Felix Salmon

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When your business model is to execute trades profitably, it’s pretty hard to destroy your franchise more effectively than contriving to lose $10 million a minute trying to do just that on the New York Stock Exchange. That’s how much Knight Capital lost yesterday morning when its electronic trading algorithms malfunctioned, causing “the firm’s computers to rapidly buy and sell millions of shares in over a hundred stocks for about 45 minutes after the markets opened”.

The damage in total: about $440 million. That’s more than the $289 million in revenue the company earned last quarter; it’s four times its annual profit. That’s 40% of tangible book value. How bad is that? With its shares down 63% on the day, and more than 75% since the error, Knight is now trading at valuations similar to Morgan Stanley, Citigroup and Bank of America. It’s now exploring that most ominous of financial euphemisms, “strategic alternatives“.

This is a really bad time to do such exploring, and not just because of Knight’s self-immolating tendencies, the WSJ reports:

Stock volumes are at a five-year low and volatility seemingly does nothing to bring trading activity back… There are a range of competitors in the wings trying to attack Knight’s core business, trading with the retail brokers. Goldman Sachs, Cantor Fitzgerald and the hedge fund firm Two Sigma have been gearing up in the business.

It’s also far from reassuring to hear these kinds of comments from the CEO of what is at heart a technology company: “Technology breaks. It ain’t good. We don’t look forward to it”.

That capacity to break may be more a feature of electronic trading programs than a bug. As Felix noted, “weird things happen when you get deep into the weeds of high-frequency trading, a highly-complex system which breaks in entirely unpredictable ways”.

Still, there is one likely cause for what happened. When you zoom in and look at the trades at intervals of less than a second, it starts to look like a new NYSE trading system may have been involved. Stephen Gandel has an explanation of the NYSE’s “Retail Liquidity Program”, which launched Wednesday and which uses “algorithms to figure out when it makes sense to offer a slightly better price than what others are offering, and snatch up stock trades, this time away from Knight and others”.

If the RLP is what caused Knight’s losses, the NYSE may have fatally wounded both a competitor and its own reputation. The whole episode is far more intriguing than a good old-fashioned busted Internet IPO. – Ben Walsh

On to today’s links:

EU Mess
Draghi’s choice to “play mind games with financial markets … marks a new low for European crisis management” – Tim Duy
Draghi downgrades the ECB’s commitment to do “whatever it takes” to save the euro to “guidance” – NYT

What Could Go Wrong
Prescription drugs’ newest ingredient: gamification – PSFK

Advanced Strategy
Google Wallet to become more like a real wallet and allow multiple cards – WSJ

Good Questions
“What’s a guy gotta do around here to lose a little credibility?” – Jesse Eisinger

Remuneration
“Central bankers just destroyed Wall Street’s 2012 bonus season” – DealBook

Regulatory Inertia
Trends in financial regulation delay tactics: overly exhaustive cost-benefit analysis – Bloomberg

Takedowns
“It’s as if we put Richard Feynman in charge of NASA, and he started talking about creationism and homeopathy” – Ryan Louis Cooper

Tech
Why the Japanese love the fax machine: an aging population that values handwriting – BBC

Wonks
Seven predictions based on the economics of Olympic success, including “Bob Costas will make you cry” – Grantland

Oxpeckers
Jared Kushner’s internal memo announcing the departure of Elizabeth Spiers from the New York Observer – Nick Rizzo

Alpha
Goldman invests in NYC jail program, but in a good way – NYT

In 2007, it became clear to Congress that there was a serious mortgage crisis, with lots of underwater borrowers. And it was also obvious that an important part of working through the mess would comprise some combination of short sales and principal reductions. Thus was the Mortgage Forgiveness Debt Relief Act of 2007 born. Until the act was passed, any lender offering a short sale or a principal reduction would in doing so leave the homeowner with a massive tax bill, since the written-off debt would count as simple income for income-tax purposes.

