Regarding Investing In Commercial Banks

This week's European government and financial tumult brings me to once again review the position of large US commercial bank CEOs, led by Chase's Jamie Dimon, that their firms should be allowed to take risks, presumably in order to drive high total returns.

At issue currently are two changes which bank managements despise: the Volcker Rule and higher primary equity capital requirements. The former strips large commercial banks of the ability to pursue riskier profits via proprietary trading, while the latter adds capital, which will depress returns on assets.

It's fair to say that, with recent hindsight, on average, the Volcker Rule will minimize societal costs of banks trying, but usually failing, to earn profits on risky trading with their own capital. The recent financial crisis demonstrated that those financial concerns capable of not losing on such risky trades are small in number, and often privately-held, while the larger US commercial banks carry deposit insurance, and, thus, indirectly, are themselves insured by the US federal government. The Dodd-Frank bill has made such insurance of firms explicit.

After several decades of US commercial money center banks cyclically posting large losses on everything from sovereign lending to credit cards, mortgages, and energy lending, requiring higher capital levels doesn't seem so harsh.  For example, as I noted in this recent post, fund manager Ron Baron declined to invest in Jon Corzine's now-failed MF Global in part because, with capital constituting only 3% of assets, the risk of total loss of equity from trading positions was too great. Today's US money center banks are fighting to avoid capital levels only a little higher, i.e., going from 7% to 9%. It seems like a lot when seen as a percentage of balance sheet assets. But it's trivial when seen as the potential loss in a trading position. What's another 3, 4 or 5 percentage points of loss once a derivative or badly-hedged asset goes wrong? It's rounding error.

But to CEOs of these companies, that means relegating them to a role much more like energy utilities than like investment banks or faster-growth firms.

Which brings me to the central point about this debate over permissible money center bank activities and their primary capital levels.

My now-deceased mentor at Chase Manhattan Bank, Gerry Weiss, observed decades ago that since banking is a derivative industry, it can't, in total, grow faster over time than the economy which it serves. Thus, shorter-term, faster growth typically comes by taking more risks. Which pays off for management when it works, and leaves shareholders with losses when it doesn't. Only, in reality, those losses now become spread to taxpayers, as well.

So long as a bank is allowed access to taxpayer money for insuring deposits, and is allowed to become sufficiently large that its collapse would create counterparty problems for the nation, it has to be restricted to a role as a financial utility. Much as CEOs like Dimon want to have the latitude to chase total returns that match the US equity market's best, doing so as a money center bank simply isn't in society's interest.

Time and again over the past several decades, US money center banks and their managements have exhibited poor judgement and incompetence at avoiding bank-collapsing risks. When enough commercial bank assets pursue similar risks, which typically occurs, the resulting systemic risk endangers the US economy.

Dimon and his fellow CEOs like Vik Pandit at Citi or Brian Moynihan at BofA may grouse about being shackled and prohibited from pursuing brisk income growth which outstrips that of their markets. But to allow them to talk their way out of both measures- restraint of proprietary trading and higher equity capital requirements- will more quickly and certainly lead to the occasion of another taxpayer-rescue of a US money center bank.

MF's Illegal Use of Customer Funds

You'd think it would be a business news sensation. Perhaps earning a picture on the front page of the Wall Street Journal.

A former co-head of Goldman Sachs, former US Senator from and Governor of New Jersey, gone missing. His residence staked out and the FBI reportedly examining the books of MF Global.

More detail regarding not just a 'missing' $600-900MM of funding in the company's books, causing Interactive Brokers to walk away from a bid to buy MF Global, but the misuse of money in that general amount from customer accounts.

I wrote this post a few days ago regarding the rather mild story of MF Global's Corzine-led big bet on European debt.

Now the story has become much deeper. At least the Wall Street Journal managed a brief piece yesterday suggesting that Chris Flowers, Corzine's backer as CEO of MF Global, has lost his golden touch of late. But no reminder of the connection which the Journal exposed in its January piece on Corzine's appointment as CEO of the firm.

Curiously, this wasn't a big story this morning on CNBC. As a frequent guest host, you'd think they'd have discussed it. But I'm being sarcastic- CNBC is a heavily liberal-leaning network, so it was and is unlikely to do much more than broadcast stories the staff has already read in the New York Times or Wall Street Journal. Bloomberg wasn't much better.

At least I had the satisfaction of watching Bloomberg use the headline of this recent post nearly verbatim on Friday morning.

Of course, MF Global's rapid demise begs the question of how US financial regulators can possibly handle a large, allegedly 'too big to fail' institution, when they were caught flatfooted by the broker's situation. As a registered Fed dealer, one wonders where that regulator was? Not just because of the excessive risk in the European bond positions but, now, the news of misusing customer funds in an attempt to avoid collapse.

It's as if the umpires of a AA minor league baseball game gone wrong are suddenly sent to handle a World Series. If regulators can't identify and measure such outsized risk as MF Global took, not to mention the funny business with customer funds, how are they ever going to manage to pre-emptively flag and liquidate an excessively-risky Citi, BofA or Chase?

Answer- they can't and won't.

Meanwhile, it should be an interesting week for breaking news on Corzine and MF Global.

Corzine's MF Global Declares Bankruptcy

Last Thursday's post concerning Jon Corzine's bungling at MF Global evidently drew plenty of traffic yesterday, despite my being unable to post due to power outages.

Imagine my horror though, reading this weekend, pre-Chapter 11 filing, of- you guessed it- J. Christopher Flowers' potential bid for the firm's wreckage.

