Lacker Leaks and Model Errors


The Lacker leak.

Yesterday Jeffrey Lacker, the president of the Federal Reserve Bank of Richmond, resigned after admitting that he was partly responsible for a 2012 leak. One way to tell this story is that a reporter got a tip that the Fed was going to vote in December on monthly purchases of $45 billion of Treasuries, and used a clever reporting trick to confirm her tip with Lacker: She called him up and, instead of asking him “hey is the Fed going to buy Treasuries in December,” said something more like “so the Fed is going to buy Treasuries in December, huh; anyway I hear you’re having some nice weather down there,” and he said “yes we sure are having nice weather,” and she knew that his lack of reaction to her tip meant that it was true. So she published it. And then he read her article and saw what had happened: “I realized that my failure to decline comment on the information could have been taken,” he said in his resignation statement, “as an acknowledgment or confirmation.” But at that point, what are you going to do?

Well, one thing that he didn’t do was accurately characterize his conversations with her when the Fed’s general counsel came calling, so that is bad. (“Although it was my intention to cooperate fully with the internal review,” begins one sentence in his resignation, and no ending to that sentence could live up to the promise of its beginning.) His memory was better when the Federal Bureau of Investigation came calling three years later, because this leak eventually turned into an insider trading investigation. Presumably Lacker was not the target: If his description is accurate, it’s hard to see how it could constitute insider trading, and “no charges will be brought against Lacker.”

The insider-trading analysis is straightforward, but it feels a little narrow-minded to start there. That’s why I started with: Lacker talked to a reporter, who did some reporting. This particular reporter, Regina Schleiger, happened to work for a publication that most people haven’t heard of, and that charges a lot of money for subscriptions. (It’s affiliated with the Financial Times.) Not many people read her story, and those who did paid a lot for it, and presumably they had financial reasons for doing so. Also Lacker refers to her as an “analyst,” and her publication is called “Medley Global Advisors,” all of which makes her sound like a hedge-fund analyst. But her background was as a newspaper reporter, and her actual job was to call people up, craft a story, fill it with both useful information and colorful details (“Some Fed staff members had stayed up past midnight to prepare for the Fed’s previous meeting”), and then send that story out to subscribers. 

Why did Lacker talk to her? Why does anyone talk to reporters? It is a mystery. “Central banks around the world sometimes guide select journalists at widely read traditional news publications such as the Wall Street Journal, on the likely direction of monetary policy.” They sure do. A few days before Schleiger’s story came out, the Wall Street Journal’s Jon Hilsenrath published an article, also full of colorful insider detail, noting a “strong possibility” of the additional Treasury purchases that Schleiger later confirmed. The Wall Street Journal offers subscriptions for $198 a year. As its name implies, it tends to draw its subscribers from “Wall Street,” broadly defined. (Disclosure: I work for Bloomberg LP, which also sells subscription services, for money, often to people on Wall Street!) 

You can see the problem here, and it’s not a technicality of insider trading law. The problem here is that if it’s okay for reporters at some expensive Wall-Street-focused publications to call up government officials and ask them for information about upcoming government decisions, then it’s hard to say that it’s not okay for other reporters to do that, just because their publications are even more expensive and Wall-Street-focused. (Perhaps you think it’s not okay for any reporters to ask government officials questions! That seems like a view with a lot of support in some circles! It is not one that I share, but, disclosure, I am employed as a journalist!) I mean, sure, fine, you know it when you see it, and something called “____ Advisors” that employs “analysts” to write “reports” for “customers” is different from something called “____ Journal” that employs “reporters” to write “stories” for “subscribers.” But the actual activities are pretty similar.

A Fed leak to someone who trades seems obviously bad and insider-trader-y. (Or, at least, a violation of the “Eddie Murphy rule” against trading on government leaks.) But a Fed leak to someone who reports it to someone who trades is much hazier. That might be indirect insider trading, but it might also just be news. This was a problem for the investigation into this leak, which “stalled as the agency and Manhattan federal prosecutors were unable to serve a subpoena on Medley because it considers itself to be a news organization.” But the embarrassment of this leak might also be a problem for news:

It also could make it more difficult for central bankers to have private conversations with market professionals, economists and journalists.

The conversations with market professionals give officials a chance to learn more about the state of the financial system and the economy, while conversations with reporters enable the policy makers to explain the central bank’s thinking.

It’s not great for the Fed either: “It certainly does not diminish the risk that their independence will be curtailed,” says Roberto Perli of Cornerstone Macro LLC.

What even is a DCF?

Morgan Stanley initiated equity research coverage on Snap Inc. last week with a $28 price target, based on a discounted cash flow model. The next day, though, it realized that the cash flows it was discounting were wrong, as Matt Turner and Rachael Levy report. It had made “a tax calculation error” that overstated earnings in the later years of its model; in 2025, for instance, it had projected almost $4.1 billion of free cash flow, but when it fixed the calculation it projected only $2.4 billion of cash flow. So it put out a new report with those numbers corrected and a … $28 price target. Hmm! Apparently the original report didn’t just get the cash flows wrong; it also had an offsetting error in the discount rate: 

We have also corrected our discounted cash flow calculation so that it is consistent and comparable across our US internet coverage. More specifically, we are lowering our SNAP equity risk premium from 5.59% (an estimated pre-IPO rate) to 4.29% (consistent with other companies in our group). This change lowers our WACC to 8% (from 10%). On an aggregate basis, our price target is unchanged at $28/share.