In 2007, however, no one had a clue how long the mortgage crisis would drag on for, or how slow lenders would be to offer principal reduction. The original act expired at the end of 2009; it was then extended, through the end of 2012. But here we are, in August 2012, and principal reductions are only just beginning in earnest.

David Dayen has a good piece on the expiry of the tax break, including the interesting nugget that the CBO has put the cost of extending it for two more years at $2.7 billion. If the average underwater homeowner pays a marginal tax rate of 20%, then that means the CBO expects write-downs from principal reductions and short sales of somewhere in the $10 billion to $15 billion range during 2013 and 2014. And this, remember, is six years after the housing bubble burst.

My guess is that the tax break will be extended, somehow, somewhere in the horribly complex mess of legislative give-and-take that will arrive with the fiscal cliff. But it’s instructive to realize that if Ed DeMarco had actually agreed to Fannie and Freddie doing principal reductions, they would realistically only get started, in earnest, in 2013. As it is, thanks to his obstructionism, they’ll probably only happen even later than that.

The housing recession is dragging on for longer than anybody anticipated, and there’s no end in sight. Principal reductions are a good way of bringing it to an end; they should of course not incur a massive tax bill. I hope that we’ll see most of them done by 2015, eight years after the housing bubble burst. But in my heart of hearts, I don’t actually believe that. This housing crisis, I think, is going to last a decade. Or more.

Almost two years ago, in September 2010, the Japanese currency reached an all-time high of just 83 yen to the dollar. The Bank of Japan, shocked into action, brought out the big guns: a massive intervention in the fx market, which immediately sent the currency down more than 3%. And I responded with a blog post headlined “Why Japan’s FX intervention might actually work”: the intervention was unsterilized, which meant that the Bank of Japan was essentially printing money. If a central bank prints enough money, the currency will, eventually, fall.

Of course, that didn’t happen. A commenter, gpowell, looked into the details of what was going on and discovered that the intervention was only technically unsterilized: in reality, the Ministry of Finance ended up issuing new debt within days to repay the central bank. And so the inevitable happened, and the yen kept on strengthening. It’s now hitting new all-time highs around 78 yen to the dollar: the Japanese wish it were back at the 83 level which seemed so unacceptable two years ago. The Bank of Japan’s actions are barely making a dent in deflation, let alone weakening the yen.

Now Martin Fackler has a good piece on the psychology and politics behind the central bank’s actions. The politics are simple: Japan’s politically-powerful elder generation is living on fixed incomes and loves deflation and cheap imports. But it’s the psychology which fascinates me.

Critics say the central bank’s entrenched bureaucrats have resisted doing something similar in recent years out of an outdated fear of rekindling the rampant inflation in the value of real estate and other assets of the 1980s bubble economy. But the bank argues that it makes little sense to intervene without longer-range economic fixes, like deregulating protected domestic industries to spur competition.

The thing which jumps out at me here is the central bank’s perceived fear, not of price inflation (which they actually want), but rather of asset price inflation. In the US, everybody’s asking what the Fed can do to support home prices; in Japan, by contrast, people are genuinely worried that central bank actions might make houses more expensive.

One of the big differences is that Japan is a nation of bond investors, while the US is a nation of stock investors. In the US, the daily gyrations of the stock market are reported in every newspaper and on every newscast, nearly always in a context of “rising prices good, falling prices bad”. Americans feel personally invested, quite literally, in the fortunes of the stock market, and love to cheer it on from the sidelines.

Bond investors, by contrast, are a very different breed. They make no money when stocks go up; they just lose money when there’s inflation. And if stocks go up — which would happen, if the central bank started printing money, causing the yen to fall and inflation to rise — Mrs Watanabe, the apocryphal Japanese bond investor, would not be happy.

