Matt Levine’s Money Stuff: Leaving Russia for Morals or Money

ESG

If you are an international company or investor, why might you stop investing or doing business in Russia? There are two basic reasons:

1. Moral reasons: Russia’s invasion of Ukraine is bad and you do not want to support it. Exactly whose morality matters here could vary: A company might pull out of Russia because of its chief executive officer’s personal moral views, or to respond to (or avoid) moral pressure from shareholders, employees or customers. But the idea is that by stopping investing in Russia you are in some way punishing Russia and raising the costs of its aggression, even potentially at some cost to yourself.

• 2. Risk reasons: Russia’s invasion of Ukraine has led to international sanctions, which have disrupted international business with Russia and might still be expanded. These sanctions have also led to retaliatory economic actions by the Russian government, and to an economic contraction in Russia. If you continue to invest money in building a factory in Russia, further sanctions might make it impossible to keep running the factory, or the Russian government might seize it, or Russian consumers might not have money to buy the output. So you might as well stop now.

You can obviously have both of these reasons, even though they are sort of opposites. The first reason is essentially altruistic (“we’ll sacrifice money to do the right thing” ), the second is essentially profit-seeking (“we will get out of Russia to save money”). But if you get out of Russia for moral reasons and that also turns out to be good for you economically, well, you won’t complain.

These are also the two standard mechanisms of environmental, social and governance investing. One theory of ESG investing is that the point is to raise the cost of capital of bad activities; you avoid investing in socially harmful companies, making it more expensive for them to operate and so reducing the total amount of social harms. You are pursuing aims other than maximizing cash flows, either because you care about them yourself or because you have to answer to stakeholders who care about these things.

The other theory of ESG investing is that the point is to avoid investing in things that are unsustainable in the long term. The idea is that right now you can, say, mine thermal coal profitably, but in the long run the externalities of coal mining will catch up to you: People will stop burning coal, future regulations will ban it, etc., so you might as well divest now. This is just standard capital allocation to maximize cash flows; your job is to predict long-term cash flows, and you do it in part by predicting future social and regulatory changes.

This is well-known stuff, in ESG investing, and we talk about it a lot. And now Russia’s invasion of Ukraine has become, more or less overnight, the big ESG issue:

“Ukraine is one of the most important ESG issues we’ve ever had,” said Philippe Zaouati, chief executive of Mirova, the $30 billion sustainable-investing unit affiliated with Natixis Investment Managers. “It’s a vital issue for energy and human rights, and questions whether we still want to live in a democracy or not.”

One point here is that, while this is an ESG issue, it is not one that implicates only or primarily ESG investors. Every company and investor faces some pressure to have a position on Russia. Some level of public morality, and some accounting for systemic risks, is now built into every aspect of international finance.

The two theories of ESG each have odd implications. The risk/sustainability theory essentially anticipates government actions: You get out of a business because you think that, in the long term, future regulation will make it untenable. Sometimes this puts investors in conflict with the actual goals of current regulators. For instance, many ESG investors avoid fossil fuels out of an expectation that future regulations will ban them, but in the U.S. actual Republican governments tend to want more fossil fuels; I wrote last year about anti-ESG rules in Texas:

Not only has Texas not taken steps to limit oil and gas drilling, it has taken steps to make it illegal not to support oil and gas drilling. If your theory of ESG investing is “we have to divest from fossil fuels because ultimately regulators will ban them,” it has to feel a little weird when the regulators instead ban divesting from fossil fuels.

Similarly, there has been a great deal of “self-sanctioning” of Russian oil exports in anticipation of future broader sanctions, even though actual sanctions so far have not only exempted oil and gas but, as of last week, specifically encouraged the continued financing of Russian energy exports. From the U.S. Department of the Treasury’s Office of Foreign Assets Control last week:

Treasury remains committed to permitting energy-related payments — ranging from production to consumption for a wide array of energy sources — involving specified sanctioned Russian banks. To help protect Americans, partners, and allies from higher energy prices that would drive more resources to Russia, Treasury swiftly issued and updated Russia-related guidance to allow U.S. financial institutions to continue processing these transactions and underscore that such activity is not prohibited by sanctions. While current circumstances and the dangers from Russia’s war in Ukraine may lead entities and individuals to make their own risk assessments and business decisions, Treasury is making clear that sanctions will not block energy payments.