Did I not predict this one? I did, in this passage from that post,

"The only thing that could top this week's MF Global news is to learn that, as rumors swirl regarding the firm now being an acquisition target, we learn that Chris Flowers' private equity shop is involved in such an acquisition. I don't know what portion of MF's equity is owned by Flowers, but it's just possible that half the value of the rest of the firm, which would now not be paid to own 100% of the firm, might well be more than the losses Flowers has just taken on his share of MF Global.



That would be just too much, wouldn't it, if it occurred? Watching a private equity guy install a partner in a firm on the board of which one of his representatives sits as CEO of the company. Then seeing said CEO dramatically and quickly lop off half the value of the publicly-held firm. Followed by the private equity guy opportunistically buying the now-tainted firm for half of what it would have cost him last year."


What's curious is how silent all the cable news media are about this. Neither CNBC nor Bloomberg, nor even the Journal, bothered to note Flowers' original intrusion into MF Global's board to force Corzine's selection as CEO. Nor do any of them now note how Flowers must have been on board with Corzine's strategy.

Regarding that strategy, I heard it lampooned on CNBC last night as having basically gone all in on a specific European debt play. It's hard to believe Corzine would be so stupid, or Flowers would consent.

Funny, though, isn't it? All that silence on the original Corzine-Flowers connection? Even now they don't remind us that Corzine is a partner in Flowers' group.

Or is it more of being muzzled to power, because nobody with a network with hours of programming to fill wants to cross a private equity mogul like Chris Flowers?

Perhaps the Chapter 11 filing will take Flowers out of contention for swallowing the whole of MF Global on the cheap. We can only hope so.

Regarding Low Volatility Stock Portfolios

Saturday's edition of the Wall Street Journal contained a long, prominent article extolling the virtues of so-called low-volatility equity portfolios entitled, somewhat immodestly, Beat the Market- With Less Risk.

It's a piece that runs the equivalent of a full Journal page. Suffice to say, the title makes the major claim. Never mind that risk, which is what the piece claims is minimized, isn't the same as volatility, though the latter is what is actually minimized. Here are some of the piece's key passages,

"But what if there were a way to beat the stock market's returns over the long haul with significantly less short-term instability?

More surprising, however, is that the Low-Volatility Index has returned 80% during the past 10 years, compared with the S&P 500's 42.9%, assuming reinvested dividends. Go back 20 years, a period that includes most of the go-go 1990s, and the index has beaten the S&P 500 by about 180 percentage points, according to S&P, which set up the Low Volatility Index in April.


The success of low-volatility investing flies in the face of what most investors consider the central axiom of investing: the greater the risk, the greater the reward.

The low-volatility strategy has some downsides. The biggest: It can underperform badly when the overall market is rising. That is because investors tend to pile into riskier stocks during big rallies. For example, the S&P Low-Volatility Index approach gained only 19.2% in 2009, compared with 26.5% for the S&P 500.



Sometimes the market can rally for long stretches, making the pain of missing out even worse. Low-volatility stocks gained 126% for the eight years leading up to the dot-com peak in March 2000, for example—less than half of the S&P 500's 307% rise.


The upshot: Investors who embrace this strategy should be focused on the long term.


"You need to have an honest conversation with yourself," says Joe Wolfe, director of quantitative research at Northern Trust in Chicago. "You have to be able to live with the results."


Yet even if market sentiment turns to riskier assets, investors aren't likely to lose money, says Pim van Vliet, a senior portfolio manager at Robeco—they will underperform only until the next bout of risk aversion. "If your neighbor earns a lot of money, you may feel poor," Mr. van Vliet says. "But if you look at what you can do with your money, you'll feel rich." "


Let's take the points in order.

It's usually most helpful to describe equity strategy performance in terms of a timeframe, its gross or net basis, and a compounded or arithmetic average annual over the period. Thus, it's not clear just what the average annual differences are between the S&P Low Volatility Index and the S&P500 Index. The claim of performance difference of "180 percentage points" over the past twenty years is even more difficult to assess, as it is a single net figure. I happen to know, though, from some recent work, and Penn's noted finance professor, Jeremy J. Siegel's remark on the exact same phenomenon, that the past 20 years of the S&P500 performance are the same as its long-run average, which is a bit over 11% per year, gross. No dividend reinvestment, which distorts results.

So to suggest that the past two decades are unusual is wrong. But it's hard to know precisely what the claim means, compressing so much information into literally a single net performance number.

All of those performance statistics omit what I have learned, from experience in the industry, is among the most important characteristics which institutional investors use to evaluate equity strategies- the duration and magnitude of so-called drawdowns. These are the periods during which a strategy continues to underperform relative to its benchmark, on a monthly basis.

Simply stating that a low volatility strategy outperforms the S&P by 180 percentage points over 20 years tells us nothing about how consistent that performance was. How badly it trailed the S&P500, cumulatively, at its worst point. This is important information for several reasons.

First, consistency has a value. And inconsistent approach which has a few runs of extreme outperformance isn't as valuable as a more consistent approach which may have a lower average annual return.

Second, inconsistency, or volatility of returns, especially posting negative absolute or relative (to the benchmark) returns, is precisely the sort of performance which leads investors to suspect a strategy no longer works, and abandon it. That's why the exclusive use of backtesting can mislead. Without any live data, including, if appropriate, redemptions, it's impossible to know whether real investors would have calmly absorbed losses and remained invested in a strategy.

The next point, that there is some proven relationship between all returns and risks, is simply false. My own proprietary equity strategy has outperformed the S&P500 by more than two-fold, on a gross basis, over the past twenty years, with considerably lower volatility. I'm not alone in managing to do this. Those equity managers who really find niches of superior performance deliver less volatility, while the mainstream subjective horde of stock pickers and index-shadowers typically do not.

The last general point of the passages concerns the lower returns the low volatility equity portfolio approach earns during periods of rising markets.