It seems to me that what Japan really needs is some kind of massive debt-to-equity conversion, which would help to align incentives a lot more. I have no idea how such a thing could be done. But it looks a bit as though there are actually two ways that debt can cripple an economy. If it gets big, then that eventually weighs on the debtor sovereign, as we saw most spectacularly in Greece. But it can also cause unhelpful incentives among the creditors, too, if the creditors are national households. They should be excited about growth. But all too often, they end up getting excited about deflation.

It’s rogue algo day in the markets today, which sounds rather as though the plot to The Fear Index has just become real, especially since the firm at the center of it all is called The Dark Knight, or something like that. At heart, however, is something entirely unsurprising: weird things happen when you get deep into the weeds of high-frequency trading, a highly-complex system which breaks in entirely unpredictable ways.

In fact, it’s weirder than that: HFT doesn’t just break in unpredictable ways, but works in unpredictable ways, too. Barry Ritholtz has an excerpt from Frank Partnoy’s new book, Wait, all about an HFT shop in California called UNX:

By the end of 2007, UNX was at the top of the list. The Plexus Group rankings of the leading trading firms hadn’t even mentioned UNX a year earlier. Now UNX was at the top, in nearly every relevant category…

Harrison understood that geography was causing delay: even at the speed of light, it was taking UNX’s orders a relatively long time to move across the country.

He studied UNX’s transaction speeds and noticed that it took about sixty-five milliseconds from when trades entered UNX’s computers until they were completed in New York. About half of that time was coast-to-coast travel. Closer meant faster. And faster meant better. So Harrison packed up UNX’s computers, shipped them to New York, and then turned them back on.

This is where the story gets, as Harrison put it, weird. He explains: “When we got everything set up in New York, the trades were faster, just as we expected. We saved thirty-five milliseconds by moving everything east. All of that went exactly as we planned.”

“But all of a sudden, our trading costs were higher. We were paying more to buy shares, and we were receiving less when we sold. The trading speeds were faster, but the execution was inferior. It was one of the strangest things I’d ever seen. We spent a huge amount of time confirming the results, testing and testing, but they held across the board. No matter what we tried, faster was worse.”

“Finally, we gave up and decided to slow down our computers a little bit, just to see what would happen. We delayed their operation. And when we went back up to sixty-five milliseconds of trade time, we went back to the top of the charts. It was really bizarre.”

Partnoy has a theory about what’s going on here — something about “optimizing delay”. But that sounds to me more like ex-post rationalization than anything which makes much intuitive sense. The fact is that a lot of the stock-trading world, at this point, especially when it comes to high-frequency algobots, operates on a level which is simply beyond intuition. Pattern-detecting algos detect patterns that the human mind can’t see, and they learn from them, and they trade on them, and some of them work, and some of them don’t, and no one really has a clue why. What’s more, as we saw today, the degree of control that humans have over these algos is much more tenuous than the HFT shops would have you believe. Knight is as good as it gets, in the HFT space: if they can blow up this badly, anybody can.

I frankly find it very hard to believe that all this trading is creating real value, as opposed to simply creating ever-larger tail risk. Bid-offer spreads are low, and there’s a lot of liquidity available on a day-to-day basis, but it’s very hard to put a dollar value on that liquidity. Let’s say we implemented a financial-transactions tax, or moved to a stock market where there was a mini-auction for every stock once per second: I doubt that would cause measurable harm to investors (as opposed to traders). And it would surely make the stock market as a whole less brittle.

It’s worth recalling what Dave Cliff and Linda Northrop wrote last year:

The concerns expressed here about modern computer-based trading in the global financial markets are really just a detailed instance of a more general story: it seems likely, or at least plausible, that major advanced economies are becoming increasingly reliant on large-scale complex IT systems (LSCITS): the complexity of these LSCITS is increasing rapidly; their socio-economic criticality is also increasing rapidly; our ability to manage them, and to predict their failures before it is too late, may not be keeping up. That is, we may be becoming critically dependent on LSCITS that we simply do not understand and hence are simply not capable of managing.

