"We Are Doneski Gorgeous!" - How Bond Trading On Wall Street Really Works
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.
Jesse is a former MBS trader from Jefferies, who got just a little too greedy, and 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.
What exactly was the charge? The SEC summarizes it briefly as follows:
Jesse Litvak arranged trades for customers as part of his job as a managing director on the MBS desk at Jefferies. Litvak would buy a MBS from one customer and sell it to another customer, but on many occasions he lied about the price at which his firm had bought the MBS so he could re-sell it to the other customer at a higher price and keep more money for the firm. On other occasions, Litvak misled purchasers by creating a fictional seller to purport that he was arranging a MBS trade between customers when in reality he was just selling MBS out of his firm’s inventory at a higher price. Because MBS are generally illiquid and difficult to price, it is particularly important for brokers to provide honest and accurate information.
The SEC alleges that Litvak generated more than $2.7 million in additional revenue for Jefferies through his deceit. His misconduct helped him improve his own standing at the firm, as his bonuses were determined in part by the amount of revenue he generated for the firm.
A more detailed summary of what Litvak did over and over:
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.
As an intermediary, Litvak generally purchased MBS from one customer and then sold the same security to another customer. In those circumstances, Jefferies and Litvak typically re-sold the MBS on a riskless, principal basis; this meant that, while Jefferies would momentarily own the MBS in a principal account, it had minimal or no risk because it knew that it could re-sell the MBS to another customer. Litvak earned compensation for Jefferies by reselling the MBS at a higher price and collecting the spread (or difference) between the purchase price and the sale price. The customers were aware that Jefferies was compensated in this way, and the amount and source of the compensation were part of the negotiations around the purchase and sale of the MBS.
From 2009 to 2011, Litvak engaged in misconduct on over 25 trades. In each instance, Litvak made misrepresentations to, or otherwise misled, customers about the price at which Jefferies had purchased the MBS before re-selling it to the customer and Jefferies’ compensation for arranging the trade. In some cases, Litvak also pretended to be arranging the trade between customers when Jefferies was actually selling MBS out of its own inventory.
When Litvak offered customers MBS, he lied to them about how much Jefferies had paid (or was paying) for the securities. In order to negotiate a higher sale price to the customers, Litvak misled them into believing that Jefferies had paid a higher price for the MBS than it actually had.
By misrepresenting Jefferies’ purchase price, Litvak misled customers about the amount of compensation Jefferies would receive on the transaction. For example, if Litvak told the customer that Jefferies’ purchase price was 80 and the sale price was 80 and 4 ticks, the customer understood that Jefferies received 4 ticks in compensation. However, if Jefferies’ purchase price was actually 79 and the sale price was 80 and 4 ticks, then Jefferies received an extra point in compensation as a result of Litvak’s misrepresentation. On some occasions, Litvak and the customer explicitly agreed on the amount of Jefferies’ compensation based on the purchase price as represented by Litvak.
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.
The above is the basis of SEC's just announced case. In reality, Litvak's biggest crime was getting too greedy. Because all of the above is well-known to everyone in the industry, and it certainly was known to Litvak's clients, most of whom were sell-side traders and salesmen before they moved to the buyside, and certainly knew how the game is played.
And what the result of today's civil charge against Litvak is that, for at least the foreseeable future, every single bank will come down like a brick house on any and all inhouse bond, loan, CDS and OTC salesmen and make sure that every single transaction is recorded, the entry and exit prices are fair and honest, and as represented, and in the process both banks and salespeople will make millions less in profits. This will continue at least for a year or so, or until the SEC finds some other major case to focus on, far away from the realities of modern day bond trading.
Another direct result is that courtesy of 31 page SEC complaint, the general public will now be aware just how much even very sophisticated traders were being abused as muppets by those who had the information about both sides of the trade. Because at the end of the day, as the old saying goes, the only true commodity on Wall Street is information.
While arranging a trade on May 28, 2009, Litvak lied to both the seller and buyer of $25 million of a MBS called IndyMac INDX Mortgage Loan Trust (“INDX”) 2007-AR7 2A1 (INDX 2007-AR7 2A1).
A representative of MFA Mortgage Investments, Inc. (“MFA”) told Litvak he was interested in bidding 42-00 for $25 million in the INDX MBS. After negotiating with the seller, Litvak told the MFA representative in an instant message, “I can sell to you at 42-8 . . . I Bot EM AT at 42-4.” MFA agreed to buy the MBS at 42-8.
Litvak lied to MFA about the acquisition price. He had bought the security at 41-4, not “42-4” as he had reported. The next day, Litvak admitted to a Jefferies colleague that he had lied to MFA, while also misrepresenting the purchase price to his colleague. Litvak wrote, “we bot at 41-12. Sold to him a[t] 42-8. He thinks we bot em @42-4 fyi.” Thus, he misrepresented the purchase price (41-4) both to MFA and to his own colleague.
