Towards a Better Way to Hunt Timberwolves
I’ve been talking to the founders of a two-person start-up called profit.ly. They’re profitable and popular with a simple business model: they use technology to expose, and therefore eliminate, pump-and-dump scam artists in the penny-stock market.
Pump and dump artists are fly-by-night stock promoters, not-so-affectionately referred to as “bucket shops” in the industry. They promote typically random stocks with low prices and low trading volume. They’ll buy a small amount causing a price increase, then spreading rumors that the increase is based on unknown fundamentals in the company.
People see the stock value rising when one of the schemers, referred to as a “promoter,” spreads rumors the rise in stock price is in anticipation of something substantive. Promoters used to use the whisper circuit, so friends and family would say they’ve heard something about a secret stock, which they had. That channel still works, though they also predictably now use the Internet.
As people clamor for the “sure thing” the value of the stock rises, and the victims — believing they’ve found a clever bit of inside information — clamor on for more. At the height the initial cabal of crooks sells their early stock purchases and, if they’re smart and there’s a float, shorts the stock as it inevitably crashes.
Bucket shops are an ancient problem; government regulators have been chasing them down for decades with little success. As soon as one is shut down three more spring like weeds to take their place.
Now two guys and a few servers have begun to make a substantive dent.
Let’s repeat that: two guys, and a few servers, have actually made a difference where an army of regulators and law enforcement officials have failed since our grandparents were children.
Two guys who didn’t even set out to save the world. They set out to make money, which they’re apparently doing quite well at.
Their secret sauce: transparency and training.
I’m not underestimating their skills. One is obviously a great software engineer: I’ve been programming computers my whole life, software and software related businesses are what I’ve done until inadvertently wandering into the world of high finance, and he is at the top of his game. His partner is a former hedge fund manager who is on reality TV show Wall Street Warriors. Still, there’s just two of them.
They added transparency to penny-stock trades so that if somebody likes a stock their trades are tracked to show that they’re purchasing it and at what volume. If they then go on to dump it once others do the same the system picks that up to; the promoter is called out, their reputation ruined, and it’s not far-fetched that they’d be subject to prosecution since pump-and-dumps are illegal.
Let’s compare and contrast the derivative market.
Bucket shops typically trade a few thousand dollars; derivative trades are typically tens of millions. Both have low volume, allowing the market to be easily manipulated. Even before profit.ly bucket shops had more transparency than OTC derivatives in that OTC derivatives have no transparency at all. Exchanges are supposed to be set up to remedy that: bucket shops have thrived just fine with mature exchanges.
Let’s compare the behavior of, say, Goldman Sachs selling their infamous Timberwolf CDO to that of a bucket shop operator.
First, a quick review: a CDO is a Collateralized Debt Obligation. Most CDO’s back in the day were groups of B-rated Group 2 MBS’s that were run through a Magical Midas (Garbage-To-Gold) Machine at the ratings agency that transformed a portion of the previously non-investment grade B-rated securities to A rated investment-grade paper.
Goldman-Sachs infamously sent an email around calling the Timberwolf CDO “a shitty deal.” Then they sold it, hyping it in exactly the same way any bucket-shop promoter pumps their own stock. Predictably, it dumped, though not before Goldman and their real clients — hedge funds that purchased CDS insurance that paid-out if a security bombed — walked away with a fortune.
Watch the video in the link above as the Goldman executives simply deny any wrongdoing.
Now let’s think about how tough it would have been for Goldman Sachs to sell Timberwolf if clients knew Goldman thought it was a “shitty deal,” and that they were betting against it. Their own disclosures raised the possibility, though that sounds like boilerplate legalese to buyers talking to a Goldman-Sachs broker backed by Goldman-Sachs reputation.
What a difference a website like profit.ly would have made. Pension funds, villages, municipalities, and foreign government might not have gotten caught up in Goldman’s “shitty deal.”
At the consumer house market level lending standards would have been tighter because the secondary market would have had a tougher time selling the mezzanine level B-rated paper, dampening or even preventing the housing bubble. We all paid for Goldman’s “shitty deal,” and we continue to pay.
Everybody wants regulations but history has shown us that regulations are easy to avoid and regulators easy to skirt. Government works only to a degree, especially when there’s complicated financial products that are bought and sold on a world market.
But if information is released it flows freely, allowing the market to make its own decisions as long as there is adequate transparency. Government could easily mandate, as a matter of public policy, that all OTC deals be publicly listed and available to anybody for free. The burden to banks would be negligible since somebody is obviously keeping track of the trades somewhere or it would be impossible to trade them.
Open the information up, for free, and maybe two guys and a few servers will go on to solve a problem that no amount of government regulation has been able to.
Postscript: People may wonder why I’m not commenting on the Attorney General Settlement yesterday. That’s because the terms still haven’t been publicly released; I prefer analysis, not guessing games. Next week I’ll also be releasing a spreadsheet revisiting the Freddie Mac inverse-floater deals showing that they weren’t as clean as originally believed. They weren’t illegal, and given the mandate of Freddie under HERA 2008 they might not even be immoral. They were more like Kosher imitation crab: technically OK but definitely not in the spirit of what we expect to see from a government-supported agency that’s soaked up almost $200 billion in public funds .. a shitty deal.