Today’s actions, I think, demonstrate that we’ve already reached that point. The question is whether we have any desire to do anything about it. And for the time being, the answer seems to be that no, we don’t.

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You will have been disappointed this week if you thought policymakers with doctorates in economics would be capable of using cost-benefit analysis. First there was Ed DeMarco’s decision not to allow principal reduction for mortgages held by Fannie and Freddie Mac. The benefits here were clear: mortgage relief for 500,000 borrowers and net savings for the taxpayer of about $1 billion; not to mention, as Paul Krugman noted, the “positive effects on the economy of debt relief”. DeMarco, however, thought these benefits were outweighed by the specter of higher mortgage costs, lower availability of mortgage credit and a greater number of strategic defaulters.

It’s hard to see how DeMarco came to that decision on empirical grounds. As far as higher costs and less credit are concerned, “the horribles aren’t particularly horrible,” as Felix wrote yesterday. And if you believe Treasury, the risk to a homeowner of having his request for principal reduction denied far outpaces the reward from a potential strategic default:

a borrower who defaults cannot be certain that he and she will obtain a HAMP modification, much less … principal reduction. Therefore, a borrower would take a substantial risk by deliberately defaulting: they would have to choose to damage their credit for years to come and perjure themselves on the chance that they would be found eligible for the program.

Ben Bernanke and the rest of the FOMC faced similarly stark costs and benefits this week when they weighed additional monetary easing: in Ryan Avent’s words, it’s a choice between “a trillion dollar output gap and 6 million unnecessarily unemployed workers,” versus “having 4% inflation for a year rather than 2%”. For Tyler Cowen, who in his own words is “more agnostic about the gains from monetary expansion than are many of its advocates,” the choice was easy: The Fed clearly should pursue a more expansionary monetary policy because “the costs of inflation, within reasonable ranges, are not very high”. Ultimately, the Fed announced this afternoon that although inflation has declined and unemployment hasn’t, there would be no new easing.

Exactly why the Fed’s cost-benefit calculus this time around differs from that of doves like Avent and now Cowen isn’t readily apparent, but in the past Bernanke has maintained that it would undermine the Fed’s credibility without producing any lasting improvements. But, as Ryan Avent wrote back in April, if Bernanke is saying that the Fed’s credibility is worth the cost of very high unemployment and a level of national income that’s below potential, then he must lay out a much more rigorous argument that supports that.

If the chairman is serious in arguing that 1) the Fed’s credibility is extremely valuable, 2) that its credibility is vulnerable to even short periods of above-target inflation, and 3) that the expected cost of putting this credibility at risk outweighs the beneficial impact on the serious, existing-right-now unemployment problem, then he really ought to explain at length his reasons for thinking all this. Point us to the research. Show us when in history a central bank in the Fed’s position has attempted to boost employment by raising inflation a bit above target for a short period of time, only to watch all hell break loose. If the argument for behaving as he has is really so clear, he ought to be able to convince us, some of us anyway, that he has a point. Instead, to date, he’s simply reached for handwaving about credibility and let the matter rest there. That’s not good enough.

– Peter Rudegeair

On to today’s links:

Inefficient Markets
Algo accident: “technical issue” causes irregular volatility in dozens of stocks on the NYSE – Bloomberg

Politicking
“Nearly two-thirds of annual federal spending is on autopilot and doesn’t require an annual vote by Congress” – Salon

Facebook
Facebook is a great reminder that stock picking is a terrible idea – DealBook

Housing
Treasury can bypass Congress to get Senator Merkley’s housing plan started – Mike Konzcal

Oxpeckers
Twitter admits its commercial relationship with NBC was central to censorship of a critical journalist – FT

Recovery
America needs to revive the “other 30%” of the economy that’s not based on consumption – Stephen Roach

Eschatology
The best news story, and lede, of the day, by far – Huffington Post

The Fed
The Fed acknowledges that the economy is decelerating, but takes no new action – Federal Reserve

New Normal
The financial industry may be set to lose 50,000 more jobs – The Big Picture

The wonkier edge of the blogosphere (Joseph Cotterill at Alphaville, Anna Gelpern at Credit Slips, Matt Levine at Dealbreaker) has been paying a lot more attention than any non-blogger journalists I can find when it comes to a very significant recent decision, in the English courts, on the subject of exit consents. (The decision can also be found here, in PDF form.)