The fact is that, over the long term, the S&P500 rises about 2/3 of the time, on a monthly basis. And it earns more in a positive month, in absolute magnitude, than it typically loses in a down month.

Moreover, volatility has risen, and fallen, by my proprietary measure, frequently over the past decades. The article discusses volatility as if it's a contemporary, observable phenomenon. It isn't. Often the specific nature of market volatility- its duration and magnitude- isn't really clear until a good way through a bout of either high or low volatility. On a monthly basis, which is how most portfolio performances are measured, and often investment decisions made, fairly typical market turbulence may be indistinguishable from unusually high volatility for a while.

Thus, between potentially switching in and out of the low volatility approach, and getting timing wrong, and the cost of actively running such an approach, it may not be the panacea which the Journal article suggests.

Moreover, comparing such a strategy to a purely passive S&P500 Index return isn't strictly correct, either. The latter, when used as a primary equity investment vehicle such as the Vanguard S&P500 Index fund, is typically invested monthly for a dollar-averaging effect. That makes the raw S&P 500 return no longer equal what a typical investor is realizing. Thus the need for a more detailed performance comparison than one or two net returns over a long period with no assumptions explicitly stated.

However, as I've explained to inquiring colleagues recently, if you're dollar-averaging a passive S&P index fund already, you can do even a little better with this simple tactic. If the S&P has risen above its long term average rate for the past few prior months, invest less than your average monthly target. If it's been underperforming its long term average for the past few months, invest a little more than your target monthly amount. For investors with a long time horizon, this effectively adds more investments when the S&P is relatively lower, and less when it's higher, thus providing a little more return on the same passive index stream. What's actively managed is the amount of investment each month, not the equities in the fund.

I'm frankly surprised that the Journal ran this article without some sort of rigorous academic test of the implicit hypothesis that a low volatility strategy is superior to the S&P500 Index. And a test involving more than just backtesting.

Call it what you will, a low volatility approach is a cousin of the long-discussed low-beta approach. As the article mentions, then dismisses, if such a simple, long-known effect really exists, you can bet it would have been exploited into triviality long ago.

In summary, I found the Journal's piece on low volatility equity strategies, while interesting, to be far short of conclusive. And entirely lacking in the rigor appropriate to include a section providing detailed advice and options for actively implementing such an approach..

Delta Desks Pose Banking Risks

I don't categorically exclude any particular sector from my quantitatively-based equity selection process. Rather, I let the specific performance of each company either qualify or disqualify the entity.


That said, over the past 20+ years I've operated the portfolio selection process, to my knowledge, only one investment bank- Goldman Sachs- and no more than two or three commercial banks, briefly, have managed to merit inclusion.


My experience with Chase Manhattan Bank in the 1980s provides me with an understanding of what occurs inside these large financial institutions which tends to exclude them from my process' portfolios. It's a combination of size, diversity and asymmetric payoffs to traders and managers while limiting their risks.


Consider this recent Wall Street Journal article concerning UBS' recent admission of $2.3B in losses by their so-called rogue trader.


Delta Desks Emerge as Mine Fields



A Key Revenue Source for Banks Has Been at the Center of Two Recent Scandals.
By Carrick Mollenkamp



The scandal at UBS AG is casting a harsh spotlight on a corner of the financial world—so-called Delta trading—that Wall Street has been counting on to boost revenue in the wake of a financial crisis.


Kweku Adoboli, the UBS trader formally accused Friday of fraud in UBS's $2 billlion loss, worked on UBS's "Delta One" desk in London. Delta trading—the name is derived from the fourth letter of the Greek alphabet—is a gauge of risk exposure for bets made on the movements securities such as stocks and securities.


The transactions generally involve two parts. First, a client would request a "derivative" trade, effectively a bet on the direction of a group of stocks or other securities. When the bank executes the trade, it actually acquires the securities in question.


In the second part of the trade, the bank creates a mirror of the derivative to mitigate the risk.


The "delta" is a measure of how the value of the derivatives would change compared with the underlying stock or other asset. Delta has become a term to indicate that a bank can customize a security for a client and then closely replicate it on the banks books.


At UBS, Mr. Abodoli's Delta One desk specialized in exchanged-traded funds and other securities positions, according to people familiar with the situation. On Friday, Mr. Abodoli was charged on three counts: two counts of false accounting and one count of fraud. He didn't enter a plea during a court hearing.


Delta trading has gained momentum in a markets environment in which the mortgage-bond trading business is on the skids and global regulations require banks to set aside expensive capital for loans.


Wall Street is counting on trading large volumes of stocks and derivatives to bolster revenue.


There is nothing inherently improper about such Delta trading. And many large financial institutions employ this strategy, including Société Générale SA, BNP Paribas SA and Goldman Sachs Group Inc. in Europe and Goldman and Morgan Stanley in the U.S., according to a J.P. Morgan Chase & Co. report.


The trading requires state-of-the-art technology systems and can produce as much as $1 billion in annual revenue at top banks, J.P. Morgan said, which noted, "Delta One products in one area of growth in our view, with strong growth in client volumes, resilient margins and untapped potential in emerging markets."


But it earlier gained notoriety in 2008, when French bank Société Générale said that Jérôme Kerviel had worked on a Delta One desk while trying to hide $7.2 billion in losses in another rogue trading scandal. Last year, Mr. Kerviel was sentenced to three years in prison.




I recently wrote this post placing these 'delta desk' type trades and losses in a larger perspective.

Except, perhaps, for Goldman Sachs, which has a reputation, and performance record, for better risk management than its competitors, extensive and deep participation in these delta trades in a proprietary fashion by large financial institutions seem to create their own pattern of volatile earnings or, more specifically, large losses.