Snap’s cash flows were lower than they had thought, but its weighted average cost of capital was also lower than they had thought, so no harm no foul. Hmm!

“It almost feels that they’re backing into the numbers,” said Charles Lee, a professor at the Stanford Graduate School of Business. “It just so happens that the two work out so that they don’t have to change their price target.

“It’s almost humorous,” Lee added. 

Turner and Levy point out that other banks who worked on Snap’s initial public offering and published research reports used higher WACCs than Morgan Stanley, though they got pretty similar price targets. Hmm! 

Look, I am going to say some upsetting things in this paragraph, and you may want to avert your eyes. But one obvious point is that Morgan Stanley was not “wrong” to say that Snap’s free cash flow would be $4.1 billion in 2025, and it was not “right” to change that number to $2.4 billion. Morgan Stanley has no idea what Snap’s free cash flow will be in eight years. Snap has only existed for about five years, and its free cash flow in 2016 was negative $709 million. Estimating its free cash flow in 2025 is not primarily a problem of getting the tax calculations right. Snap is worth what people will pay for it, and there is an accepted arithmetic relationship between price and discounted cash flows, and so if people will pay $X for it you can build a discounted cash flow model that produces $X. (Or some other number anchored on $X.) And if you find an error in your model, correcting the error and revising your price target is in some crude but obvious sense the wrong reaction. Your model made sense mainly because its output made sense. If you find an error that messes up that output, you’d better go find another error to offset it.

Jamie for America.

It is a little weird that a bank would put out a shareholder letter purporting to describe solutions for the U.S.’s economic, political and social woes, isn’t it? But I guess if running a family real estate business prepares you to fix the nation’s problems, why not running a bank? Or: If talking about politics is a good idea at Thanksgiving dinners and in Facebook status updates, why not in bank shareholder letters? Everyone is so agitated about politics all the time that genre boundaries have broken down; every bank shareholder letter and soda ad and poem and furniture-assembly instruction sheet is also unavoidably about politics.

Anyway Jamie Dimon’s letter to JPMorgan Chase & Co. shareholders came out yesterday, divided neatly into three parts: one about JPMorgan, one about financial regulation, and one about “public policy” generally. The public policy section has something for everyone: a vague hint at criminal-justice reform, praise for a vocational high school in Queens, a call for “proper immigration,” even a defense of the Administrative Procedures Act against the modern trend of regulation through interpretive guidance. The financial regulatory section is a bit more one-sided. Dimon thinks the data “definitively proves that there is excess capital in the system,” and that bank capital requirements should be lower. Fed economists disagree

Elsewhere in Jamie Dimon news, he told Yahoo Finance that “we had someone do a $100 million F-X trade on their mobile phone the other day”:

He then transitioned to joking about a potential future innovation that could save banks and investors money – keeping people from doing trades after a few drinks.

What they’re going to have to do one day is “put a breathalyzer on that phone, so you don’t feel macho after dinner and a drink or two and say – I’m going long the yen!” Mr. Dimon blew into his hand to simulate the process, drawing laughs from the crowd.

Blockchain blockchain blockchain blockchain.

Oh man, we haven’t had one of these in a while: A centralized financial intermediary is going to continue doing its centralized financial intermediation, but on the blockchain! Today’s intermediary is Broadridge Financial Solutions, Inc., which among other things takes care of proxy voting for a lot of investors: Broadridge asks investors how they want to vote on corporate events, and then fills out their proxies for them. Now it will do that on the blockchain. Because everyone knows that the blockchain is the best way for a single trusted intermediary to keep track of a list.

Ahh, I’m kidding, a little. Actually we have talked about Broadridge’s role in proxy voting before. It’s a mess! Broadridge was part of a bizarre chain of decision-making involving T. Rowe Price Group Inc., State Street Corp., Institutional Shareholder Services Inc. and the Depository Trust Co., all of which had some responsibility for asking T. Rowe how it wanted to vote on the Dell Inc. leveraged buyout and then conveying that vote to Dell. Somehow they got it wrong. I mean, mainly T. Rowe got it wrong, but the point is: It was very complicated and hard to keep track of. Maybe putting it all on the blockchain will make it less complicated and easier to keep track of?

Meanwhile here is Craig Pirrong on the blockchain in financial services:

The nature of public blockchain means that it faces extreme obstacles that make it wildly impractical for commercial adoption on the scale being considered not just in commodity markets, but in virtually every aspect of the financial markets. Commercial blockchains will be centrally governed, limited access, private systems rather than a radically decentralized, open access, commons.

His concern is that blockchains controlled by centralized incumbents will become monopolies. The magic of the blockchain was supposed to be that it would disintermediate the big incumbents and allow anyone to participate in markets. The effect will probably be the opposite.

People are worried about bond market liquidity.

