The Journal had an article this morning about how cash equities traders are getting used to having computers as coworkers but I say unto you: can a computer do this?1
52. On March 31, 2010, Customer A, an investment adviser to a private fund, asked Jefferies to find buyers for several MBS, including Lehman XS Trust Series 2007-15N 2A1 (LXS 2007-15N 2A1) and Harborview Mortgage Loan Trust Mortgage Loan Pass-Through Certificates, Series 2006-10 2A1A (HVMLT 2006-10 2A1A). [Jefferies trader Jesse] Litvak approached a representative at AllianceBernstein about buying the MBS.
53. Litvak told the AllianceBernstein representative that the seller had offered to sell the HVMLT MBS at 58-00 and the LXS MBS at 58-8:
- he will sell to me 20mm orig of hvmlt 0610 @ 58-00 but he is being harder to knock back on the lxs bonds … said that he thinks that one is much cheaper yada yada yada … he told me he would sell them to me at 58-8 (30mm orig) … I would be fine working skinnier on these 2 … but think you are getting good levels on these …
- is he paying u or am I?
- all the levels I put in this room are levels he wants to sell me … I will work for whatever you want on these …. so to recap levels he is offering to me:
hvmlt 06-10 2a1a (20mm orig) @ 58-00
lxs 40mm orig at 58-8…
- Can u wash the hvmlt and [add] 5 ticks to lxs?…
- thats fine.
54. Litvak misrepresented to AllianceBernstein the prices at which Jefferies had acquired the MBS for re-sale. Litvak bought the HVMLT MBS at 57-16 (not the “58-00” he told Alliance Bernstein) and he acquired the LXS MBS at 56-16 (not “58-8” he represented).
55. Litvak also misrepresented the compensation that Jefferies would receive for these trades. AllianceBernstein purchased the $20 million HVMLT MBS at 58 and $40 million of the LXS MBS at 58-13. As a result, on the HVMLT trade, Litvak made 16 ticks for Jefferies; he did not work for free (or “wash” the trade) as he had agreed. And, on the LXS MBS, Litvak made 61 ticks for Jefferies; he did not work for “5 ticks” as agreed.
56. As a result of his misconduct, Litvak made over $600,000 more for Jefferies on the LXS trade and over $50,000 more on the HVMLT trade.
That’s from the SEC’s complaint against former Jefferies trader Jesse Litvak, who apparently made a habit of this sort of thing. He would (allegedly!) tell a potential buyer (seller) of RMBS bonds that he had a seller (buyer), but he would inflate (deflate) the price that he was supposedly getting from the other side in order to inflate his spread. This worked 25 times – that the Feds caught – and allegedly made Jefferies $2.7 million in deceptive profits. This is particularly lovable:
Sometimes, in addition to misrepresenting the price and Jefferies’ compensation, Litvak also misled his customers into believing that Jefferies was arranging a trade between two customers, when Jefferies actually was selling a MBS out of its own inventory. In these instances, Litvak pretended to be actively negotiating with an outside party to buy a MBS that he would then re-sell to his customer. Litvak communicated precise details to customers about the state of negotiations with the imaginary seller. But none of these negotiations were taking place; instead, Litvak fabricated the existence of the seller and every detail about active negotiations with it. In fact, as Litvak knew, Jefferies had purchased these MBS days (and even months) before and already held them in its inventory.
So, I mean: this is terrible? And funny? And also … I dunno, I always thought that the main skills of a bond trader were:
- convincing your customers that you’d paid so much for these bonds you’re selling them, and that at these levels you’re practically giving them away, and that just this once you’ll do a trade at stingy levels like this for them, because they’re your favorite client and you like them so much, and
- actually, y’know, making money on those trades, and
- not getting caught doing that.
Like … when Litvak says “he is being harder to knock back on the lxs bonds” in the exchange above, that’s, y’know, bad, but I have a feeling that this exchange has happened before:
Customer: Can you go to 97?
Salesman: I really want to get this done for you. Let me put you on hold and check with my trader.
Salesman: [Files nails for 15 seconds]
Salesman: Sorry, he can’t budge from 98. Do we still have a trade?
Customer: I guess. Thanks for trying.
“Conducting imaginary negotiations” is kind of a core Wall Street skill.
But subtlety matters: the trader’s job is to create the appearance that the thing he’s selling you is worth more than you’re paying, without actually, y’know, lying about stuff. This is not much different from any other dealer in any other product – art, even – or, um … as the SEC’s George Canellos put it on a call announcing the charges, Litvak’s tactics were “unfit for a used car lot, let alone the market for mortgage-backed securities,” which, what, other way maybe?
The problem seems to have been that Litvak was mostly screwing around with riskless-principal trades, where he was explicitly lining up a seller at Price X and a buyer at Price X + S, where S was an explicitly negotiated spread. You sell out of inventory and your profits are, more or less, your business; you do this – explicitly tell clients you’re working for 4 ticks while actually making 20 – and they become federal prosecutors’ business. It’s bad behavior, but you can maybe be a tiny bit sympathetic: Litvak, according to these charges, just wasn’t good at switching from the super-non-transparent risky-principal market-making to riskless principal brokered trades where transparency really was expected. (If you think he’s alone in that, ask yourself why moves toward real-time reporting of trade prices are often controversial.) “Why should I tell my customers what I paid for these bonds?,” he asked himself, like any used-car dealer would, and now he’s under arrest.
