Exercise Caution: A New S&P Index

At first glance, the announcement was an impressive one. At the swanky Word Economic Forum in the Swiss resort town of Davos last week, the Canada Pension Plan Investment Board joined Standard & Poor’s in announcing the creation of the new S&P Long-Term Value Creation Global Index.

Standard & Poor’s, of course, is the global provider of financial information that maintains a corporate mission of providing “data and research … (that is) independent, transparent and cost effective.” Presumably, S&P achieves its mission by utilizing its own expert professional staff to create clearly defined financial metrics without undue influence from — or overt reliance on — asset management and investment advisory firms.

In fact, that’s exactly what S&P is claiming to do with its new Long-Term Value Creation Global Index, comprised of 246 companies that purportedly “have the potential to create long-term value based on sustainability criteria and financial quality.” S&P continues:

The S&P LTVC Global Index is constructed by combining qualitative and quantitative measures into a single metric to determine the potential for long-term value addition. The Economic Dimension Scores provided by RobecoSAM are included in the qualitative assessment to gauge corporate governance effectiveness.  The quantitative assessment consists of drivers of long-term investment returns – Return on Equity, Balance Sheet Accruals ratio and leverage ratio.

Okay … but what is RobecoSAM? And are those investment metrics expertly and transparently designed to focus on long term value creation? In addition, doesn’t more than one balance sheet accrual ratio actually exist? And more than one leverage ratio as well?

Apparently, RobecoSAM is an asset management company. And one can find those investment metrics in elementary primers of standard accounting financial statements. And yes, there are many accrual and leverage ratios in active use by financial specialists.

In other words, S&P’s new Global Index of Long Term Value Creation simply takes a set of qualitative metrics that is computed by a single asset management company, and combines it with a set of generic and undefined financial metrics. Although S&P’s press release appears to imply that its qualitative assessment function encompasses other activities, it doesn’t specifically describe any additional work.

To be sure, the Canadian Pension Plan Investment Board should be commended for attempting to promote a long term value perspective in the financial industry. And S&P should certainly be encouraged to continue its mission of developing expert metrics that are “independent, transparent, and cost effective.”

Nevertheless, when the qualitative component of an S&P index emphasizes the metrics of a single asset management firm, it doesn’t bode well for the firm’s mission of independence. And when an index provides no detailed description of its investment metrics or its other qualitative assessment activities, it doesn’t bode well for the firm’s mission of transparency.

One could argue, of course, that such effortless approaches to constructing indices may help S&P achieve its mission of cost effectiveness. Nevertheless, given these other concerns, financial investors might wish to exercise a bit of caution while reviewing the S&P Long-Term Value Creation Global Index.

Bartleby, The Scrivener

Are you feeling a little overwhelmed by the recent spate of films about the unethical and immoral activities of Wall Street professionals? From Leonardo DiCaprio’s dissipated performance in Martin Scorcese’s The Wolf of Wall Street to the current film adaptation of Michael Lewis’ The Big Short, we seem to be inundated with tales of banking dishonesty and brutality.

Come to think of it, though, has there ever been a successful film or book about a moral and upstanding Wall Street professional? It’s awfully difficult to name one. After all, even Jimmy Stewart’s George Bailey in It’s A Wonderful Life conducted business in Bedford Falls, which was a long way from downtown Manhattan. And the classic Christmas movie hardly portrayed financiers in glowing terms, pitting Bailey against the evil banker Mr. Potter.

In fact, we might need to reach all the way back to the year 1853 to find a published tale about an admirable Wall Street professional. Bartleby, the Scrivener, written by Herman Melville just two years after he published Moby Dick, is a short story about a kind-hearted Wall Street attorney who hires a para-legal assistant named Bartleby and then doesn’t have the heart to dismiss him.

Or, to be more accurate, he tries repeatedly to dismiss him, but he doesn’t have the heart to insist that Bartleby leave when the employee decides to stay. So what’s a generous boss to do when a gentle but utterly unproductive worker politely refuses to go home?

The brief text begins as a light comedy, but quickly evolves into a perplexing mystery and then concludes as a spiritual metaphor. The entire content is now in the public realm, and is available for free download from the Project Gutenberg web site.