There’s a bit of a tinge of panic to some of the coverage: Gelpern, for instance, calls the decision “a really big deal”, while Cotterill calls it “a depth charge”. And on the surface, it’s easy to see why they might think that way. Exit consents are a standard weapon in the debt-restructuring arsenal, a clever way for bond issuers to get their bondholders to agree to a restructuring. And now an English judge seems to have ruled that they’re illegal.

In order to understand the real problem here, it’s helpful to understand a key difference between bonds and loans. One upon a time, when companies wanted to borrow money, they would go to the bank — and then, if they ran into trouble, they would negotiate new terms with their lender. That didn’t change when simple bank loans became syndicated loans: borrowers then just had to negotiate with a consortium of banks, rather than with just one. But when banks became just intermediaries, and companies borrowed in the bond market, things did change. You can’t negotiate directly with your lenders when you don’t even know who your lenders are, and when there might well be many thousands of them.

So, how do you restructure a bond? One option is that you simply don’t: you go bankrupt instead, and let your creditors fight it out in court for whatever pickings they can find on your carcass. That’s unpleasant: there are serious costs of filing for bankruptcy, and often a nice bond restructuring can be a lot cheaper and result in a better outcome for all concerned. If you can manage to pull it off.

So, how can you restructure bonds, if you need unanimous consent from thousands of different and often anonymous bondholders? Isn’t that akin to herding cats? Well, yes. But exit consents offer a clever solution: you ask bondholders to voluntarily tender their bonds into a bond exchange, taking some kind of a haircut in the process. Lots of bondholders will be willing to do that, if the alternative is bankruptcy. But they also worry about free riders: what will happen to the bondholders who don’t tender into the exchange? Will they continue to get paid out in full? Not if all the bondholders who do tender into the exchange vote, while tendering their old bonds, to cripple the old bonds at the same time. They might not be able to change the payment terms — that normally requires unanimity — but they can change other terms, and would-be holdouts end up holding highly illiquid, crippled instruments of very little value.

Exit consents come in various different flavors, from the polite to the extremely coercive. But the general idea behind them is the same. Whether or not you think the offer is a good one, bondholders are incentivized to vote for it, rather than just sitting on the sidelines, because sitting on the sidelines can be dangerous. But in one particular case, according to Mr Justice Briggs, the exit consent was so coercive that it became downright illegal.

I can see why he said that. The debtor in question was Anglo Irish Bank, and the exit consent in this case was particularly evil: exiting bondholders gave the bank (which at that point had already been nationalized) the right to buy back all of its old bonds at a price of €0.01 per €1000 in principal amount. Assenagon Asset Management owned just over €17 million of bonds, and didn’t participate in the bond exchange; shortly thereafter, it found all of its bonds redeemed in return for a payment of just €170.

The exchange was a success, with some 92% of bondholders participating; at that point, the bank could easily have reopened the offer and given the holdouts a second chance to say yes. Instead, it got vindictive — and got sued. The result: the entire exchange was found to be illegal. Which has some lawyers, like those at Davis Polk, rather alarmed:

The Anglo Irish decision casts doubt on the legality under English law of any form of exit consent that imposes less favourable consequences upon those who decline to participate in any associated exchange offer, even if such exit consent does not lead to a complete expropriation of the relevant securities as occurred in the Anglo Irish case.

Brown Rudnick, too, thinks this is a Very Big Deal:

The repercussions of this judgment are potentially huge, and could affect all bond restructurings carried out by the Irish banks in the period 2009 to 2011, as well as restructurings in other jurisdictions.

