Repo 105- The Water Gets Hotter for Dick Fuld

It's mid-afternoon, and the topic for today's post became obvious a few hours ago.

Among, I am sure, others, this piece in yesterday's New York Times, co-authored by Andrew Ross Sorkin, details the evolving mess now catching up with Lehman's ex-CEO, Dick Fuld. A similar article appeared on the Wall Street Journal's front page this morning, as well.

The dead bank's examiner has uncovered Lehman's use of a structure known as 'Repo 105.' This was a sale/repurchase agreement which delivered 105% of the assets' value to Lehman's balance sheet during the term of the sale.

Similar in effect to the once-derided SIVs at Citigroup, these assets were moved off of Lehman's balance sheet, thus dressing it up as healthier than it actually was.

As you might expect, Fuld's attorney stated that he

“did not know what those transactions were — he didn’t structure or negotiate them, nor was he aware of their accounting treatment.”

However, Bart McDade, one of Fuld's hand-picked lieutenants, was cited in the Journal and the NY Times as having explicitly briefed the ex-CEO on the particulars of the structure.

Bottom line, Fuld is going to have one hell of a time wiggling out of this one. McDade will have no reason to perjure himself on Fuld's behalf, and Fuld's public statements, and declarations to a Congressional Committee will probably now look suspect.

Looked at from the vantage point of a later date, with more pieces to the puzzle now publicly available, it sure looks like Dick Fuld consciously directed Lehman's financial balance sheet moves to disguise the firm's problems, then asserted there were none.

Was it not Greenlight Capital's David Einhorn who pursued this like a terrier during the summer of 2008? Dogging then-CFO Erin Callan?

Seems he was onto something, doesn't it? Perhaps more than he knew. This examiner's report should set the stage for quite the trial if/when Fuld is charged with violating Sarbanes-Oxley regulations regarding the accounting maneuvers he authorized to attempt to deceive Lehman's creditors, rating agencies and regulators in the final months before the firm's collapse.

As a final note, and food for another post, does this not serve as a cautionary tale regarding regulation, and reliance on it to detect and prevent this sort of behavior?

With the Lehman example so fresh, financial sector misbehaviors are looking an awful lot more like crimes committed with illegal firearms. That is, we've passed lots of laws forbidding them, and hire police to enforce the laws.

But the truth is, the laws and enforcers don't stop the illegal behaviors in either case. They just provide more charges when the guilty are finally caught and tried

What's that tell you about the grand schemes afoot to 'reform' US financial sector regulatory oversight?

On Proposed Naked Swaps Regulations

Yesterday's Wall Street Journal featured a lengthy piece on swaps regulations. With the recent Greek bond problems as a context, European regulators want to ban dealing in naked swaps, i.e., trading/holding swaps when one does not hold the underlying instrument on which the (risk of default) swap is written.

I had a long conversation with a colleague about this yesterday over lunch.

Why, I asked, is there a presumption of pressure on the interest rate and value of the underlying instrument from naked dealings in a side bet which is the default swap on the instrument?

Swaps are not options. They are simply insurance against default.

If there is any basis for disliking their naked trading, it would seem to be more akin to the aversion regulators have for people purchasing life insurance on third parties in whom they are disinterested. It's become a hot field lately, with investors picking up life insurance policies for the aged, in exchange for paying the premiums.

Our society has had moral reservations against bets on death of this sort for a long time.

As my colleague pointed out, nobody would probably mind if you could bet on a bond's performing as promised. It's the bet on failure that seems to arouse angst and emotion.

Yet, in the case of Greek bonds, it's hard to see how an unrelated, naked derivative position would or could possibly affect the bonds' values as much as the simple trading in the bonds themselves, isn't it?

It's understandable how heavy pressure on an equity's price from options or shorting can occur. Shorts have obvious affect by causing selling pressure, driving equity prices down. Lopsided options activity can create arbitrage opportunities which affect equity prices, too.

But simply executing a parallel bet on an event by buying, or selling, a credit default swap, wouldn't seem to do more than, as today's Journal piece on the topic notes, provide a sentiment indicator. Since the swap confers no rights to buy or sell the underlying bond, it simply can't have an influence on the bond's price beyond that of trading activity in the actual debt instrument.

The entire discussion topic seems, to me, to be one sparked by hysteria, emotion and faulty logic, rather than a genuine, proven causal effect between swaps prices and the price of the underlying debt instrument.

Scary News of the Fed's Regulatory Snafus in the WSJ

Yesterday's Wall Street Journal carried an extensive article reporting on internal Fed bickering and regulatory oversight errors stretching back to the Greenspan era. It's a troubling, scary and cautionary tale for those who believe that regulatory Nirvana for the US financial sector consists of simply giving any one regulator, especially the Fed, omnipotent and sole power for this task.