Now, of course, these firms are supposed to be sunsetting their proprietary trading activities. Which makes them less loss-prone, but, also, prone to lower growth rates, as well.

However, reading a companion Journal article (to the above piece) detailing UBS' efforts to improve, overhaul and generally tackle risk management since 2007, and how it has failed, gives me little hope that firms of that ilk will ever get this right.

Years ago, I actually knew and played squash with Barry Finer, the guy who was the risk manager on the desk where Joe Jett ran his trading scam at GE's Kidder Peabody unit. I subsequently compared notes with colleagues at then-independent consulting firm Oliver, Wyman & Co., who had been hired by GE to do a post-loss review of what had happened.

We all agreed that Finer had done his job, but essentially been ignored in the typical fashion that occurs in so many large financial institutions. Until line/desk risk managers and the risk management function is better-compensated, insulated from desk managers, and reports directly to a CEO, with penalties for failure commensurate with compensation, these unpleasant trading loss surprises will continue to be a periodic staple of large investment and commercial banks.

Regarding Warren Buffett's Investment in BofA Preferred Stock

Yesterday's other major business news story, aside from Steve Jobs' resigning as CEO of Apple, was Warren Buffett's Berkshire Hathaway buying $5B of BofA preferred stock with a 6% dividend, plus warrants- terms set by Buffett.

As with his prior capital infusions to Goldman Sachs ($5B @ 10%, plus warrants) and GE ($3B @ 10%, plus warrants) during the 2008 financial crisis, Buffett capitalized on BofA's weakness in the eyes of investors, but carefully avoided buying common equity.

Despite Moynihan's and Buffett's comments that this represents the latter's vote of confidence in the bank, that's not strictly true. If it were, Buffett would have purchased common equity in the market. It's more a case of Buffett extracting a hefty price- the 6% dividend and warrants- for being an unofficial credit rating agency whose selective investments calm other investors. 

It's crucial to understand that in all three cases- Goldman, GE and, now, BofA, Buffett focuses on preferred stock, which is senior to common equity, and on which he can demand a special premium, plus warrants, just in case the firm pulls out of its problems.

Think of him as a sort of reverse greenmailer. Instead of the greenmailers of old, like Carl Icahn, whom companies paid to go away, these companies pay Buffett to come on in. In short, it's crony capitalism, because you'll never get access to the deals Warren Buffett does. But don't expect the SEC to be investigating him anytime soon for extracting such a high dividend rate on his preferred shares. Or, apparently, the BofA board for being so wasteful with its shareholders' money.

However, as the nearby chart illustrates, and at least one Bloomberg talking head had the guts to say yesterday, Buffett's equity kickers, the warrants, have been busts. Neither his GE nor Goldman warrants are in the money.

I've included in the nearby price chart Wells Fargo, as well, since Buffett is known to maintain a large position in that bank. I don't know when he began building his position, but it, too, has underperformed the S&P500 Index for the past five years.

In searching for articles with information on the date of Buffett's initial Wells Fargo investment, the best I could do was to estimate that he's been invested in the bank since at least 1999. He says he bought equity prior to the 1998 Norwest merger. The second price chart displays WFC's and the S&P500 Index's prices since 1985. If Buffett bought Wells in, say, 1995, then he's done better than the index. But if he bought later than sometime in 1997, he's probably no better off than he would have had he bought the index.

So much for Buffett's fabled equity selection skills, and back to the BofA preferred equity buy.

Late this afternoon, a family office manager and guest on Bloomberg explained that he had done much the same as Buffett only about a week or so ago. Not wanting to risk his capital on BofA equity, he found the preferred to yield an acceptable dividend with much less risk. But his yield is not as great as the one demanded by Buffett.

One of the Bloomberg anchors jokingly asked a pundit if he thought the administration asked Buffett to shore up BofA by investing in it. I don't think that's just a joke.

It also focuses on the lack of risk in Buffett's position, which is different than that of the bank or its common equity holders. First, Buffett has so ingratiated himself with this administration that it's unlikely to take any actions toward BofA which would endanger Buffett's investment.

Second, Buffett knows that BofA is one of the 'too big to fail' institutions, so chances are it will be bailed out by the government before Buffett loses his investment.

Recall, if you will, that freely-operating markets are supposed to result in neither buyer nor seller having sufficient power to dictate price or terms. Buffett's move, the third such example of his dictating investment terms to his targets in three years, demonstrates how our financial markets aren't fair. Buffett can engage in crony capitalism, using his name and resources to extract expensive terms for his borrowers, while other market participants have to resort to the markets to buy their investments.

On that subject, I learned yesterday that Buffett had insisted, as part of the terms of his Goldman Sachs investment, that no Goldman senior executives could sell shares in the firm until he had his money back. In that case, I suspect Buffett realized he was playing with some very sharp operators who wouldn't think twice about leaving him holding an empty bag.

In BofA's case, it was reported that no such terms were required. I suspect that speaks both to Buffett's sense that the firm's management is mediocre, and that the government will unquestionably step in to save his investment before it would vaporize amidst a bankruptcy.

Watching this sort of activity by Buffett, while generating no whiff of impropriety, validates for me how useless the SEC has become.

BofA, Merrill Lynch & Counterparty Risk

I saw an unbelievable story on Monday's CNBC noontime program.

Merrill Lynch is offering a 4-year bond which pays, if I remember correctly, according to the following conditions:


S&P500 down 16% or more:  99% of principal


S&P500 down 0-16% : 100% of principal


S&P500 up 0-15% : 100% of principal plus 15%


S&P500 up 16%+ : 100% of principal plus S&P gain


A quick look at the structured payoffs reveals that an investor appears to get all the S&P upside and virtually no downside, thus competing with simply buying the S&P.


