from the underlying stocks. But I suspect that it’s even harder to create liquidity out of illiquidity than it is to create a triple-A credit rating out of junk-rated subprime securities. You might be able to credibly pretend that you’re doing it, but there’s a strong whiff of fakery as well.

Clearly the SEC is concerned about manipulation, since it put in place those 70% and 50% limits in the first place. But if limits should be put in place, why not set them at 100%? This is a genuine question, incidentally: I’m not saying that Bradley is right here. But I do think he’s asking an important question.

Update: Some very smart comments below, and be sure too to check out Izabella Kaminska, who does a great job of explaining the market mechanisms in English.


High speed electronic trading and dark liquidity pools will have three blindingly obvious consequences:
1. The small investor not hooked up to the hardware will be at a bigger and bigger disadvantage.
2. The manipulative directionalising of a sector will become ten times easier, and impossible to trace.
3. The stock markets will become further and further removed from the right situation – where bad stocks are seen to fail – to the wrong situation – where a certain amount of excrement can be mixed with the putty.

I’ve done a lot of preparatory investigation of this practice in the UK, and some on the US West Coast. It is obviously already being massively abused, and awaits only a whistleblower to grab the media’s attention.

As a trend, however, the electrification of the stock trading system is just another dimension of a global trend right now: for ordinary investors, bank customers, web users etc to become third-class customers increasingly remote from the actions of a greedy elite.

http://nbyslog.blogspot.com/2010/08/anal ysis-bizarre-public-offering-that.html

Posted by nbywardslog | Report as abusive

The failure of HAMP

Felix Salmon
Aug 23, 2010 17:33 UTC

ProPublica’s Paul Kiel crunches the latest HAMP numbers, and gets Treasury’s Herb Allison on the record saying the kind of things which so upset Atrios and others:

Allison put a positive spin on the fact that hundreds of thousands of homeowners have waited for several months for a final answer from their servicers. Homeowners in the trials have “benefited from lower payments … for many months” and from “having time to obtain other solutions to their needs,” he said. And that relief has come “at no cost to taxpayers.”

Kiel also links to an older ProPublica piece, from May, which spells out exactly what the weakness is in this argument:

Once they’ve been denied a permanent modification, homeowners owe the amount they were discounted during the trial. Banks often demand that the entire amount be paid as a lump sum right away or over a short period of time, causing a homeowner’s payments to swell beyond the original monthly payment.

What’s more, homeowners’ credit scores are damaged because trial payments are reported to credit agencies as delinquent or as part of a payment plan.

“Being in a trial modification if you don’t get a permanent modification is worse than having not been in a trial modification. Period,” said Diane Thompson, an attorney with the National Consumer Law Center. Worse yet, people “may have a hard time finding alternative housing because some renters check credit scores,” she said.

This is the real problem with the fact that 629,751 eligible home loans — 43% of the total — have been cancelled. In some cases, such as that of Goldman Sachs subsidiary Litton Loan Servicing, cancelled trials account for more than two thirds of the total. Treasury is trying to persuade us that those loans were still, on balance, a good thing. But I haven’t yet heard anybody outside Treasury attempt this line of argument, which indicates to me that it’s pretty unconvincing.

HAMP might well have been a success in the ways that Treasury enumerates — helping out banks on the solvency front, reducing the rate of foreclosures, that sort of thing. It was almost certainly a good idea politically, as well: you don’t hear much about the plight of homeowners being foreclosed upon, these days, certainly compared to the huge amount of noise on the subject around the time that Obama was elected president. The government is perceived to have Done Something, and the circus has moved on.

But it’s still a tragedy that hundreds of thousands of people who signed up for loan modifications — and who made all of their modified loan payments in full and on time — have had their modifications cancelled. Many of those people blame the servicers; Treasury, meanwhile, is more prone to blaming the borrowers themselves, claiming they’re incapable of verifying their income.

My feeling is that even if income hasn’t been verified, servicers shouldn’t simply cancel the loan mods if they’re performing well. And that if that’s what the servicers are doing, the incentives within HAMP have been designed very badly. That’s a Treasury failure, and it’s impossible to credibly spin it as any kind of success.


The servicer’s job is to collect a debt and help to maximize investor ROI.

All they’re doing here is collecting money that was historically left on the table.

