Nearly a year ago, we predicted that the party for bond traders was over. The reason: MBS bond trader Jesse Litvak, formerly of mid-tier, perpetual aspirational bulge bracket, and the place where every fired UBS banker has a safety cubicle, Jefferies, got not only too greedy (that’s ok, everyone on Wall Street is), but what’s worse, got caught. Understanding why Litvak got caught requires an understanding of just how modern bond trading works, or rather worked, and why it was a dollar bonanza for years.
This is how we explained it:
For many years one of the best jobs on Wall Street in terms of a mix of job safety and compensation, was to be a fixed income trader-cum-salesman working for a major bank with a deep balance sheet, which could hold illiquid securities on its prop account, to dispose of as the “flow” (or clients) required, and on unsupervised and unregulated terms that were simply a verbal arrangement between the bank trader and the end client, usually a counterparty trader working for a major institutional buyside shop, including mutual or hedge funds.
Since for the most part, the buyside traders operated with other people’s money, they were largely indiscriminate on the fine pricing nuances of the acquisition (or disposition) of the securities at hand, and while to the “other people’s money” under management whether a given bond was bought for 55 or 55.75, or a given MBS was sold for 72-6 or 72-16 meant little (after all the trade was driven by a big picture view that the security would go up or down much more and certainly enough to cover the bid/ask spread, resulting in much larger profits upon unwind), the transaction price had a huge impact for the bank traders-cum-salesmen arranging said deals. Because when one is selling a $40 million MBS block, a 1 point price swing equals a difference of $400,000. Make 15 such deals per year, and one’s $1,000,000 bonus (assuming a ~15% cut on the profits) is in the bag.
It wasn’t necessarily an easy job – it required an extensive rolodex, a keen ear for who held what securities in one’s given space, constant schmoozing, and manning the phones constantly. More importantly, everyone knew how the game is played: everyone knew that the middlemen would usually skim a few basis points on the top or bottom of the bid-ask spread, in exchange for having the first call the next time a juicy security was being shopped around, or whenever one had to offload some debt in a hurry.
Keep in mind this type of trading of OTC (Over The Counter) instruments, which included and still includes most corporate bonds, Credit Default Swaps and all other derivatives, Mortgage Backed Securities, Bank Loans, Bankruptcy Claims, and other blocky piece of paper, was always vastly different from equity trading where every trade was electronically recorded, where the bid/ask spreads were negligible due to infinite competition for every trade, yet which ultimately led to the advent of such robotic predators as High Frequency Trading algorithms which do at the micro scale what the old equity specialist and current bond salesman/trader do at the macro level. In short: the highly lucrative and extremely profitable bid/ask skimming that every bond trader engaged in for years has been impossible in equities for the simple reason that the bid/ask spread on most equity-related securities is minute and the market is far deeper and (at least used to be) far more liquid.
It also explains why 4 years after the Great Financial Crisis, there is still no centralized, computerized trading portal for OTC trades, including corps, CDS, loans, etc. Doing so would mean that the banks would give up billions in additional commissions that they could charge if all such trades were facilitiated by the kind of sales coverage middlemen described above. Because while a salesman was incentivized to peel as much as they could of a given trade, they would at best pocket some 10-15% of the total spread. The rest went to the bank, and thus to management in the form a massive bonuses: comp at banks is not 40% of revenue for nothing, with some money left over for “retained earnings.”
But back to the credit traders which for years had built up their reputations in given product verticals, and which had a coverage of fiercely guarded clients, which no other salesmen at a given firm were allowed to converse with. Now was it well-known that salesguy X would pick an additional 50 bps on top of the price being quoted? Sure. After all, someone had to pay for those weekly trips to the Hustler Club, and that’s precisely what the Salesmen did. And who really cared about a little vig? Remember – it was all being down with “other people’s money.”
Well, the days of rampant skimming on top of the bid/ask spread, and with them record bonuses for bond traders and salesmen, may just ended with a whimper not a bang, and all bond traders hoping to make millions by misrepresenting what the true purchase or sale prices are to buysider clients, even if completely voluntary on both sides, may want to seek employment elsewhere.
They have Jesse Litvak to thank for it.
A senior SEC official at the time described the alleged conduct as “unfit for a used-car lot, let alone a marketplace for mortgage-backed securities.” Either way, little did we know how correct we would be, because not only did the former MBS trader, who as we said then “proceeded to rip virtually all of his clients on seemingly every single trade he executed for the three years he was employed at Jefferies, lying to everyone in the process: both clients and in house colleagues, generating some $2.7 million in additional revenue for Jefferies for the duration of his tenure, and who knows how much in personal bonuses”, end the party, but it appears he has managed to unleash the next big regulatory crack down on Wall Street. And one which may just cost perennial Department of Justice favorite JPMorgan another several billion in “litigation reserves.”
The WSJ reports that with the fraudulent mortgage bond crackdown largely in the history books, the next target for regulators will be to focus on precisely what Litvak was doing (full disclosure: Patrick J. Smith, a lawyer representing Mr. Litvak, said last year that his client “did not cheat anyone out of a dime.” Mr. Smith declined further comment Tuesday). On a mass scale. To wit:
“Prosecutors are working alongside regulators in a broad investigation into whether a number of Wall Street banks cheated mortgage-bond clients in the years following the financial crisis, according to people close to the probe.
The Justice Department is investigating alongside the Securities and Exchange Commission and the special inspector general for the Troubled Asset Relief Program, or Sigtarp, the people close to the probe said. The investigation, revealed by The Wall Street Journal in a page-one article Wednesday, is the first known wide-ranging probe into mortgage-bond sales by banks in the years after the economic meltdown of 2008.
The involvement of prosecutors wasn’t previously reported.
And guess who is involved: everyone’s favorite allegedly criminal bank that neither admits nor denies manipulating everything – JPMorgan.
J.P. Morgan Chase & Co. said in a securities filing last year it had received requests for information from the U.S. attorney’s office in Connecticut, as well as subpoenas from the SEC and a request from Sigtarp to review “certain activities.” The requests relate to “communications with counterparties in connection with certain mortgage-backed securities transactions,” according to the filing.
J.P. Morgan’s disclosure refers to the government probe reported by the Journal, according to a person familiar with the matter.
The New York firm is one of at least eight banks under scrutiny in the wide-ranging probe, the people close to the investigation said.
The investigation underscores how J.P. Morgan’s legal headaches are far from over, even as it shells out billions to resolve numerous probes. The largest U.S. bank has agreed to roughly $22 billion in payouts over the last year to end a slew of lawsuits and investigations into many aspects of its business, including the 2012 “London whale” trading debacle and alleged failures to stop Bernard L. Madoff’s massive fraud.
Make that $22 billion plus $1-2 billion more. Oh, and in case you didn’t realize it yet, this is why Jamie Dimon is richer than you.