What compelled Melville to write such a story? It’s possible that he was terribly disappointed by the dismal failure of Moby Dick, which reportedly only sold 3,200 copies during his life, earning him a mere $1,200. Melville’s Great American Novel was only rediscovered by the literary world after the First World War, decades after his death.

In a sense, Captain Ahab’s compulsive connection with the Great White Whale is analogous to the attorney’s inability to squirm free of his pale skinned employee. Perhaps Melville wrote both stories to symbolize how writers become enslaved to their own blank white sheets of writing paper … or, in today’s terms, to the blank white screens of word processing files.

Even if these interpretations are a bit too surrealistic for your tastes, I’d recommend giving the Bartleby story a little of your time. Considering all of the vicious characterizations that have lately plagued our friends in the banking industry, the tale might restore your faith that there is a little human goodness in every corner of the world.

Yes, even on Wall Street.

Yet Another Global Banking Scandal

Just when we thought that the global banking industry couldn’t possibly produce another financial scandal, guess what happened last week?

Yes! Yet another scandal emerged from Wall Street, according to the Wall Street Journal. Or perhaps we should refer to it as a potential scandal, given that the federal government has only begun to launch its investigations.

This time around, the Fraud Section of the United States Justice Department and the Commodity Futures Trading Commission are looking into allegations that the banks manipulated (or “rigged”) their sales of government Treasury Bonds. The banks help the federal government sell its debt securities in order to finance its deficits.

If proven true, would this represent a new and unusual type of illegal activity? Not really. In fact, the accusations represent a somewhat archaic and musty version of Wall Street brazenness.

That’s because the very first banking scandal in American history involved the manipulation of debt securities that were issued by the United States Treasury. In 1792, a former Treasury official named William Duer and his accomplices drove up the prices of the government bonds that were issued to help refinance the loans that were first incurred during the American Revolution.

Duer briefly became wealthy as he drove up the valuations of the securities, but the inevitable subsequent market collapse (known to history as the Panic of 1792) drove him into bankruptcy. He spent years in a debtor’s prison, and eventually died there.

Alexander Hamilton, America’s first Treasury Secretary, led the government’s effort to quell the panic. But fear of the future damage that might be wrought by further financial manipulations compelled two dozen major Wall Street brokers to establish a set of rules for regulating market behavior. This contract, known as the Buttonwood Agreement, served as the founding document of the New York Stock Exchange.

So if you’re concerned about the federal government’s ability to investigate and decipher innovative criminal financial activities in this new age of derivatives and flash crashes, you need not worry about the latest global banking scandal. There is actually nothing innovative at all about rigging the Treasury bond market, a scheme that was first hatched 223 years ago.

Basket Options: Wall Street Launders Again!

Have you noticed that the financial wizards of Wall Street tend to implement the same strategies over and over again?

During the late 1980s, for instance, financial institutions turned high-risk “junk bond” debt into a staple of corporate finance. And two decades later, many of the same organizations churned out “sub-prime” mortgage debt securities.

Here is another example: during the 1990s and early 2000s, investment bankers helped American corporations reduce their tax burdens by advising them to move their headquarters to nations with lower rates of taxation. Today, of course, their “tax inversion” acquisition strategy is following the same path.

And a few days ago, the United States Senate held an investigatory hearing into yet another questionable Wall Street strategy. This one, called the basket option, operationalizes the time-tested principles of money laundering.

Money laundering? Isn’t that illegal? Well, when firms launder funds through intermediary organizations to hide criminal activities, it is most certainly illegal.

But what does “money laundering” mean? For a simple example, let’s assume that the owner of a criminal syndicate earns significant amounts of cash from illegal narcotic or prostitution activities. Let’s also assume that the owner decides to purchase an empty strip of land and operate a parking lot.

Why would he do so? Because parking lots are cash businesses. The owner will deposit his illegal business cash receipts into a bank account that serves his legitimate parking business, while attributing those receipts to parking services. In essence, the owner will use the parking lot to “clean” (or “launder”) his “dirty” illegal money by attributing it to a legitimate business.

Wall Street’s basket option strategy utilizes the same principle. Instead of trading securities on a continuing basis, an American investor will contract with a financial institution to create a “basket” of securities that trades frequently on his behalf. The investor will also hold an option to purchase (or sell) the basket, and will exercise that option on an infrequent basis.