Posted by reactiontm | Report as abusive

The cruelty of HAMP

Felix Salmon
Aug 23, 2010 15:49 UTC

Atrios, reading Steve Waldman on Treasury thinking, concludes that they are “truly awful people”:

Conning homeowners by announcing a government program designed to help them when in fact it was designed to help the banksters is, in my world, “cruel.”

It’s a powerful point, and it’s definitely one of those things which Treasury is only going to say off the record. Even when Waldman was told it on deep background, he characterized it as “surprisingly candid”.

Treasury told Waldman — and told my group of bloggers, too — that HAMP, even if it was a failure, was a success. It might not have helped much in terms of its ostensible stated aim of permanently modifying millions of home loans. But it did help in at least three other ways: it gave temporary tax and payment relief to millions of homeowners; it massively reduced the rate at which homeowners in default were being foreclosed on; and, in the words of Waldman, “it helped banks muddle through what might have been a fatal shock”.

Was HAMP a bait-and-switch? Did Treasury know all along that it was likely to fail in its stated aim, but go ahead with it anyway because of its second-order effects? That seems to be the message they’re sending — that HAMP was a way of encouraging owners to apply for loan modifications, not because they were likely to get those modifications, but just because the sheer fact of applying for the modifications would help out homeowners generally, by reducing the rate of foreclosures, and banks too.

At the same time, I find it hard to believe that Obama personally was quite that cynical when he announced HAMP. And even within Treasury, I suspect that there was rather more hopefulness and rather less cynicism than the present viewpoint would suggest. On the other hand, if Treasury really did think at the time what it’s thinking now, Atrios is right. It’s undeniably cruel to raise people’s hopes like that if you know those hopes will end up being dashed.



Nobody bats zero for the season without a plan.

Follow the money. The administration is extremely competent, like the previous administration, at servicing the banksters by shovelling them money. That tells who who their constituency is.

Posted by lambertstrether | Report as abusive

Is the stock market pricing in U.S. fiscal tightening?

Felix Salmon
Aug 23, 2010 14:27 UTC

Why are stocks yielding more than bonds? The expected 2011 earnings of U.S. stocks are more than 8% of their current price, while bonds yield much less than that. Rob Dugger has an interesting explanation: the market is looking at fiscal deficits as far as the eye can see, and trusts the US government to close the fiscal gap over the medium to long term. And doing so will inevitably mean hitting corporate profits:

The higher taxes and spending cuts needed to reach fiscal sustainability will echo throughout the economy in millions of ways. Companies that are dependent on the current structure of spending and taxes will be hurt. Their earnings and balance sheets will be weakened. In a sense, fiscal adjustment costs are off-balance sheet liabilities of every US company.

This might also help explain why companies have been so conservative about raising their debt issuance, even as the cost of debt has plunged: they don’t want to add to their on-balance-sheet liabilities even as their off-balance-sheet liabilities, in the form of fiscal adjustment costs, are rising sharply.

The book value of the stock market — the value of its assets minus the value of its liabilities — has, on this view, been declining steadily of late, as the size of America’s liabilities has steadily risen. This is why people lump Spain in with Greece: while Spain’s liabilities are largely in the private sector and Greece’s liabilities are largely in the public sector, ultimately it’s the economy as a whole which is responsible for them.

Of course, we have no idea whether or how future governments might seek to achieve fiscal balance by reducing corporate profitability. But that very uncertainty is something all investors hate: it’s impossible to price in, or to hedge against. Which is why bonds seem — are — so much safer, and yield so much less than stocks.


A much higher tax burden for companies makes a lot of sense.

On the other hand, large corporations are run by groups of very smart people that can quickly adjust to changes in tax law.

If taxes locally get too high for example, corporations can just keep money growing and snowballing overseas for not just a year or two but for a generation. We have already seen this on a large scale in the last decade as US corporations have been furious engines of job creation… just not at home where tax policies aim to soak corporations while most individuals pay almost no taxes.

Warren Buffett and Berkshire Hathaway have shown that, tax wise, it is possible for a corporation to act like a submarine and stay submerged (by growing without realizing profits) for not just a year or two but for fifty years. Can Uncle Sam wait that long for his tax money or will he begin to look elsewhere?