Or, perhaps, any believing that regulation will really cure future systemic ills.

In any event, we learn that Greenspan claims he punted on regulatory matters to his colleagues. Does this inspire confidence in a Fed-only regulatory scheme? What if another Fed chairman eschews much interest in this function, and there's nobody at FDIC or OCC to provide any sort of complementary coverage?

Then we have Helicopter Ben issuing bone-chilling warnings to Congress, saying it would be a "grave mistake" to 'dilute' its regulatory and supervisory role. Nevermind that they had sufficient powers before and during the recent meltdown, and failed to prevent it.

Then we have Tim Geithner, when NY Fed chief, fighting for regulatory power, and dragging his weaker fellow regional Fed Bank presidents behind him for cover. Of course, those presidents had a lot to gain by allying with Geithner back then.

Now, of course, safely ensconced at Treasury, Geithner is mum about the issue.

Here's a thought. Rather than be entertained by news of fights between the Fed Banks and their Washington colleagues, or the Fed and other regulatory agencies, why not dream of a 'best practices' approach?

Surely our multiple financial sector regulatory agencies have more than sufficient data with which to supply objective, academics for in-depth research into what factors pre-figured bank failures, and what the corresponding ratings by various regulators were along the way.

I'm put in mind here of something analogous to NYU's Ed Altmann's pioneering and still-outstanding work on the factors predicting bond defaults.

Why are we forced to watch, and, through Congress, choose among qualitatively-determined regulatory schemes and standards, when the best approach should, and could be, objectively and quantitatively determined?

That, to me, is the scariest aspect of this topic. There should be no qualitative wiggle room on this issue. Collectively, our regulators have the descriptive data and outcomes, in sufficient volume, to identify statistically significant predictors of bank failure, along with time paths to that failure.

Why is developing and implementing a regulatory solution along those lines so hard?

Probably because a lot of rice bowls are at stake among our government regulatory entities. Salaries to be lost, careers truncated, children's' educations to be paid for by another line of work, less-lush pensions from other employers, as the mystery and duplication of this activity is drained, and fewer, more objectively focused regulators engage in less expensive, more timely and effective regulation of our nation's banks.

Comings, Goings & Returns On Business Television

I get a lot of visits to this blog from people searching for Charlie Gasparino or news of his latest row with Dennis Kneale on CNBC.

After seeing several of those searches in the past week, I began to wonder where Gasparino had gone, since I literally cannot recall when he was last on CNBC.

Now, I know why. He popped up on Neil Cavuto's Fox News program last night in the 4-5PM hour.

As of mid-February, Gasparino joined the Fox News channels of Rupert Murdoch's NewsCorp.

I still can't get Fox Business News on ComCast, but I am sure that is where Gasparino is spending his daytimes. At this rate, perhaps the fledgling channel will eventually assemble a sufficient number of interesting on-air people to challenge CNBC.

So it's goodbye to the days of verbal fist-a-cuffs between Alan Murray and Charlie Gasparino on CNBC. Both are now at NewsCorp, and couldn't see them if they do spar during market hours.

Which brings to mind the also-absent Herb Greenberg. I vaguely recall him announcing some changes in his status a few years ago, having found this missive about him. He's a guy I truly do miss on CNBC, or anywhere during business days.

Meanwhile, this morning, on CNBC, I saw a very old face who I haven't seen for over a decade.

Long-time auto sector analyst Mary Ann Keller appeared this morning to discuss the latest Toyota problems, i.e., yesterday's runaway Prius in California.

I recall Keller as a frequent guest on Lou Rukeyser's old PBS program. Back in the day, she was the go-to auto sector analyst. Then, at least to me, it seemed that she disappeared. A Forbes bio of her career reveals that she moved from, I believe, PaineWebber to Furman Selz, which was bought by ING. Then she worked in a senior position at Priceline.

In any case, it was good to see her on air again dispensing sensible insights about her sector.

Passive Risk Management Tools

Almost a month ago, I wrote this (second) review of Wall Street Journal reporter Scott Patterson's recently-published book, The Quants.

The book's early chapters, on which I did not dwell in my review, discuss Ed Thorp's early exposure to Claude Shannon at MIT and, through Shannon, the work of John Larry Kelly.

Thorp was the prototypical quant hedge fund manager, but, in a sense, he simply followed, then outstripped, Shannon's and Kelly's own instincts of applying information theory to gambling opportunities, or any other situation in which imperfect information allowed for profitable employment of risk capital.