Here’s a fascinating story about “portfolio trades” in bond exchange-traded funds, where a bond investor swaps a bunch of bonds that it already holds for shares in the ETF. This one involved a Texas pension fund run by Leighton Shantz and some BlackRock Inc. ETFs. Shantz sent BlackRock a list of hundreds of investment-grade bonds that he might want to sell, and BlackRock spent time “looking at the potential candidates and seeing how they could map onto our ETFs”:

Those names were then sent to BlackRock fund managers, who made the final call on whether to accept or reject the offerings. A little more than half the bonds were a match. Elated, Shantz handed over the debt in exchange for shares in two ­investment-grade ETFs. Just like that, step one was complete.

Step two was that Shantz sold the ETF shares so he could buy different bonds. That is, it turns out that:

  1. you offer BlackRock your entire portfolio of investment-grade bonds;
  2. BlackRock picks the ones it wants;
  3. you give BlackRock the bonds it wants;
  4. it gives you back ETF shares;
  5. you sell the ETF shares; and
  6. you use the money to buy junk bonds and Treasuries;

is more efficient than:

  1. you sell some investment-grade bonds; and
  2. you use the money to buy junk bonds and Treasuries.

Intermediating through the ETF involves more steps, but it can still be more efficient than intermediating through the bond market, just because the ETF shares are so much more liquid than the underlying bonds.

Elsewhere in Fed departures.

Daniel Tarullo, a Federal Reserve Governor and the Fed’s point man on financial regulation, is leaving the Fed today too, though in more auspicious circumstances than Jeffrey Lacker. He gave his “Departing Thoughts” at Princeton yesterday, offering “a broad perspective on how financial regulation changed after the crisis.” There are bits of it that read a little like Jamie Dimon could have written them! I mean, not really, but here is Tarullo on the Volcker Rule:

The second problem is that the approach taken in the regulation in pursuit of consistency was one that essentially contemplated an inquiry into the intent of the bankers making trades to determine, for example, whether the trades were legitimate market making. The agencies knew this approach would be complicated when we adopted it, but it seemed the best way to achieve consistency, at least over time. I think the hope was that, as the application of the rule and understanding of the metrics resulting from it evolved, it would become easier to use objective data to infer subjective intent. This hasn’t happened, though. I think we just need to recognize this fact and try something else.

Compare Dimon’s complaint that, under the Volcker Rule, “you have to have a lawyer and a psychiatrist sitting next to you determining what was your intent every time you did something.”

Professional hackathoners.

These guys, who make a living traveling around and winning corporate hackathons, seem fun, but I worry about their breath:

“You know how a soldier goes to battle with a sword? Our weapons are our laptops.”

Ma brings his computer, his iPhone, two Androids, a microprocessor development board and sensors for temperature, humidity and touch. He doesn’t pack a toothbrush. “I bring the basics,” he said.

Clark packs his favorite blue fleece blanket and small pillow into his backpack along with his laptop and charging cables. (He also doesn’t bring a toothbrush.)

People are worried about unicorns.

Poor Yik Yak never quite made it to unicorn status (its biggest fundraising was at a $400 million valuation in 2014), and its investors are giving up: The company is talking to potential buyers, “but none of the deals will provide a return for the company’s investors.” 

Yik Yak’s tale is a common one in Silicon Valley: Investors race to pour money into the hot app of the moment, only to watch adoption and usage drop shortly after the ink dries on the term sheet. Then the app becomes a punch line, then it’s forgotten, then somebody snidely tweets “remember yikyak?” (or frontback, or secret, or yo, or ello, or meerkat, or wuwu)… Social media is a hits-driven business, but even harder than making a hit is staying one.

That was all true of the turn-of-the-century internet companies too, but they were smart enough to go public before they became punch lines.

Things happen.

Credit Suisse Investors Urged to Reject ‘Excessive’ Bonuses. Deutsche Bank Loses Senior Executives After Bonuses Slashed. BlackRock’s big funds cut commission rates for Wall Street research. A Pimco Fund Just Became the Biggest Active Bond Fund, and It Wasn’t Bill Gross’s. Staples Explores Sale After Failed Office Depot Deal. Coffee Giant JAB to Buy Panera Bread Chain for $7.5 Billion. Gillette, Bleeding Market Share, Cuts Prices of Razors. Global Shipping Fleet Braces for Chaos of $60 Billion Fuel Shock. “The integration of China’s financial system into the global economy is fraught with peril.” Chinese Stock That Jumped 4,500% Set to Be Cut From Russell 2000. Why regulators should focus on bankers’ incentives. The IRS took millions from innocent people because of how they managed their bank accounts, Inspector General finds. Balancing Concessions to Activists Against Responsiveness to the Broader Shareholder Base. Corporate tax reform, explained with a cartoon about sandwiches. “If settlement agreements filed on Monday are approved, up to 1,400 people may claim up to three free buttered muffins, bagels or other baked goods from the 23 locations in Grafton, Leominster, Lowell, Millbury, Shrewsbury, Westborough and Worcester.” Shia LaBeouf Thriller ‘Man Down’ Sells Just One Ticket at U.K. Box Office. 

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net


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