Posted by DanHess | Report as abusive

Why hedge funds are less risky than banks

Felix Salmon
Aug 23, 2010 13:49 UTC

I’ve been waiting for a good critical review of Sebastian Mallaby’s tome on hedge funds, and the longer that we go without one, the stronger Mallaby’s pro-hedgie case would seem to be. Now, Noam Scheiber comes along in the New Republic, and his criticisms of Mallaby are pretty unconvincing:

The Financial Times reported earlier this month that “many star traders across Wall Street and the City of London are … decamping for hedge funds in their droves amid a crackdown that will sharply curtail banks’ riskier activities.” So some of the same folks who brought you the financial crisis will henceforth be working their magic with more leverage and less regulation. How reassuring.

As Mallaby is at pains to point out on a regular basis, hedge funds in fact have less leverage — a lot less — than banks. Many have none at all; those who do lever up tend to do so only by a factor of two or three, compared to leverage ratios in the 30 to 40 range for many investment banks and even commercial banks, in Europe.

These numbers aren’t precise or perfectly comparable, it’s true: there’s no simple and universally-adopted measure of leverage which includes all the clever ways that investors can get outsized exposure to certain assets. And indeed it’s almost impossible even to directly compare leverage numbers between European and US banks. But the fact is that the first and biggest loser, when an overlevered hedge fund fails, is its prime broker. And since the LTCM blowup, prime brokers turn out to have done a very good job of curbing any attempts by hedge funds to take overlarge risks.

Scheiber is worried that people like Morgan Stanley’s Howie Hubler — who lost $9 billion at what was essentially an in-house hedge fund — will simply now repeat their failures at standalone funds, if banks are barred from taking those kind of bets. But that misses the point. Hubler could put on those bets only because there was no prime broker breathing heavily over his shoulder, and because he had the full faith and credit of all of Morgan Stanley backing him up. The same is true of CDO losses at places like Merrill Lynch and Citigroup. And it’s also true of the pair of Bear Stearns hedge funds whose implosion marked the beginning of the crisis — when their prime broker sensibly withdrew, Bear Stearns itself stepped in to take losses on them.

Hedge funds, especially big hedge funds, need more regulation than they get right now, as Mallaby readily admits. They might not have caused this crisis, but they still pose a potential systemic risk, and someone needs to be looking not only at the risks that individual funds take, but also the risks that they pose collectively. After all, given their extreme secrecy, they simply don’t know when they’re entering a crowded trade — as many of them discovered painfully during the quant meltdown of 2007.

But in general there’s one thing that the hedge fund system does well, and that’s confine hedge fund losses to the investors in those funds. Hedge funds will blow up occasionally, and that’s fine; the investors in those funds will lose money, and people betting against those funds will make money, and there will be few if any systemic repercussions. Even if the losses exceed the amount invested in the fund, those excess losses will be borne with few systemic implications by the fund’s prime broker.

Scheiber worries that “the hedge fund industry will never fulfill its promise if its rank-and-file has a Hubler-esque weakness for market fads”. But the way that the hedge fund universe is set up, there’s really no such thing as a rank-and-file. And Hubler wasn’t jumping on to a market bandwagon: in fact, he thought he was betting against subprime bonds. He just funded that bet in a very unfortunate manner. His story is not, I don’t think, a cautionary tale for hedge fund managers. Instead, it’s Exhibit A in the annals of why the Volcker Rule makes a great deal of sense.

Update: Scheiber responds, saying that I “way overstate the benefits” of hedge funds. I didn’t think I’d come up with any benefits at all!


y2kurtus, I think y2kurtus nailed the difference. Leverage isn’t and never was the issue. The main issue was liquidity, a large portion of the banks liquidity was at the extreme short end whereas their assets were long term and illiquid. Throw in the fact that hedge funds didn’t have to follow the same accounting rules that put the banks assets in a circle of death.

One should also not forget that this whole crisis had a proximate cause in a few major hedge funds failing. Hedge funds also acted as the transmission mechanism for crashing marks. Just because we are spending time beating up big bad banks and because somehow the incompetent hedge funds who failed became “victims” of slick sell-side salesmen doesn’t make them this of a systemic risk.