While he was lying to the buyer, Litvak was also lying to the seller of the MBS, Third Point LLC (“Third Point”). Although he knew MFA was willing to pay 42-00 for the MBS, Litvak told a Third Point representative that the MFA representative—whom Litvak referred to as “one of my circle of trust guys”—had bid only 41-00. Litvak then reported that he had convinced MFA to raise its bid to 41-16.
Litvak acknowledged to a Jefferies colleague that he misled Third Point, writing, “So we bot [INDX] bonds from [the Third Point representative] at 41-4. . . . she thinks we sold at 41-16 . . . we really sold em at 42-8.”
Through his misconduct, Litvak generated more than $200,000 in extra profit for Jefferies on this trade.
A whole lot of lying to everyone involved to scalp a $200,000 profit.
On December 23, 2009, Litvak approached a representative at Wellington Management LLP (“Wellington”) about purchasing a MBS called Wells Fargo Mortgage Backed Securities 2006-AR12 1a1 (WFMB 06-AR12 1a1). Litvak suggested to the representative that he was arranging a trade with an active outside party:
yo yo yo….if there is any color you can share on your wfmbs 06-ar10 4A1 from yest…maybe i can use that as leverage to go beat the guy up that owns the 06-ar12 1a1 bonds….as of late last nite it sounded like he was starting to warm up to the idea of coming off his level…..
The Wellington representative asked Litvak, “what’s the current size and offer” on the MBS, and Litvak responded, “its 3+mm current and he was offering them at 77….” About twenty minutes later, Litvak reported that the seller was not in yet: “he … usually rolls in around now…..so should know soon brotha…..” Half an hour later, Litvak told the Wellington representative that he had bought the MBS at 75-28 and provided details of the supposed negotiation:
winner winner chicken dinner…he is gonna sell em to me at 75-28 as I told him to not get cute and just sell the bonds so you can own them at 76….he said cool…..its 6.23mm orig….a’ight?
Wellington agreed to purchase $6.23 million of the MBS at 76. 42.
In actuality, Jefferies had purchased the MBS on December 14, 2009 at 70 (not “75-28”) and held it in its inventory at the time of the sale to Wellington. On December 23, 2009, Litvak concocted the supposed seller and fabricated the details of a negotiation. As he had done before, Litvak lied about the purchase price, Jefferies’ compensation on the trade, and the fact that the MBS was being sold out of Jefferies’ inventory.
Through his misconduct, Litvak made over $150,000 in additional compensation for Jefferies on this trade.
Many more lies, just to add another $150,000 in the bag.
It goes on:
On January 7, 2010, Litvak communicated with a representative at York Capital Management Global Advisors, LLC (“York”) about selling $40 million of a MBS called DLSA Mortgage Loan Trust 2006-AR1 2A1A (DLSA 2006-AR1 2A1A), held by York, to another customer. Litvak told the representative that the other customer had bid 60-24. The York representative asked Litvak how much he wanted to be compensated for the trade:
Litvak: i am happy when I get any trades…..lol…in all seriousness….i think 8/32s is great….so maybe you sell em to me at 60-28 and i sell em to him at 61- 4….something like that..but im also happy to get you 61 and just tell him to pay me 61-8…..wanna get you the highest i can…
York representative: well i want best execution obv so try to get him to 61-8!
Litvak: we are doneski gorgeous! im selling him bonds at 61-8……will buy em from you at 61 k?. . .
York representative: great! . . . .
As a result of this back-and-forth, York agreed to sell the MBS at 61.
Litvak misrepresented the resale price and the compensation he would receive for Jefferies. He did not sell the MBS at “61-8,” as stated, but at 62-12. Thus, instead of the “8/32s” he represented Jefferies would make, the firm actually was compensated 44 ticks for the trade.
Through his misconduct, Litvak made over $220,000 more for Jefferies on this trade.
More lies, another $220,000.
And on, and on, and on.
This continues to this day, and will continue tomorrow, albeit at a more modest pace for at least a few months, at every single Wall Street firm, and such skimming off the top is precisely what ends up going into both the bank's bottom line, and the trader's bonus.
Is it any wonder that virtually all Wall Street "professionals" are habituated sociopaths who lie for a living just to skim a few pennies (metaphorically speaking: make that millions of "other people's" dollars in the real world). And is it any wonder that all banks demand their inner workings never see the light of day so they can operate in absolute secrecy, and exchanges like the above, and 22 more, are never read by the public.
Take these examples and multiply them by a thousand: only then will you have a sense of what truly goes on behind the scene of every Wall Street firm in the US and around the world on any given day: a shadowy netherworld populated by uber-wealthy sociopaths, whose ethics are dominated not by what is right or wrong, but who can lie the most, rip their clients off without their clients pulling the plug, and, of course, who has the biggest year-end bonus and shiniest and newest toys at the end of the year. Everything else is of tertiary importance.
And since everyone on the inside knows that only the most conniving, most sociopathic survive and, most importantly, make the most money, nobody complains, or else is shown the door.
That is how Wall Street truly works, for better or worse (we have omitted the inevitable bailout that happens once bank after bank loads up on too much prop risk and has to be bailed out by the government, but that is, by now, well-known).
The full complaint against Litvak can be found here.