How infrequently? Invariably, he will exercise his option less frequently than once a year. Why not more often? Because more frequent trading would defeat the purpose of owning the basket option.

You see, if an American investor sells a security that is owned for less than a year, he would pay a relatively high “short term capital gains” tax rate on his profit. But if he sells a security that is owned for more than a year, he would pay a much lower “long term” rate.

Thus, by relying on a different entity to make short term trades while transacting with that entity on a long term basis, the investor can utilize the entity to “launder” those short term trades and redefine the resulting profits as long term profits. And by doing so, the investor can reap the benefit of the lower tax rate.

This laundering strategy, incidentally, is reminiscent of an incorporation structure that Goldman Sachs proposed to Facebook before the social media giant “went public” in an Initial Public Offering. Apparently, Facebook’s corporate officers decided to go public because the firm was about to expand its investor roster to more than 500 individuals, a level at which any American firm must accept (by law) the regulatory burdens of public ownership.

Goldman, however, proposed to create a Special Investment Vehicle (SIV) to serve as the sole owner of Facebook stock. This holding company, according to Goldman, would then resell that stock to far more than 500 investors.

Such a strategy, in essence, would have permitted Facebook to rely on a new entity to “launder” large numbers of investors into a single unit for the purpose of avoiding the responsibilities of public ownership. To its credit, Facebook declined to accept Goldman’s offer and decided to launch its Initial Public Offering instead.

Nevertheless, this strategy of “laundering” transactions through an intermediary entity appears to have been employed again in the form of today’s basket options. Apparently, Wall Street’s wizards of finance cannot resist the temptation to utilize intermediary organizations to “clean” transactions, a strategy that they implement over and over again.

Wall Street and the Pac-Man Defense

Do you remember Pac-Man? A Japanese company named Namco first released the rudimentary video game in May 1980, several months before Ronald Reagan was elected President of the United States for the first time. It quickly became an iconic product of the 1980s, and one of the most widely celebrated video games in history.

Oddly enough, the Pac-Man game has reappeared in the news recently, thrust into the headlines by a classic Wall Street corporate battle. Six weeks ago, a relatively small but venerable men’s fashion retailer named Joseph A. Bank Clothiers dropped its hostile takeover bid for Men’s Wearhouse, a larger discount clothing outlet.

So how did the board members of Men’s Wearhouse respond to this unwelcome suitor after Bank dropped its bid? One week later, the board members turned the tables and launched their own hostile takeover bid for Bank!

At that bizarre moment when the hunter became the hunted, Bank suddenly found itself in a defensive crouch. And now Bank is striving to avoid the very merger that it had previously espoused, when it initially played the role of the stalker and not of the target.

This Men’s Wearhouse strategy is known on Wall Street as the Pac-Man Defense. Its name refers to the brief moments in the video game when the gamer’s Pac-Man avatar is suddenly blessed with the ability to “gobble up” its ghostly enemies Inky, Blinky, Pinky, and Clyde, and is no longer forced to flee from them. During those moments, Pac-Man reverses course and pursues the four “would be” hunters.

Wall Street first developed the Pac-Man defense in the early 1980s, at a time when the video game was achieving its heights of popularity. The 1982 Martin Marietta – Bendix Corporation takeover battle represented the first application of the strategy.

Interestingly, many financial analysts believe that today’s proposed merger of Bank and Men’s Wearhouse, a men’s fashion retailer and a complementary discount clothing outlet, is a sensible one. And Bank is not arguing the point; instead, it is claiming that the Men’s Wearhouse acquisition offer does not fully reflect the value of the Bank franchise, repeating the very claim that Men’s Wearhouse previously made about Bank’s previous offer!

In other words, the Pac-Man offer / counter-offer process appears to represent an incredibly elaborate (and thus extremely costly) passive – aggressive mating dance between two compatible organizations that have already accepted the logic of a business combination.

But then why waste all this effort on the dual takeover battles? Why not simply ask the board members of the two firms to either hash out a deal, or to forget about it?

Wall Street does not appear to have an answer to this question. Thus, the mating dance continues unabated.

If you were a board member of Joseph A. Bank, what would you do?