OFAC is constrained by U.S. politics, and U.S. politicians do not particularly want to see energy price inflation, so they exempted Russian oil from sanctions and then made a point of clarifying that so no one was confused into self-sanctioning. People self-sanctioned anyway. And they were … possibly right? Yesterday “oil had its biggest daily swing ever, with Brent surging to nearly $140 after the U.S. said it was considering a ban on Russian crude imports.” The market may have more accurately predicted future U.S. sanctions than the U.S. government did.

Meanwhile, the moral theory — the theory that the point of ESG is to raise the cost of capital of bad activities — has the corollary that people who do invest in bad activities, who are not ESG investors, should expect a higher return on their investment. That’s what a higher cost of capital means; it means that companies that do bad activities have to promise higher returns to their investors to attract investment.

Applied to Russia that means: If everyone is divesting Russian assets to signal their morality, somebody is, in expectation, getting rich by buying them. People have noticed:

Investors are starting to buy Ukrainian and Russian bonds that plummeted to discounted prices, betting that they will recover if the war between the two countries comes to an end.

The trade is high-risk, given uncertainty over what Ukraine will look like after the war and how long the financial cordon around Russia will last. It also poses reputational dangers because of the human cost of the conflict and the increasing unwillingness of many financial institutions and corporations to be associated with Russia in any way.

And:

Strategists at JPMorgan Chase & Co are recommending clients boost positions in some Russia-linked corporate debt, even as the U.S. and allies tighten sanctions to restrict investments in some of the country’s assets.

Strategists in the bank’s research team led by Zafar Nazim upgraded debt of Russian companies including oil and gas giant Lukoil PJSC and steel producers Novolipetsk Steel and Magnitogorsk Iron & Steel Works to overweight in a note sent to clients on Friday. ...

The strategists said in the note that Lukoil is the “best recovery play” on distressed Russian corporate debt because the company has substantial international operations and relatively low international debt. They see the bonds, which were quoted on Friday in a broad range of 20 to 40 cents on the dollar, ultimately paying out at par.

If divesting from Russia is primarily about putting morality above profits, then that leaves a lot of profits for the people who don’t divest. Those people are, in expectation, the ones who don’t care as much about morality; given market-structure and sanctions dynamics they are particularly likely to be Russian buyers. We talked last week about international oil companies abandoning Russian joint ventures at zero value, which does seem a lot like donating their shares to the Russian government. (I proposed donating the shares to Ukraine instead but I do not think that is very practical.)

You could almost make the argument that divesting from Russia is bad because it gives all those expected profits to Russian buyers. I mean, I wouldn’t make that argument myself, but here’s this:

H2O Asset Management said it is maintaining its exposure to the Russian ruble in part because exiting its positions would be a gift to Vladimir Putin.

“We consider that selling Russian assets, among which currencies, at such discounted rates is a counterproductive ‘gift’ to buyers, among whom the Russian government,” London-based H2O said in a letter to investors seen by Bloomberg News.

See, it’s important not to sell your Russian assets, because that would put them in the hands of Russians.

CDS

Loosely speaking, a credit default swap is an insurance policy on the bonds of a country or company. If you buy a $100 bond and a $100 CDS, you should always get back $100: If the bond defaults and pays back only $30, the CDS should pay you $70; if it defaults and pays $0, the CDS should pay you $100. (If the bond pays back at par, the CDS should pay you zero.)