Oh yeah: in addition to the SEC suit, Litvak was also arrested today2 and charged criminally with TARP fraud and stuff, because several of Litvak’s ripped-off counterparties – including the AllianceBernstein fund mentioned above – were TARP public-private investment partnerships, and so the pumped-up fees that Litvak charged ended up coming from taxpayers.3
He was also arrested for regular flavors of securities fraud, but I’m guessing that Litvak particularly regrets the TARP connection: that ripping the faces off a few hedge funds – the indictment helpfully lists them and they include DE Shaw, Third Point, and, somehow wonderfully, Magnetar – would have led to, like, a thorough tongue-lashing from Dan Loeb, but maybe not criminal charges. The SEC’s complaint is eloquent about why Litvak’s behavior is Bad, but also about how bad market participants thought it was:
The MBS market operates through relationships between customers, who buy and sell the bonds, and broker-dealers, like Jefferies, that arrange the trades. Customers seek to pay the lowest price for purchases and get the highest price on sales. It is not unusual for a customer’s view of the current market price for a security to come from the broker-dealer that is selling the security. Because of this, there is an emphasis on establishing relationships, building
trust, and having a good reputation within the industry. In part because of the opacity of the market, and in part because the market relies on repeat transactions between the same parties, customers seek to avoid broker-dealers who are not honest with them. Upon learning that Litvak had lied to them about the price he paid for MBS, some customers indicated that their firms would have temporarily stopped doing business with Jefferies had they known the truth. At least
one customer, upon learning that Litvak had lied, temporarily stopped doing business with Jefferies. Some customers indicated they would have sought lower prices on trades, or even tried to re-negotiate trades, had they known the truth.
That’s kind of the thing about trust-based markets where the participants are sophisticated: if you’re a lying scumbag, they find out,4 and then they don’t trust you. Or, at least that’s the theory – I suspect a theory under which the Magnetars and DE Shaws of the world, and the AllianceBernsteins for that matter, operate. And when those guys find out that you’re screwing with them, that’s a problem for you. It might even lead to your clients temporarily stopping doing business with you.
SEC Charges Former Jefferies Executive with Defrauding Investors in Mortgage-Backed Securities [SEC]
U.S. charges ex-Jefferies exec in mortgage debt fraud [Reuters]
Update: “We Are Doneski Gorgeous!” – How Bond Trading On Wall Street Really Works [ZH]
Update: Ex-Trader for Jefferies Is Charged With Fraud [DealBook]
Traders Make Peace With Computers [WSJ]
1. Do read the Journal article, by the way. It’s a little vague but I guess the idea is that banks are trying to find ways to move cash equities trading up the value chain to justify using human traders instead of just computers. The one example of that working is this:
[S]oft trading volume has left many traders unable to move stock as quickly as they might like. That is one reason why Barclays connected its recently launched DirectEx platform to its trading floor. The move paid off when a client who was buying 150,000 shares on the electronic network decided, after chatting with a Barclays salesman, to take an additional 150,000 shares.
That is sort of adorable isn’t it? I’m sure there’s more going on but I imagine this as:
Barclays salesman: Oh hey Bill. I saw on DirectEx that you bought 150,000 shares of XYZ.
Client: So I did.
Salesman: How’s that working out for you?
Client: Pretty good, pretty good.
Salesman: Hey you know what goes great with XYZ stock?
Client: What’s that, Jim?
Salesman: More XYZ stock!
Salesman: I’ll put you down for another 150,000 shares!
Salesman: Great! See you later!
2. By SIGTARP agents! Do they have guns? Christy Romero, the SIGTARP, um, SIG, or whatever … was super hard-boiled on a conference call, saying things like “the arrest occurred without incident” and “the investigation is ongoing.” It’s their first arrest, ever! SO CUTE!
3. Also they were caught as part of the RMBS Working Group, a federal-state initiative to do lots of things tangentially related to mortgages to make everyone feel better about the mortgage crisis. Pretty sure this dude inflating bid/ask spreads in 2010 didn’t cause the mortgage crisis.
4. Don’t they? Several of Litvak’s dishonest trades were bid-wanted-in-competition trades: a seller was shopping bonds to a bunch of dealers, and those dealers were sourcing bids from a bunch of clients, and … it’s a little odd that Litvak would repeatedly be able to make a big spread in that circumstance without buyer or seller noticing, isn’t it? The SEC’s Canellos says that the price information was “uniquely within the knowledge of Litvak,” which I guess is true, but it’s weird that it would be. Here’s one of his BWIC trades:
83. On July 1, 2010, Litvak sent out a bid list that included a MBS called Structured Adjustable Rate Mortgage Loan Trust, Series 2005-21 7A1 (SARM 2005-21 7A1). (Customers typically send “bid lists” to their brokers to solicit offers on a list of bonds.) A representative from Invesco responded to the list. The representative said that Invesco would bid 79-24 on the MBS. Litvak responded that he would “brb” (“be right back”), to which the representative replied, “thx, got some room too.”
84. Litvak then informed Invesco about the results from his bid:
Litvak: winner bro…he had 2 other guys that were at 79 and trying to improve…but he just sold em to us…I bid your level….so will work for whatever you want big man….
Representative: wow…that was fast. nice work. 6 ticks cool? 79-30 to me?
Litvak: ure timing was perfect…3pm bwic and he is good about trading things fast…so we got in there right at the right time…good teamwork…6/32s is great…thanks BN.
85. Litvak lied to the representative that he had “bid” his “level.” Jefferies had acquired the security at 79-16, not at Invesco’s requested bid of 79-24. Litvak also misled Invesco about the compensation that Jefferies would receive. Invesco purchased $59 million of the MBS at 79-30, and therefore, Litvak received 14 ticks for the trade and not the agreed to “6 ticks.”