As I sped through the early chapters of Patterson's tale, I noted the mention of Kelly's name and general idea, but, since Patterson never focused on it, neither did I.

Fortunately, one of my friends and former colleagues, once a member of Bell Labs' EMT staff, reads this (and its companion political) blog on a daily basis. Thinking I'd find Kelly's work useful, he lent me William Poundstone's Fortune's Formula, published in 2005. The linked page on Kelly is from Poundstone's website.

Here is a paper Ed Thorp wrote concerning Kelly's Criterion over a decade ago.

My friend has been considering applications of Kelly's Criterion to his own work involving defense project management, so passing on the references and book to me were topical for him.

When I began reading Fortune's Formula, I found it engaging, but not particularly compelling. Until I came to Poundstone's painstaking explanation of how elegant Kelly's application of Shannon's theory was in the area of risk capital investment, be it at the track, casino, or securities markets.

Unlike the unsuccessful active risk management methods applied by traders before and during the financial market meltdowns of 1987, 1998 and 2008, Kelly's approach is passive in nature. The difference is important.

As Patterson portrayed in the latter chapters of his book, the major quant hedge funds employed pretty much similar VAR-based risk management systems. These systems naively assumed that, in the event of sharp losses in portfolio positions, there would exist a relatively unfettered ability to sell, or buy, the offsetting leg of existing portfolio positions, in order to hedge exposure.

Patterson didn't really dwell on the details of Ed Thorp's original employment of what Poundstone correctly identified as 'delta hedging.' It's an active risk management approach for adjusting hedges between equities and the companion warrant or option position.

Thorp originally did this in relative isolation and obscurity, with little in the way of market pressure from similar strategies swinging tens or hundreds of millions of dollars of such activity.

In the 1980s, the variant of active risk management was known as portfolio insurance. And it failed in 1987. When major trading operations all attempted to hedge the plummeting values of their positions in major indices, the values of which they were arbitraging, values plunged even further and orders went unfilled.

In 1998, similar results occurred in the last gasp of pre-swaps markets amidst a panic. In that era, there were quite a few statistical arbitrage clone funds, but only LTCM was actually brought down by the market plunge.

The 2007-08 financial market meltdown featured newer instruments, e.g., CDOs and swaps. But, in reality, these were simply variants of older financial products, albeit inherently possessing greater risks.

And, thus, when market values reversed their ascent, and active hedges became unbalanced, the usual stampede of many managers employing similar strategies to sell additional exposure in order to re-align their hedges once again failed.

Among my more experienced securities markets friends, and me, we agree on the notion that risk management solutions need to be passive and in place before a market event, because active risk management approaches never actually work as planned. A sort of 'fallacy of composition' defeats them, as abstruse investment strategies, employed in parallel by many smart quants, simultaneously react identically, pushing market values even further in the direction that is already causing them such large losses.

Kelly's Criterion is the ultimate passive risk management tool because it addresses the size of the investment, and is not affected, per se, by the actions of others. In fact, one of the valuable extensions of Kelly's work by Thorp was his apparent refusal to leverage his funds.

This was something ignored by the next generation of quants, including his own acolyte, Ken Griffin, founder of Citadel.

Reading Poundstone, on Kelly, provides a very clear, refreshing portrait of a seriously intelligent, rigorous mind grappling with the realities of risk capital deployment. And Thorp, with his casino beginnings, understood this perspective intuitively.

Sadly, quant kids two generations and more on, do not.

And that is why active risk management has been so ineffective. It becomes not a matter of discretion, but of survival.

That is, in Thorp's world, trimming the exposure to a Kelly bet is advantageous, but not essential. Because the bet was scaled according to rigorous theoretical principles, losing it all isn't crippling.

When that bet is with 3x, or more, levered money, you only have a 25-33% loss cushion before you've burned through equity and are out borrowed money.

The gambler's ruin. Busted.

Needless to say, we've already begun working on applications of the Kelly Criterion to our proprietary options investment strategies. As a passive, rigorously theoretical and internally-focused approach, it meets our criteria.

Hank Greenberg's Rx For Financial Sector Reform

Last Friday's Wall Street Journal featured an editorial by Hank Greenberg, former CEO of AIG, entitled "Six Steps Toward Financial Reform."

His six steps include:

-Improve regulation and regulators
-Tie compensation to long-term performance
-Make rating agencies independent
-Allow our financial institutions to remain competitive
-Institute responsible risk-management systems
-Use stimulus money strategically

Like these sorts of recommendations by other well-known CEOs, public office-holders or academics, Greenberg's list contains some gold and some dross.