One way to think about the mechanics is that, if there is a default on the bond, you hand the bond over to the CDS seller, and the CDS seller gives you $100. That way you get your $100, and the CDS seller gets whatever the bond is worth, $30 or $0 or conceivably even $100 or more. (It is possible to have a default that triggers CDS but that leaves the value of the bond fairly intact.) This is not quite the actual mechanics — the actual mechanics involve an auction for the defaulted bonds to set a cash settlement price, which can lead to strange results — but it is roughly the right way to think about it.

If you do think about it this way you can imagine ways for it to go wrong. One way for it to go wrong is: Imagine a sanctions regime that banned anyone from owning, trading or transferring Russian bonds. If you owned a Russian bond that defaulted and was worthless, and you owned CDS, you’d call up your CDS counterparty and say “hey I’m going to hand you this bond in exchange for $100” and the counterparty would say “no you won’t, you can’t, those bonds are not transferable.” And the CDS would (maybe?) not pay out. This seems absurd, but as we discussed last week, there is some risk of some form of it happening to Russian sovereign bonds: There are enough restrictions on transfer that it might be hard to deliver bonds to settle CDS, which might result in CDS not paying out much.

Another way for it to go wrong is: Imagine if, instead of just defaulting on the bonds, Russia sent thieves to sneak into your vault and steal all the bonds. You’d wake up with no bonds. You’d call your CDS counterparty and say “I have a $100 loss on my bonds, please reimburse me,” and the counterparty would say “okay hand over the bonds” and you’d say “I can’t, they’re gone,” and the CDS would not pay out.

That one seems even more absurd, but you can get weirdly close to it. The problem with CDS is that the contracts do not reference specific bonds, but rather refer to categories of “deliverable” bonds. A CDS contract might cover, for instance, dollar-denominated bonds of a Russian issuer. If Russia changes the characteristics of a bond in certain ways, the bond stops being deliverable, so you can’t deliver it to a CDS seller, so you can’t get a payout. This is bizarre:

Russia and Russian companies will be allowed to pay foreign creditors in rubles, according to a decree signed by President Vladimir Putin on Saturday, as a way to stave off defaults while capital controls remain in place.

The decree establishes temporary rules for sovereign and corporate debtors to make payments to creditors from “countries that engage in hostile activities” against Russia, its companies and citizens. The government will prepare a list of such countries within two days. ...

While some of Russia’s foreign sovereign bonds allow payments in rubles, the new measure could still pose a problem for holders of credit-default swaps, which are used as insurance in case of a default.

That’s because, given the capital controls in Russia and the sanctions, the payment in rubles “may render these bonds out of scope for CDS as ‘obligations’ and ‘deliverable obligations’,” JPMorgan Chase & Co. strategists led by Trang Nguyen wrote in a note to investors on Friday.

If a bond issuer defaults so hard that it renders your bonds undeliverable, then that’s when you most need CDS to pay off!

You never know

Here’s this though:

Some holders of a $1.3 billion Gazprom PJSC bond due Monday said they received payment in dollars, even after Russian President Vladimir Putin gave issuers the option of repaying foreign-currency debt in rubles.

Bondholders said they received cash to pay off the bonds Monday, according to the people with knowledge of the payments, who declined to be identified because they aren’t authorized to speak publicly about the matter. A spokesperson for the company didn’t immediately respond to requests for comment.

Although the company last week was already in the process of servicing the dollar debt maturity and a coupon payment on another bond, there was growing concern that a Saturday decree from Putin allowing borrowers to repay their debt in rubles would disrupt the payment. It underscores just how uncertain investors have been since Russia’s invasion of Ukraine prompted the U.S. and its allies to slap multiple sanctions on Moscow, and Moscow’s numerous capital controls introduced within the past two weeks. ...

It’s possible, however, that Gazprom’s payment process was too far gone to be impacted by Putin’s recent directives. The payment was meant to be transferred to bondholders by the settlement bank on March 4, a day before Putin’s decree. While the bonds are Gazprom’s, they were issued by Gaz Capital SA, a special purpose vehicle incorporated in Luxembourg.

