By James Kwak
That’s what Jesse Litvak’s lawyer said at the start of his trial earlier today. And technically speaking, it’s true. If you’re trying to sell a bond to a client, and during the course of the conversation you say you can bench press 250 pounds when you can only bench 150, that’s not a federal crime. But if you lie about a material aspect of the bond and the client relies on your lie in buying the bond, that’s another story.
Litvak’s case is (barely) in the news because it has a financial crisis connection; some of the buy-side clients he is alleged to have defrauded were investment funds financed by the infamous Public-Private Investment Program (PPIP) set up in 2009 using TARP money, and hence one of the counts against Litvak is TARP-related fraud. But it bears on a much more widespread, and much more important feature of over-the-counter (OTC) securities markets.
Litvak was trading mortgage-backed securities for Jefferies when the alleged behavior occurred. The key feature of OTC markets is that there is no way to look up the prices at which securities are trading, as opposed to, say, on the New York Stock Exchange. If you are a buy-side investor and you want pricing information, you depend largely on the securities dealers themselves to tell you what the current prices are.
Litvak’s thing was that he lied to his clients about the prices of other transactions that he made up. For example, first Jefferies bought an MBS at $51.25. (SEC complaint, beginning on page 20.) Litvak then approached a potential buyer and claimed that a seller was offering him that bond at $55. The buyer offered $50.50. Litvak then lied three more times about the price that his phantom seller was offering: first $54, then $53.50, then finally $53, after which the buyer agreed to pay $53.25. Who would fall for this? Well, in this case it was Magnetar, the hedge fund renowned for destroying the U.S. economy (exaggeration). The complaint has dozens of similar examples, replete with ungrammatical emails detailing fictional negotiations.
The legal issues are whether Litvak violated Section 17(a) of the Securities Act or Securities Exchange Act Rule 10b-5, for which the lie has to be material and the buyer must have been harmed by it, among other things. Litvak’s defense is the usual one: his clients were sophisticated investors who could have read the documents themselves and analyzed the value of the securities independently. This might work with a jury, but it’s just wrong as an economic matter. If you’re an investor, you know that your analysis of a bond’s expected cash flows is just one opinion. What other people think the bond is worth is also valuable data—especially if you’re thinking you might want to unload the bond to another investor. If Litvak says that one investor expects to sell for $55 and only reluctantly parted with it at $53, that’s different from the fact that the investor sold it at $51.25—more than 3 percent different.
The broader issue is that this is the way OTC markets work. Dealers match buyers and sellers, or sometimes trade out of their own inventory, and everyone knows that they make money by taking a spread on each trade. But it’s impossible, or very difficult, to tell from the outside what the spread is. So even if the majority of bond dealers are upstanding model citizens, the system depends on them being upstanding model citizens—probably not what we want in a cutthroat, aggressive, money-driven culture. But the dealers want to preserve OTC markets precisely because it lets them charge large spreads, whether through deceit or not.
But why does the buy side put up with it? Partially because they don’t realize the extent to which they are being lied to. Litvak’s clients knew that he was buying low and selling high, but they had no idea how low he was buying because he lied about it. Had they known, they would have demanded lower prices or taken their business elsewhere.
But partially because everyone in this casino is playing with other people’s money, as described at length by Zero Hedge when the SEC first filed its complaint. Bond trading is a world of mutual back-scratching in which traders, who are paid a percentage of their profits, charge inflated spreads, and clients go along with it because they are paid a percentage of assets under management—and they get kickbacks in the form of gifts and entertainment from the traders. Everyone is better off except the investors at the end of the line. Which is the big reason why OTC markets are bad for ordinary people.