His first suggestion is rather tautological, but enduringly debatable. It's a desirable-sounding goal, but seems always to be over the horizon. One could argue, and I do, that the Fed was responsible and well-armed to have identified and stopped much of the irresponsible behavior which contributed, but did not directly, solely cause, the recent financial sector meltdown. For example, Greenberg does not mention, by name, Fannie Mae, Freddie Mac, nor the public officials responsible for fueling the unwise growth of those two agencies. Yet, that growth in low-quality, risky mortgages was the spark that touched off the fuse which caused the financial services sector explosion.

I like Greenberg's second recommendation. As long ago as the late 1990s, I wrote public pieces endorsing such policy. But which CEO or senior manager, in the heat of the moment, faced with a talented trader, or desk, will deny them short-term compensation in some new, clever, regulation-evading manner, in order to book current profits and gain market share in selected markets?

Isn't that, indeed, how we arrived at the current third-party payer health care mess? By causing businesses to evade Congressional restrictions on cash compensation during WWII?

Does any thinking person honestly believe this can be legislated and enforced?

In fact, it's debatable that Greenberg's contention,

"No one is worth a $60 million cash payment a year,"

is true.

If a talented trader or deal-maker at some financial services company is given capital to deploy, and, either through trading or astute M&A activity, engages in activities which bring cash profits to the firm, through closed trades or advice on corporate actions, in the range of hundreds of millions of dollars, who is to say that person isn't worth 5% of that value?

Greenberg's third suggestion is also problematic. Who would judge whether the employees at rating agencies have "the appropriate background and abilities?"

From my discussions with executives at one agency, it became clear that the issue was not one of competence, but opportunity and the market share power of clients.

For someone so hounded by a "government institution," I am shocked that Greenberg would offer this option to ostensibly make rating agencies non-profit in nature.

That said, the very model of client-paid ratings ought to simply cause users to beware. I remain convinced that ratings, in this era, are simply less valuable than they once were. Any investment committee relying solely, or largely, on ratings is probably already in trouble.

Perhaps the most tenuous suggestion is Greenberg's third one, implying allowing "too big to fail" institutions to continue to exist in their current forms, with current government backing. He specifically rejects the Volcker Rule. In that linked post about Volcker's recommendation, I wrote,

"The solution we need isn't more complex regulation, so much as a reasoned return to a past regulation, and better, permanent severing of the riskier finance activities from the federally-insured, mainstays of deposit-taking and basic consumer and commercial lending. "

Greenberg continues to mouth the fallacy that integrated, universal banks are somehow better, and more competitively advantaged in the marketplace.

Which integrated, globe-girding bank didn't experience trouble in 2008? Which major US financial institution didn't risk its shareholder's equity and require taxpayers to provide ultimate backstopping? The only two that come to mind, Wells Fargo and Chase, are sufficiently lackluster to begin with that they were simply too late to the risk party of 2003-2007.

What Greenberg truthfully acknowledges in his comment is that this issue ultimately leads to regulator domicile shopping. In effect, any constraints applied by the US will result in the flight of those companies wishing to be integrated banks.

I say, good riddance. Is the price I pay not having to bail them out? I'm so worried.

Because if it's financial services competitiveness you want, integrated banks aren't where you find that. Typically, that comes, initially, from privately-held monoline financial entities. Trading, asset management, underwriting, can and are all performed in non-publicly-held companies. Often by far more talented people than are left out in the poorer-paying, regulated, publicly-held part of the sector.

Greenberg's views on risk management, while laudable, are equally unenforceable as are his notions about regulation and compensation. It's well and good to call for "responsible risk-management systems."

Just what would one look like? Will ten of the same still be considered 'responsible?'

Because, according to Scott Patterson's recently-published book, The Quants, that's pretty much what happened in 2008. So much for cutting-edge risk management.

By the way, where does leverage factor into this, Hank?

Greenberg's final thought concerning government stimulus money. To me, it's unrelated to the other issues as Greenberg treats it. If he had simply railed against using it as a bailout fund, that would make sense. Instead, he wanders out of the financial sector to make unsupported assertions about economic policy.

Hank Greenberg is a very smart, tough cookie. He has unique and vast experience in the financial services sector. If someone of his stature, intellect and experience can't get this topic right, who can?

Perhaps this, alone, suggests that the solution is not more regulation, but less. End government subsidies to risk-taking entities in the form of deposit insurance. Let rating agencies be who and what they are, with users of their information aware of the conflicts and history of their ratings.

Then, ultimately, let investors bear the risk of assessing their own selections, with no recourse to the political sector for bailouts, do-overs and insurance.

That might be reform which actually brings individual responsibility in line with financial services choices.