Posted by Danny_Black | Report as abusive


Felix Salmon
Aug 23, 2010 04:29 UTC

Mikael Blomkvist vs Andrew Sorkin. Hardly seems fair — NYT

Forgot Your Password? The game — Wonder Tonic

Viacom Digital Boss Greg Clayman Headed to Rupert Murdoch’s iPad Newspaper — All Things D

Ten year annualized real GDP has dipped to 1.62%, the lowest level since the early 1950s — Econompic

The Tragic Death of Practically Everything — Technologizer

AABender1 leaves me a very smart comment on closed-bank vs open-bank resolution — Reuters

Whom would you rather date: a guy with lots of expensive stuff, or a guy with lots of savings? — NYT

NOAA Claims Scientists Reviewed Controversial Report; The Scientists Say Otherwise — HuffPo

Things People Believe — Yglesias

How the social security trust fund works — Drum

Mortgage rates hit new all-time lows, ranging from 3.53% to 4.42% — WSJ

Charles Komanoff slaps down the energy-savers-are-delusional meme — Grist

There are bond buyers, and then there are scripophilists — Bloomberg

E.J. Graff on the jurisprudence of gay marriage — The Nation

ShoreBank, RIP

Felix Salmon
Aug 20, 2010 23:32 UTC

Remember the ShoreBank rescue, back in May? Well, it got lots of headlines at the time, but it didn’t pan out in the end, and now ShoreBank has failed. The FDIC’s deposit insurance fund is taking a $367.7 million loss, and the money which was going to be invested in ShoreBank by Goldman, JP Morgan, Citigroup and others is now going to be invested in ShoreBank’s successor institution, Urban Partnership Bank. UPB will have a whole new management team, led by former Bank One executive William Farrow — something which rather puts the lie to conspiracy theories which said that Goldman et al were only investing in ShoreBank because its CEO was a friend of Barack Obama’s.

This clean-sweep approach makes a certain amount of sense: it’s right that ShoreBank’s shareholders should be wiped out when it managed to lose so much money. But it’s interesting to me that the government, given the choice between losing $368 million of the Deposit Insurance Fund or investing an extra $75 million in bailout funds, chose the former option. The deposit insurance fund, I guess, isn’t really considered taxpayer money, and will ultimately (eventually, hopefully) be repaid with future insurance premiums.

I wish Urban Partnership Bank well, and look forward to it proving that community-based urban lending can not only perform a crucial social function but can also be reasonably profitable. It’s sad that ShoreBank failed, but the main reason for the failure seems to have less to do with its community lending and more to do with its overexposure to speculative commercial real estate ventures. Urban Partnership Bank, I trust, will stick to its core competency, and do well for all concerned by doing so.


@ AABender1: incorrectish. The FDIC was supportive of using TARP funds, Treasury was unwilling to, because of political pressure. Glenn Beck et al picked up on it and turned it into a cause celebre. It required both the Treasury and FDIC acting in tandem, Treasury couldn’t.

@ Eric_H : Mostly incorrect. Shorebank would not have been closed by the FDIC had it received TARP funds, at least not in the short-run. Determining long term viability is of course challenging, but it is probable that Shorebank could have survived with additional TARP money. Not giving Shorebank money was for political reasons, not practical. Had the bank been anywhere other than Chicago, there would never have been issues in terms of government assistance.

Posted by David_Michaels | Report as abusive

Monetizing Emma

Felix Salmon
Aug 20, 2010 22:25 UTC

What’s scarier than Pride and Prejudice and Zombies? That’s easy: Pride and Prejudice and Structured Finance! Which is essentially the theme of Monetizing Emma, a play which I finally got around to seeing at the New York Fringe festival last night. As playwright Felipe Ossa puts it:

Girls have always been involved in economic compromises. We wanted to pose the question: In the 21st century, would a mother be marrying her daughter off to a suitor, or to the marketplace?

The play displays a lot of sophistication about structured finance, as you might expect from a playwright who has also written for the International Financing Review. It’s also very funny and sharply written, which you might not. And, lots of Jane Austen!

I went to see it with someone who knows pretty much nothing about high finance, and she loved it, but the finance-geek in-jokes are great too. Go for the Paris Hilton jokes, stay for the close reading of a bond prospectus. It turns out to be dramatically much more riveting than you could possibly expect, and the sold-out audience of downtown New Yorkers last night loved it.

(Incidentally, the theme of the play is a financial instrument not dissimilar to the jock exchange that Michael Lewis promised us back in 2007. Whatever happened to that?)