Those bonds are the 6.51% dollar bonds due March 7, 2022 (i.e. today). My Bloomberg screen shows them trading at 50 cents on the dollar last Thursday (down from a bit over 100 two weeks ago), for a yield of, uh, it says 11,290%. Basically a coin flip between “you’ll get paid back at par on Monday” and “all your money is gone forever.” Looks like they got paid back.

Shorts

One thing that we have discussed around here is that, if you are a short seller, you are in the business of betting that things will go poorly for the companies you short, and you hope that things will go poorly, but not too poorly. If you short a company and it has disastrous earnings and the stock goes down by 95%, you make money. If you short a company that you think is a fraud and the authorities agree it’s a fraud and halt all trading in its stock, you … might be stuck in your position forever?

Similarly, if you shorted Russian stocks, that probably worked out well for you:

Investors in Russian stocks may be finding it difficult to dump their holdings, but forward-looking short sellers are sitting on around a billion dollars in gains, given the collapse of Russian shares over the past two weeks. ...

Even with the local market shut, the stocks have been tumbling — which is good news for the bears. “With Russian ADR\GDR stock prices in a freefall, short sellers have had outsized returns in their trades,” Ihor Dusaniwsky, managing director of predictive analytics at S3 Partners, wrote in a research report Thursday.

But you are also maybe a bit nervous?

“Stock borrow availability in Russian ETFs, ADRs and GDRs is getting very tight — additional short selling may be limited and will definitely get more expensive,” he said. In RSX, for example, he said, “we are seeing rates top the 20 percent level today as demand is far outstripping supply.” ...

But realizing all these gains may be difficult, S3 Partners warns: “Shorts sellers, as well as long shareholders, may be stuck in their positions until trading re-opens in many of these securities.”

If you shorted Russian stocks that are now halted, you are paying expensive stock borrow rates for positions that you can’t close. It’s probably good! Better than being long those stocks and unable to sell them. Still. Betting on disaster is hard because, if you win, there has been a disaster, and you might not get paid.

Pornhub

Well, here’s a claim:

In December 2020, Visa, Mastercard, and Discover stopped processing payments for Pornhub, a website based in Canada that allows users around the world to upload and view pornographic videos. Cut off from traditional payment processors, Pornhub had to rely on cryptocurrencies. ...

I find that deplatforming Pornhub increased the value of bitcoin by 45.7 percent. It increased the value of other cryptocurrencies accepted on the site by 19.1 percent on average. These results are consistent with the view that bitcoin is primarily valued as a medium of exchange and that the market for cryptocurrencies is characterized by large network effects.

I am not so sure about the size of that effect, or about “the view that bitcoin is primarily valued as a medium of exchange” for that matter. Still you could have a basic model of Bitcoin that says that it is primarily useful as a medium of exchange for transactions in the illicit economy, and that anything that increases the size of the illicit economy — for instance, by recharacterizing some activities from “licit” to “illicit” — is good for the value of Bitcoin. Like the Pornhub deplatforming. Or, of course:

After surging as much as 20% at the start of last week and briefly topping $45,000 on speculation that sanctions and a collapsing ruble would drive Russians into cryptocurrencies such as Bitcoin, the original digital token reverted to acting like just another risk asset by Friday. It was trading at about $38,390 as of 6:56 p.m. New York time on Sunday, close to the lowest since Feb. 28.

Bitcoin was born in the wake of the global financial crisis as an alternative currency outside the traditional monetary system. Since that time, it has been promoted as a means of exchange and a store of value that is detached from governmental control. Those use cases had become secondary as speculation become the primary use case until the war renewed the haven discussion.

“It’s a monetary asset that you can bring with you and not be subject to the banking system,” said Jeremy Schwartz, global chief investment officer at WisdomTree Investments Inc. “A lot of what’s happening in Russia I think helps illustrate for people the value of Bitcoin.”