But I think that Clifford Chance is closer to the realities of this case. In a note entitled “Liability Management: Exit Consents and Oppression of the Minority”, they conclude that the English courts merely “provided a timely reminder that the English courts will not uphold structures that seek to impose unfair or punitive outcomes on dissenting or non-participating Noteholders”. Or, to put it another way: go ahead and use exit consents, if you must. But don’t be evil about it.

This is actually one of the things I like about UK law: judges are perfectly free to use common sense, instead of taking everything to its logical conclusion. To use the language of regulation, there are principles involved as well as rules. So while investors are now being urged to buy English-law bonds, and issuers are being urged to issue in New York, the fact is that the difference between the two is not as great as the headlines about the ruling might make it seem. Unless, and until, the issuer decides to be incredibly, and quite unjustifiably, vindictive towards holdouts.

Last week, Arik Hesseldahl — a tech writer who’s the first to admit he’s no expert on finance — discovered the wonderful world of credit default swaps in general, and single-name CDS on Hewlett-Packard, in particular. The cost of single-name protection on HP has been going up, and that can only mean one thing: it’s “mainly a barometer of the state of anxiety over its finances and its balance sheet”, he wrote.

Hesseldahl’s corporate cousins Rolfe Winkler and Matt Wirz followed up a couple of days ago:

A $10 million five-year insurance policy on H-P debt costs $260,000 according to data provider Markit. That price has doubled since April and quadrupled since a year ago. While there is no prospect of H-P going under any time soon, bond investors are clearly unhappy about the company’s deteriorating prospects and balance sheet.

But I don’t buy it. For one thing, as David Merkel points out in a comment on on Hesseldahl’s latest post, the HP bond market is not panicking at all: its bond prices remain perfectly healthy. He continues:

The markets for single name CDS are thin because there are no natural counterparties that want to nakedly go long credit risk. Those wanting to nakedly short credit risk therefore have to pay a premium to do so, usually higher than the credit spread inherent on a corporate bond of the same maturity.

And if one or two hedge funds want to do it “in size,” guess what? The CDS market will back off considerably, and make them pay through the nose.

It’s hard to spook the bond market for a liquid bond issuer; it is easy to spook the CDS market.

Why might one or two hedge funds suddenly want to buy protection on HP (and Dell, and Lexmark)? There’s an easy and obvious explanation: their share prices. HP, Dell, and Lexmark are all trading at less than 7 times earnings, at the lowest prices they’ve seen in a decade. They’re all in the fast-changing and volatile technology business. The only certainty here is uncertainty: it’s reasonable to assume that in five years’ time, each of these companies is going to be in a very different place to where it is now.

Which sets up an easy and obvious capital-structure arbitrage. You go long the stock, and then you hedge with single-name credit protection — the only way you can effectively go short the debt. The stock market is deep and liquid enough that you can buy your shares without moving the market; the single-name CDS market isn’t, but no mind. Even if you overpay a bit for the CDS, the trade still looks attractive, on a five-year time horizon.

In five years’ time, it’s entirely possible that at least one of these companies will be toast — in which case anybody who bought the CDS today will have scored a home run. On the other hand, if they’re not toast, the stocks are likely to be significantly higher than they are right now. Basically, the stock price is incorporating a significant probability of collapse, and if you take that probability away, then it should be much higher. And buying protection in the CDS market is one way of effectively taking that probability away.

This kind of trade only works for companies in unpredictable sectors that have low stock prices and relatively low borrowing costs; such opportunities don’t come along very often. But when they do come along, it’s entirely predictable that a hedge fund or two will put on this kind of trade. In no way are such trades a sign that bond investors are worried about the company’s future: in fact, bond investors are not the kind of investors who put on this trade at all.

And so, as Merkel says, reporters should be very wary indeed of drawing too many conclusions from movements in the illiquid CDS market. Sometimes, they really don’t mean anything at all.