However, Gary Kaminski asked the correct question, which is, if a herd of investors bought this offering and the S&P rose, say, 50% in four years, how will Merrill Lynch, a unit of the too-big-to-fail BofA, hedge its exposure? What if it doesn't or can't?


Isn't an investor assuming a large amount of counterparty risk of the sort that counterparties to AIG effectively assumed? Yes, an investor is assuming an immense counterparty risk on the part of a firm which imploded in 2008 due to risk mismanagement.


How can our new, souped-up, fancy, so-called-smarter Dodd-Frank regulators be allowing this to occur at the subsidiary of one of the nation's four largest commercial banks? One currently viewed probably as third weakest, in front of Citi, but behind Chase and WellsFargo?

Isn't this the sort of risk-taking that isn't supposed to be funded or subsidized by taxpayers anymore?

Counterparty Risk Arises Where You Wouldn't Expect It

There's an interesting lesson from the current drama playing out between Frank McCourt, owner of the Los Angeles Dodgers, MLB, and the courts.

Buried near the end of a recent Wall Street Journal editorial discussing the situation, Holman Jenkins mentioned that among the creditors of the Dodger organization are two retired players who are each owed several million dollars. Together, I believe they are at risk for about $20MM+.

Reading that caused me to wonder what on earth their agents were thinking when they allowed this to occur.

According to what I've read, McCourt was in violation of MLB funding requirements when he bought the Dodgers, and has more or less used the enterprise as a piggy-bank for his and his soon-to-be-ex-wife's lavish lifestyles.

Knowing that baseball franchises can become financially imperiled, you'd think that any player's agent worth his 10% would demand that a team buy an annuity or similar funding instrument, if not escrow the funds, in order to assure payment of their client's long term monies to be paid out in the future.

As it is now, the two players are unlikely to be able to get J.G. Wentworth of any of its competitors to pay a lump sum to them in exchange for accepting the at-risk time payments on their contracts.

I guess it shows, once again, how sports agents fail their clients when they, well, fail to understand and take steps to limit or hedge risks like this.

Counterparty risk. Once again, it rears its ugly head and demonstrates how the most seemingly-safe transactions can fall prey to this nasty source of unwanted financial surprise.

Large US Bank Performance In The Wake of Concerns Over Increased Capital Requirements

Tom Brown's announcement in early June that he had bought BofA shares for his sector fund. That post was on June 3rd, so Brown bought no later than that- perhaps in late May, perhaps earlier that week.

On June 9th, I wrote this post discussing the subsequent call by various regulators for large "too big to fail" banks to hold from 3% to perhaps 7% additional capital.

As of yesterday, the major US banks included in the nearby price chart, have all declined since late May. The S&P500 Index is about flat.

We don't know precisely when Tom Brown bought his fund's BofA shares, but all of the banks shown- Citigroup, Chase, BofA and Wells Fargo- have declined absolutely and relative to the S&P for the past three months.

No wonder Brown was cheering on Jamie Dimon's objections to the sensible call for these banks to be capitalized as, well, banks, rather than unsecured loan providers.

Could it be that between the divestitures and closures of now disallowed businesses, and the specter of higher capital requirements, these banks are in for a long term correction down to price levels more consistent with giant, slow-growing, government-insured deposit-taking financial utilities?

Regarding The Recent Equity Market Turmoil

There's little doubt that the mechanics and dynamics of the US equity markets changed as of late April and early May. The latter timeframe saw volatility begin to rise, while the S&P peaked on May 2nd, falling nearly 9% since then.

At times like these, I consider how different equity portfolio management styles react and perform under such conditions.

As I've written in prior posts, the framework and structure of a quantitative approach to equity portfolio management gives me confidence in relying on my tools, signals and consistent management methods. I can't fathom how a qualitative manager responds to such rises in volatility and a plunging index.

For example, my signaling tools for long/short allocation are still, despite the recent market decline, displaying values associated with long positions. Thus far, June's S&P total return is nearly -7%. A few more months like this and the signal will turn to short allocations. But it's quite likely that the next few months will see the indicator remain long. It's September and after that appears to be the worrisome period. However, while I simulate its behavior, I don't forecast the indicator- I use its contemporaneous output. That's one of the benefits of having time-tested, non-forecasted, quantitative components of a quantitative equity management system.

Thus, I was mildly surprised by the reaction I recently received from someone presented to me as a formerly-successful hedge fund manager. This recent post concerning a networking situation gone wrong due to a friend's inept and lying contact. The same contact made much of connecting me with the alleged hedge fund manager whom I'll call L.

The initial feedback was that L was seriously interested in learning more about my portfolio management approach and performance. But after a few days had passed, I grew sceptical. I requested L's email and sent him my one-page description, along with an invitation to discuss my approach at our mutual convenience. Several days passed with no reply. Not knowing L, nor having spoken with him, and seeing his non-response as possibly a change of mind, or, more likely, wrong information in the first place regarding his interest level, I forwarded my initial email with another suggestion that we talk or meet. Later that holiday weekend, L sent me a reply which read, in part,

"I personally have no need for a black box. I had a partner that left me 20 years ago to work on his algorithmic program. I am aware of all the success stories and I'm sure your is as prudent as the rest. I've seen some very sophisticated programs but in the end nothing that has held up to the tests."

I had to laugh when I read L's response, as it contained such a mix of naivete, bad thinking and errors of logic.

First, why would someone being approached to invest in or back an equity management process believe he will remain 'in the dark' regarding said process? While I've never relinquished control or shared possession of my software code, I've explained how my quantitative process works in detail to former partners. Only an idiot would believe that the process would remain a 'black box' to him.