Last week a huge swath of global commerce became more or less illicit more or less overnight. That was good for Bitcoin, for a while at least.

Are ESG funds illegal?

The attorney general of Arizona says yes:

The biggest antitrust violation in history may be in plain sight. Wall Street banks and money managers are bragging about their coordinated efforts to choke off investment in energy. It’s nearly impossible to raise money to explore for oil and gas right now, and we may all be experiencing rising energy costs because of this market manipulation. Russian and Chinese aggression overseas also is exacerbating inflation.

Here’s what is happening: The biggest banks and money managers seek to implement a political agenda, such as compliance with the Paris Climate Accord. Then a group mobilizes: Climate Action 100+, for example, comprised of hundreds of big banks and money managers that together manage $60 trillion. The group uses its coordinated influence to compel companies to shut down coal and natural-gas plants. The activism can include pushing climate goals at shareholder meetings and voting against directors and proposals that don’t comport with the agenda, even if other decisions may benefit investors.

One point here is that, while it is definitely true that some ESG-focused investors have pushed energy companies to accelerate the transition to renewable energy, it is also very much true that profit-focused shareholders of U.S. energy companies have pushed them to stop drilling so much because of their long recent history of expanding capacity whenever prices rose and then ending up losing money. Here is a Bloomberg News article from last month about how U.S. frackers “won’t repeat the mistakes of the past by flooding the world with cheap oil,” not because of ESG pressures but because of regular old economic pressures.

Another point here is that large diversified shareholders tend to make two claims:

1. They are systemic stewards; they push companies to do things that maximize long-term value for the economy as a whole, including by cutting emissions.

• 2. But they don’t push companies to raise prices and be anti-competitive.

Those claims are in some tension with each other, and if you are a Republican attorney general who does not like ESG, you can exploit that tension.

2-and-20

If you invest in a venture capital fund that has a 10-year life and a 2% annual management fee and a 20% performance fee, in expectation you will pay about 20% of your investment to the manager in management fees. (Plus, you hope, and the manager hopes, even more in performance fees.) I suppose they could … just … take the 20% up front?

The Securities and Exchange Commission [Friday] charged venture capital fund adviser Alumni Ventures Group, LLC (AVG) with making misleading statements about its management fees and engaging in inter-fund transactions in breach of fund operating agreements. …

According to the SEC’s order, AVG’s website and other marketing communications represented that its management fee for the venture capital funds that it managed was the “industry standard ‘2 and 20.’” The order found that these representations were misleading because they led some investors to believe that AVG would collect a two-percent management fee during each year of its funds’ 10-year term, and separately collect a 20-percent performance fee. According to the order, AVG’s typical practice was instead to assess management fees totaling 20 percent of an investor’s fund investment (representing ten years’ of two-percent annual management fees) upon the investor’s initial fund investment.

Honestly that is a weird move? From the SEC complaint:

In reality, AVG’s practice was to assess the entire 20 percent in management fees—i.e., 10 years’ worth of management fees of two percent per annum—upfront at the time an investor made the capital contribution. For example, if an investor contributed $100,000 to a Fund managed by AVG, AVG would immediately assess 20 percent, or $20,000, as its management fee for the expected life of the Fund. AVG typically drew and spent most or all of this $20,000 to pay expenses during the first year of the Fund’s operations. ...

AVG’s accelerated collection of its annual management fee amounted to an interest-free loan from the Funds that it managed. If the Funds had charged AVG a reasonable rate of interest on the advanced fees, AVG would have paid the Funds $4,791,401.

I feel like the point of the 2% management fee is to sort of keep the lights on during the life of the fund. If you spend it all in the first year, how do you keep the lights on for the other nine years?

