The Jim Cramer chatter precipitated by his Daily Show appearance included some links to an infamous interview Cramer gave in 2007, where he discussed how he would, as a hedge fund manager, push the prices of stocks he was short down via the futures market. It was arguably a public admission of market manipulation.
What was most striking about this incident was how quickly it was forgotten.
Now, of course, one can cynically say, that’s what traders do. And there have been times when I’ve had the vast misfortune to be watching the ticks (I hate trading, I put on very few trades, and I sweat them all and second guess myself hugely) and have seen more than once some end of day action that was clearly tape painting (and my pro investor buddies saw it the same way).
But nobody seems offended at the notion that the markets aren’t safe for mere mortals, just the sharks, even the whole US investing mythology touts how transparent, open, and well policed US securities markets are.
That’s one level of heinousness.
The next, which gets even less attention, is how traders play games with their own firms. I don’t mean the rogue trader version (although that is an out of control variant, usually born out of a trader taking on big risk to get himself out of a lossmaking position, making matters MUCH worse, then hiding his losses from management as he continues to spiral downward).
I would very much like knowledgeable readers to elaborate (particularly with any incidents they can vouch for or appeared in the press, even in specialized industry publications) but here are some typical variants (note these are crude typologies, so corrections and elaborations welcome):
Marking phony prices. Can be done in illiquid markets where what you trade doesn’t relate (much, at all) to any benchmarks). It has to be reasonably credible (you can’t be showing gains when your sector is losing, for instance). Management is supposed to have ways to vet/validate pricing, but the funkier it is, the harder it is for management to keep.
Colluding with your trader buddies to produce market prices that are distorted. This reportedly happened with collateralized loan obligations, where traders would trade them among them selves in small lots at fictive prices that they then used for valuation purposes. That kept them in the upper 80s for a while while the the rest of the credit markets were falling more severely, but the CLOs then started to be priced more realistically (I assume some real trades got done, making the ruse impossible to maintain). I presume this is a favorite activity at year end, particularly since a lot of institutions cut way back on trading as of Dec 15 to square their books, so year end volumes are particularly thin.
Now these are really amateur versions, but are still effective. Think of the games that are possible with derivatives.
Yet this type of chicanery gets perilous little notice. Why? Because management is complicit, either by commission or omission. The poster boy of “commission” was Joe Jett, the Kidder Peabody so called rogue trader who in fact never lost the firm a dime, but reported huge phantom profits due to a flaw in Kidder’s reporting system. I won’t bore you with details, but there is good reason to believe that Jett thought the profits were real, that he did not think he was perpetrating a fraud.
However, anyone with an operating brain cell, and particularly his bosses, should have questioned the idea that it was possible to make such monster profits in the Treasury market, Even if Jett had miraculously discovered some anomaly, it should have been arbitraged away, pronto.
So what happened? Jett was barred from the securities industry, and forced to disgorge his bonuses (I am going from memory, but I believe they were about $8 million). And what happened to his boss, Ed Cerullo, who made $20 million thanks to Jett? Nada.
That’s why this crap continues. As long as banks are playing with other people’s money, and the higher ups have plausible deniability, they have no incentive to rein this stuff in, save maybe a token case here and there so they can pretend they really were on top of things. And I’m being charitable and assuming the higher ups were not actively enabling it.
In a recent post on Andrew Cuomo’s investigation of Merrill’s 2008 bonus payments, I noted that Cuomo was also looking into how the Merrill traders marked their books, since it appears they held off marking down positions until after bonuses were determined. I commented that I had often heard tell of traders playing year end games, but never with enough detail for it to be substantiated. I got some confirming reader comments. From Expat:
What! Traders manipulate marks at year end to increase their bonuses! I’m shocked, appalled, flabbergasted, etc.
I also have twenty years of trading experience and can assure you that this is what happened. Most traders, trading managers, and senior managers must have known what was going on (sale to BOA but with early bonuses). The early bonuses were no doubt explained by saying it would be much more complicated to make the payments once the buy was completed (different payroll systems, tax implications, board approval, etc.). All good reasons to steal several billion bucks.
Not only should every Merrill employee have to cough up his bonus, but Thain, all senior managers and the boards of both Merrill and BOA should be beaten to death with baseball bats (think cornfield scene in “Casino”).
This behaviour was/is common. In some companies, where you had a revenue ceiling (as it was recognised that too much of a revenue meant you were probably taking too much risks, so your bonus was capped at some revenue number), people used to shift PnL between quarters. So, if you made 50M, but your cap was 30M, you tried to shift 20M to the next quarter (so you’d have to make only 10M, and not loose the extra 20 you might have got by a lucky bet).
From one Anonymous:
I was a junk bond trader for a large firm during the 1990’s. I was intimately involved in year-end book-marking chicanery to boost profits and hide bad positions.
I can guarantee you that the traders at Merrill violated every securities rule in the books and every possible code of ethics in order to boost profits.
NO QUESTION ABOUT IT. BEEN THERE DONE THAT.
So we have some confirmation of what I have heard merely from being within hailing distance of a trading floor from time to time: traders will cheat to maximize their bottom line, which makes sense, since they are screened and incentivized to be the sort that will seek aggressively to extract as much as they can (yes, there may be some exceptions, but I would bet they wind up going over to the buy side).
So why isn’t there more understanding of and outrage about this? After all, this is the heart of the looting that went on. If firms will tolerate (or even encourage) overly aggressive behavior that appears to generate profit, it isn’t just the nominal miscreants that are at fault, but the whole chain of command all the way to the top (after all, just as in the Jett case, they profited and therefore had reason not to probe too hard).
The same can be said for selling toxic products to customers. The worst is that that appears to have been a risk that paid off handsomely. How many successful prosecutions and regulatory actions have there been? UBS and Merrill on auction rate securities. I can’t think of any actions on fraudulent sales practices on CDOs, even though they would seem to be a prime candidate. Even poor clearly screwed Jefferson County isn’t suing or declaring bankruptcy (although that appears to be that the people involved in the deal are still in positions of authority, and a suit or default would likely expose that they were complicit. And a municipal bankruptcy is no biggie, markets are amazingly forgiving, particularly in a case where it was part of a negotiating strategy).
So here is my theory: the details are not specific enough for the public to see it as real. And if they can’t formulate a picture, they can’t believe it happens all that often (after all, if it did, surely it would be in the Wall Street Journal).
That is an example of a cognitive bias called the availability heuristic. If we can have examples, the more concrete the better, the more likely we are to believe that a phenomenon is valid (that is why anecdotal evidence is more persuasive than it ought to be).
Go back and look at the Cramer tape. It’s actually brilliant. He is not very specific! There is no “when I was short X stock in 2004, I did F, T, and H and the price fell by $Z and I made $100,000 in two days.” It’s all murky, to the point where Henry Blodgett, in parsing the transcript, had to insert words at quite a few junctures to make what Cramer say make sense to him (and note I in reading the transcript would have inserted different words). That’s why this incident never really stuck to Cramer. It all came off like knowing innuendo, but he didn’t present a smoking gun.
So unless we have a Pecora commission, or a lot of ex-traders and trading managers coming forth with particulars, the great unwashed public is not going to know enough of what happened to know where to direct its diffuse but well warranted anger over having been had.
I encourage readers to provide suggestions, links to any known incidents or articles about market manipulation and internal games playing with position valuations (most important, in fixed income and derivatives markets, since that is where the big damage was done), either links to stories or personal examples (per above, the more specific, the better) or write me at yves@nakedcapitalism (I promise I will not go public with any information unless given explicit permission).