By the way, even a fundamentals-based analytical type of manager who pores over 10Ks is a quantitative manager. Quantitative means numeric, and probably algorithmic, but not necessarily advanced physics or calculus.

Second, it seems that a long-ago slight by L's former partner has left him biased against all quantitative equity management processes.

Finally, the assertion that "nothing...has held up to the tests" suggests some pretty faulty logic circuits in L's brain. For example, just that week, one of the world's larger hedge funds announced that it was creating a new quantitatively-managed fund.

Several of the best-known and -performing hedge funds, including Jim Simons' Renaissance, are quantitative. So I guess they have passed "the tests."

Precisely which "tests" L is referring to is a mystery to me, and I've been involved in equity management since 1997.

Then, again, considering the wild goose chase on which I was led with the contact's first allegedly valuable network connection, I have my doubts that L had, in fact, developed, built and sold a successful equity management business. Or that he even has substantial funds to invest in one now, either.

There are varying preferences for returns, consistency, etc., over varying periods of time by individual investors or backers of hedge funds and equity management ventures. But, to my knowledge, there is no single set of "tests."

What I wondered, in contrast, was, if L doesn't like quantitative, disciplined, rigorous approaches to equity management which at least have the advantage of being able to be backtested, what does he prefer- totally subjective managers with no ability to retroactively model their selections and performance? If he's worried about "black boxes," does it get any blacker and more impenetrable than an individual manager's undocumented mental meanderings?

Equity markets like those of the past few months and, probably, the next several, always lead me to wonder why anyone would risk their investments on pure, inexplicable subjective hunches without any sort of objective guidelines or rules.

Jason Zweig's Questionable Home Mortgage Hedging Column

In this past weekend's edition of the Wall Street Journal, Jason Zweig wrote in his The Intelligent Investor column about hedging your home mortgage. I think it may be time for him to change the name of that column.

First, this is hardly a new idea. I've thought about it for decades, as I'm sure have many other intelligent, educated people who've worked in the financial sector. Why would you not consider how to hedge the value of what, for most people, is their largest asset purchase, when it reaches a lofty value?

My own ideas have included simply selling it to someone while simultaneously leasing it back. Zweig's column mentions a few firms that purport to offer value insurance for about 1.5% of value.

Frankly, that's obviously very cheap if you have had to buy into a housing market that's frothy or even merely tight and probably, at least currently, overvalued.

Of course, your home isn't just another asset. You live in it and it's probably the most ill-liquid asset you'll own. If you get a hedge on it wrong, it could have life-altering consequences beyond those of an IRA gone wrong. Plus, for real estate exposure, there are other ways to invest, if that's what you want.

Perhaps you shouldn't buy into overheated markets, and go long on undervalued ones. Simple and effective, without the major risk I'll get to shortly.

Leaving aside the regulatory hurdles, consider the challenge of making this a truly ubiquitous product. That is, consider it while recalling what happened to AIG due to its financial products unit which sold so many derivatives which were meant to function as hedges.

To me, the primary issue is counterparty risk for something so massive. Sure, it may be feasible for someone to offer home value hedging just for Syracuse, New York, as one firm mentioned in Zweig's article does.

But US home ownership is a large chunk of value. I don't have my fingers on the exact number, but it's very large. So ask yourself this.

What exists as a countervailing asset that can be reliably expected to fund a massive drop in US residential real estate values?

These sorts of bets typically come unglued when reality overwhelms prior expectations, resulting in a "black swan" event that transcends stress tests.

We're not talking about real estate values dropping by 3% or 10%. Let's talk 30% and more.

What other US-based asset class will be likely to remain able to pay off a 50% decline in the value of all US residential real estate?

Long ago, during the first great collateralized mortgage frenzy, when Lew Ranieri ran his famous group at Salomon Brothers, I discussed this issue with my boss, Gerry Weiss, SVP of Corporate Planning & Development. He had sent me to a CMO conference in Manhattan, and wanted to debrief me from my two-day experience.

In short, I said that the repackaging of cashflows into CMOs by the fixed-income wizards, who were suspiciously silent on things like 'negative convexity,'  which would affect the duration and value of longer-lived tranches, could not, by themselves, magically eliminate risks of mortgage lending.

In effect, in exchange for a few percentage points of fees to create, sell and service the CMOs, investment banks were simply recutting and spreading existing risk while extracting a fee.

Risk is conserved- it can't be eliminated. It can be hedged, assuming a perfect, reliable counterparty.

Thus, while many unwashed thought the CMO craze made the world safe for mortgage risk, all it really did was pay Wall Street investment banks to allow troubles S&L's to liquefy their damaged mortgage loans while simultaneously allowing investors to more finely select mortgage risks subject to duration and other factors.

So when I read Zweig's piece, the first thing that came to mind was, just who will be a reliable counterparty for a substantial portion of the value of all US residential real estate?

How will that work? What source of asset value will be either unaffected by, or move in opposition to, the value of US residential real estate at a time of huge value reduction of the latter?

Granted, should such a ubiquitous residential real estate hedge become available, it might provide some minor relief for a family which, due to one of the parents' careers, moves every 5-7 years. But that's a steep price for such short-term coverage.

But for the worst case scenario involving residential real estate hedges, beyond holding an instrument that purports to be that hedge, a reliable party with an asset that will perform on that hedge have to both exist amidst an expected turbulent financial and/or economic environment.

It's not the "greatest idea never sold." It's a mirage.

BlackRock's Valuation Business

This morning's Wall Street Journal featured an article in the Money & Investing section on BlackRock's valuation business. Referring to it as a "geeky guys" business, the piece actually confused me to some extent.