Hal Hartley made a film a few years back, The Girl From Monday, in which people are routinely securitised. It wasn’t all that interested in the finance geekery though.

Posted by GingerYellow | Report as abusive

Why Treasury briefings are off the record

Felix Salmon
Aug 20, 2010 20:22 UTC

Shahien Nasiripour has some excellent detailed notes from the Treasury blogger meeting. And he doesn’t hesitate to call out the senior official when doing so is warranted:

The official pointed to the futures market where traders are betting that home prices will remain stable through the fall of 2014.

But there have been just 40 trades all year through Wednesday, said Mary Haffenberg, a spokesperson for the CME Group, which runs the S&P/Case-Shiller Home Price Index Futures market, the market the administration uses as its benchmark.

Meanwhile, Matt Yglesias wishes that the meeting had been on the record:

DC officialdom ought to realize that its obsession with off the recordy-ness has some serious downsides. Treasury did two meetings this week, one that was with professional blogger types and one that was more with professional economists who also blog, and most of the attendees seem to have come away quite impressed. If that’s the case, wouldn’t people able to listen to a recording of the full session likely also be impressed?

My feeling is that the answer to that question is “not necessarily”. Having a meeting with a Treasury official is interesting and worthwhile, although I admit that my mind did wander in parts, when the conversation got too political. Listening to a recording of someone else having a meeting with a Treasury official? You need to be a real wonk to do that, and although you might come away impressed, most people doing it are likely to be on the lookout for some kind of news.

Nasiripour is reporting, for instance, that at this meeting a senior Treasury official “said that home prices will likely decline in the near future” and “argued that taxpayers should continue to prop up small banks due to their exposure to toxic assets”. I don’t recall either statement, but I was neither taking detailed notes nor recording the conversation. It would be great if we could simply go to the tape and report exactly what was said and who said it. But then the news cycle would glom onto the “X said Y” story, in a world where administration officials can get fired if they say the wrong thing.

Putting the whole conversation on background makes it almost impossible to turn the briefing itself into a news event, and that in turn allows officials to speak without worry that their words will end up being used against them in the kind of fevered political-media frenzy which regularly appears out of nowhere and nothing in Washington.

What’s more, Treasury officials in general, and the Secretary of the Treasury in particular, really can and do move markets when they start talking about things like the dollar. There is a lot of value to open conversation, but it’s pretty much impossible to have an open conversation, in public, on the record, with a sitting finance minister of any country, especially when sensitive topics like the dollar or capital adequacy standards are on the agenda.

That’s all in theory; in practice it’s even worse, at least with this Treasury. During the Great Moderation, Paul O’Neill would happily chat away to reporters, on the record; he would occasionally find himself in hot water for doing so, but he was never very important. Politico and HuffPo didn’t exist in those days, but even if they had existed, they wouldn’t have covered Treasury. As a result what O’Neill said never really mattered that much. Plus, he liked engaging in wonky Socratic dialogue with FT reporters.

When Barack Obama picked Geithner over Summers for the Treasury job, he knew he was getting a buttoned-down technocrat rather than a natural debater and schmoozer. And Geithner learned his lesson early on: first in the nomination process, when he caused a storm on the subject of whether China was manipulating its currency; and then with his hugely-anticipated speech on the financial stability plan, which contained no real detail or concrete proposals, and which looked dreadful on TV, and which sent markets tumbling. Since then, Treasury has simply understood that it has to be very careful about exactly when, where, and how it says things in public.

I’m a reporter; I naturally want as many things to be on the record as possible, and ideally to be able to link to them directly online. I also think that it’s important for news organizations to be much more transparent than they are at present about the degree to which they’re meeting and talking to the most senior administration officials — Obama, Geithner, Bernanke, Biden, Clinton, Gates. We don’t need to necessarily know what these people are saying in those conversations, but it would be a step in the right direction if news organizations simply revealed that the meetings were taking place.


Dude, having anybody from treasury department talk about the true health of the economy is liking having the bank CEO where a public company holds its accounts talk about the cash reserves status every quarter. They are the only people within HUNDRED (100%) proximity of truth and their words, any time, can have dramatic effect.

The real world needs only the speculators talk ( with partial knowledge) so that there are plenty of gambling opportunities, which keeps everybody alive and on toes.

But it is fun dreaming about the ideal world. Dream on!

Posted by mv288 | Report as abusive