Meme activism

I have said in the past that a good way to do shareholder activism these days is by appealing to retail investors with memes. You buy some stock in a company, you put out an open letter to the board saying “you need to start accepting Dogecoin, selling non-fungible tokens and installing Tesla chargers at your stores,” everyone on Reddit is like “this is cool, to the moon,” the stock goes up, and you sell at a profit regardless of whether the company does anything or any of this makes sense.

I have also said that the original meme-stock activist, Ryan Cohen, whose involvement in GameStop Corp. helped cause its stock to moon early last year, did not particularly do this. He built a big stake in GameStop, advocated pretty normal business-y things, became chairman of the board and got actively involved in a digital transformation, and continued to hold his stock even after its enormous run-up.

Still he is very popular on Reddit. If I were him I would definitely try to leverage that for some free money. Buy a big stake in a meme-y stock, announce the stake, say “I’ve got plans to turn this into the next GameStop,” it goes to the moon, maybe you sell before it actually becomes the next GameStop? I don’t know. It’s possible this will not work as well in the relatively serious world of 2022 as it did in the very meme-y 2021, but it does seem to work:

Bed Bath & Beyond Inc. shares had their biggest gain in 30 years of trading after Ryan Cohen’s investment firm RC Ventures disclosed a large stake in the retailer and asked that it consider a sale of the whole company.

The Union, New Jersey-based home-goods retailer jumped as much as 86% on Monday after Cohen said Bed Bath & Beyond should consider selling itself to a well-capitalized buyer or sell its baby-products business. ...

Cohen, co-founder of Chewy Inc. and chairman of GameStop Corp., has had a strong following of retail traders who piled into shares of both the pet supplies provider and video-game retailer at the height of the coronavirus pandemic with consumers stuck at home. GameStop surged 688% last year and 210% in 2020.

Bed Bath & Beyond, a darling of so-called meme-stock traders, reported quarterly sales that missed estimated and reduced its outlook for sales and adjusted earnings per share for the current fiscal year when it released results in January.

He should buy a big stake in AMC Entertainment Holdings Inc. and send them a letter like “you should be doing exactly what you are doing now but like 5% more of it.”

Things happen

The ‘London laundromat’: will Britain wean itself off Russian money? How Russia’s airline industry was pushed to the brink in a week. Teen Sets Sights on Oligarchs’ Yachts After Tracking Musk’s Jet. In Hunt For Russian Oligarch’s Wealth, French Customs Officers on the Cote d’Azur Got a Tip. Bankers Are Abandoning Hong Kong as Beijing and Covid Remake the City. Flow-Monster Vanguard Tightens Grip on $6.8 Trillion ETF World. Carl Icahn Exits Occidental Petroleum After Nearly Three Years. Vista’s Robert Smith Had Bigger Role in Alleged Tax Fraud Than Previously Known, Documents Show. Not even Donald Trump uses Truth Social. How the Manhattan D.A.’s Investigation Into Donald Trump Unraveled. Poutine not Putin: classic Quebec dish off the menu in France and Canada. ‘A big no': Huge, invasive parachuting spiders will begin to cover entire East Coast, experts say. Box of human heads stolen from Denver truck.

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

To contact the editor responsible for this story:
Brooke Sample at bsample1@bloomberg.net

1. These reasons shade into each other when you think about customer-driven moral stances. Companies that say “we’ll stop doing business in Russia because it’s a small part of our business and if we keep doing business in Russia all of our American and European customers, who are a bigger part of our business, will stop buying from us” are essentially maximizing their bottom line, but that bottom line is driven by their customer’s expected altruistic behavior.
   
2. We talk sometimes about a third sort of ESG investing, which is activism-driven: “We’ll buy stock in energy companies and then pressure them to pollute less,” etc. This is much harder to do with e.g. investing in state-owned Russian companies, though some form of this could be a consideration for some Western internet and social-media companies deciding whether or not to stay in Russia.
   
3. Again physical settlement is not the only or even the ordinary way to get a CDS payout, but cash settlement auctions sort of try to recreate the economics of physical settlement so you get the same problem in a more complicated way.
   

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