By way of background, when I was an internal strategy consultant/troubleshooter at Chase Manhattan Bank, working for my late boss and mentor, Gerry Weiss, the bank's market data and tools unit, Interactve Data Corp (IDC) was one of my charges. I spent quite a bit of time helping them grapple with product and market development issues and, later, worked to put down a mutiny led by the unit's head, who told his staff that he would force a sale of the unit to him and private equity backers.

I well recall how the unit's chief administrative officer referred to their bond matrix valuation service,

"Customers have a choice- we're wrong and Merrill Lynch is biased."

The point was not lost on me.

Bond matrices were essentially multifactor valuation models purporting to estimate the value of infrequently-traded securities by comparing their attributes to those of securities with some of the attributes, combining to hopefully predict a reasonable valuation with some connection to more-frequently-traded securities.

IDC didn't own an inventory of the bonds, as Salomon Brothers or Merrill Lynch did, so it wasn't able to provide valuations based on as rich a data set as Merrill. But Merrill Lynch was obviously biased in its valuation, since it was consulting on securities which were probably in its own inventory.

You can instantly see the same issue at BlackRock. And why the Journal article is clearly influenced by BlackRock's unit's head, Rob Goldstein, to emphasize a Chinese wall between his BlackRock Solutions and the asset management portions of the firm.

Gosh, they even have different elevators! Bet that's foolproof, huh?

It was confusing to read that this was supposed to insulate Solutions from "other parts of the firm that could profit from its knowledge," because I would think the reverse is the actual problem. Solutions provides somewhat sterile valuation information for which traders probably have their own preferred approach. But the Solutions staff would undoubtedly benefit from knowing trading information from BlackRock's asset management activity, and the article is silent on this directional information flow.

Getting past that, and the other details meant to reassure Journal readers that BlackRock really did consider this issue years ago, when it was founded as a separate and separable unit, the piece goes on to highlight the sort of dark assignments the unit has received from the Fed, other central banks, pension funds and even commercial banks.

The article also calls Solutions the risk-management division of BlackRock, too.

Risk management is typically more complex, as it seeks to impute the risk of loss to positions, trading desks and/or larger business units. The focus is on the volatility of valuations of the securities in a position or portfolio.

Valuation involves trying to determine a reasonable market value of a security, position or portfolio, when there are infrequently-traded or non-public securities involved.

But, according to the Journal article, these two services are offered from BlackRock Solutions, which earned revenues of $460MM last year, or 5% of the firm's $8.6B total revenues, with 1,850 people. That's revenue of roughly $250K/person. It leaves little room for profit, considering that risk management talent can be fairly expensive.

So if it doesn't make much money absolutely from this unit, why would BlackRock bother with it? The margins may be much higher than those of publicly-held asset managers, but the relative revenue volume is so small as to make that margin rather insignificant.

Well, maybe it has something to do with a point made obliquely in the article.

BlackRock may profess to have erected a Chinese wall inside of the firm. But that has nothing to do with what may happen outside the firm. Consider the following.

Pension funds like Calpers typically retain some of the best hedge funds to manage all or parts of their investment portfolios. The investment committees of those pension funds don't have the skills to do the actual work of daily investment management, nor risk management.

From the Journal piece, we also know that Calpers has retained BlackRock Solutions. It's not a stretch to envision the California pension giant retaining both parts of BlackRock. And perhaps even discussing the Solutions findings and models with BlackRock's own investment arm, as the client has paid for advice from both units.

Such flow of information from the client's portfolios through Solutions would be completely expected. And BlackRock investment managers could easily be privy to Solutions' tools paid for by Calpers.

It's an interesting twist or solution to an old Wall Street problem- how to get clients to pay for activities that don't seem to directly produce revenue for the firm.

If BlackRock used Solutions activities for its own traders/investment managers, it would probably have to absorb the costs as part of its management activities, because such management business is competitively bid.

But by offering valuation and risk management through a separate unit, it can get clients to pay for services, the value of which, if BlackRock also manages money for the same client, it will probably realize for free.

That said, it's useful to consider a larger issue involving asset managers selling auxiliary services such as risk management and valuation to their clients.

BlackRock is a publicly-held asset management firm.

Thus, you don't read of BlackRock in the same articles in which you read about Renaissance, AQR, or the other firms which were the focus of Scott Paterson's book (The Quants) last year. And BlackRock wasn't considered endangered by the financial meltdown of 2008, as it is both publicly-held and, thus, doesn't have huge pools of partner capital bet in a leveraged fashion.

Still, given the movement of people, ideas and technology among various asset management firms of various organizational stripes- private equity, hedge fund, or publicly-held- it's hard to believe that BlackRock's valuation and risk management services would be very much different or better, or for very long, than those of its competitors.

Hedge funds wouldn't bother to sell their own risk management and valuation services to clients, because, well, they don't really consult with their clients on these issues. But we know, from Paterson's work, that at least a few quant hedge funds nearly went out of business due to inadequate risk management and it's apparent poor implementation in trading.

BlackRock won't go out of business due to its own capital losses if its risk management advice is either of poor quality or badly-implemented. Their clients may lose assets, but BlackRock just loses income and, perhaps, clients.

But it's interesting to try to understand how its risk management tools, employed by some of its largest clients, won't contribute to market valuation effects, given how much money the firm manages. Or how its valuation opinions won't, at moments of maximum market stress, also effect markets.

Those effects nearly wiped out a few hedge funds several years ago. Now we learn that a competing asset management giant sells those services to clients, but not at prices that suggest BlackRock even makes much money from the effort. Margins

As its parent is managed by some very intelligent people, one assumes there is substantial value in operating BlackRock Solutions. If it's not in the operating income, where is it?

Kyle Bass On CNBC Yesterday

Occasionally David Faber has a worthwhile guest on his noontime CNBC program, Strategy Session. Yesterday was one such occasion.

Kyle Bass, a hedge fund manager who scored big by correctly betting against the residential finance boom in its latter years, was on to give his opinions on a variety of market topics.

You can probably find his appearance in a video on the CNBC website. But here, in brief, is what he said.

On municipal defaults, he agrees with Meredith Whitney.

On equity markets, he's swearing off of them, because he believes what we are now seeing is mostly just a result of QE2 and too easy money. He believes it's a global phenomenon which will end very badly. I don't recall his measure of choice, but he mentioned a particular rate which one could watch to discern when the top in equities had been reached, and the fall would begin.

One interesting anecdote he told was being at a conference of alleged observers of credit markets or some such relevant group. He asked how many of the several hundred people in the room in which he was speaking new the weighted average cost of the Greek government's debt? Nobody did. Bass said it was about 4.3%. He expressed shock and amazement at the faulty, shoddy, poor quality of basic analysis by people whose job it was to know that type of data.

The lesson, of course, is that, like the anecdotes he told in the CNBC House of Cards documentary, about Wall Street mortgage finance desks, you can't really trust the so-called experts and analysts to know what they are doing, or to have proper incentives to know it and tell you.

Bass has become recently well-known for being right on US mortgage finance markets. His comments and manner convey a sensible, thorough, reasonable approach to what he does. Very credible.

Chesapeake Energy's Derivatives Strategy

Aubrey McClendon, Chesapeake Energy's CEO, made news this week for an audacious move to juice Chesapeake's net income.


His bet on natural gas over the last few years turned bad, causing him personal losses on margined positions. Now, with gas prices looking soft for the near term, he's moving the firm into oil drilling. Sensing weakness, activist investor Carl Icahn has bought into Chesapeake.


Meanwhile, McClendon has Chesapeake aggressively hedging natural gas prices forward, with some positions allegedly not expiring until 2020.

Some analysts and fellow traders argue that Chesapeake is playing with fire. The company has already bet on gas prices as far into the future as 2020—a date so far ahead, some skeptics say, that the markets are too tough to pinpoint. CNBC reporter Kate Kelly wrote a piece yesterday which noted,



“I don’t really like the idea of selling out call options on gas prices and oil prices—mostly gas prices for the long-dated options—10 years out so that I can get more revenue today,” says Phil Weiss, a energy analyst who recently downgraded Chesapeake to a sell rating. “It’s just another way the company is mortgaging its future.”


McClendon counters that “90 percent” of Chesapeake’s hedging activity is focused on the “next eighteen months.” The trades dating to 2020, he said, are “basis hedges” intended to mitigate risk events in regional markets.


Other critics argue that Chesapeake’s hedges, while likely to succeed in the immediate future, will be tough to replicate longer-term.


“In 2011 they’re going to have material hedge gains,” said one energy trader whose company policy prevents him from speaking on the record, “but they’re not going to have that luxury going forward. Because if prices go up, they’re in great shape. But if prices stay depressed, they don’t have the flexibility they did in the past.

Chesapeake officials acknowledge that if gas prices rise far above the strike prices of the calls they sold—$5.84 and $6.19 for the next two years respectively—they could lose some money. But in that case, say officials, they’d be happy because produced gas could be sold at a higher price.



McClendon himself takes offense at the notion Chesapeake has become a hedge fund—a label Weiss and some traders have recently slapped on the company. “We don’t gamble. We don’t bet. We’re physically long gas,” McClendon says. “All we’re doing is mitigating risk.”


Unlike other gas and drillers, some of whom employ hundreds of dedicated traders, Chesapeake’s hedging team is a party of three: McClendon, newly-appointed chief financial officer Domenic Dell’Osso, and Jeffrey Mobley, the company’s senior vice president of investor relations. Before the team makes a move, its members say, their decision must be unanimous.”


Regardless of McClendon's remarks, doesn't this basically turn Chesapeake from a natural gas producer to a closed-ended natural gas options fund? Being naturally long due to their ostensibly main business doesn't make Chesapeake not a hedge fund. They could have just as easily bought options on production instead, and be just as long.

I'm not an energy sector analyst, but most pundits appearing on CNBC yesterday seemed to be shocked at McClendon's recent strategy moves.

I don't quite get how, if the firm has sold calls on current production, they can then claim that rising prices benefit them. Unless, of course, they didn't sell calls on much production capacity. It wouldn't seem that they can have it both ways.

From a larger perspective, McClendon can't both be able to profit more in the future if he's smoothing income now through the use of derivatives. Using derivatives either caps profits and/or losses, or is a one-way bet.

As I read McClendon's comments, and those attributed to the firm's executives, it's not clear which Chesapeake has really done. Which ought to give investors pause.

Pension Funds, Risk & Self-Regulation

Last weekend's edition of the Wall Street Journal featured an article in the Money & Investing section entitled Who Needs Risk Rules? Pensions Act On Their Own.

According to the article, several pension funds have begun changing their investment managers well ahead of any definitive FINREG dictates.

One public pension fund in Oklahoma dismissed Bill Gross' PIMCO as a manager because of "the risks of its use of derivatives whose values couldn't be cross-checked in audits."

That's got to sting. Is it really the case that some derivatives are so special that nobody offers the equivalent of the old bond value matrices for illiquid instruments? Apparently so.

Some states are prohibiting public pensions from engaging in derivatives investments, while some other public funds have sworn off swaps because of "counterparty risk."

Now, you're talking. My favorite misunderstood risk of all is counterparty. Accepting a promise to perform by a party that can't is far more risky than mere exposure to the vagaries of market valuations.

The Oklahoma fund was detailed as not even being able to discern, from PIMCO's statements, which side of some swaps they were on.

Looks like some investors are actually learning from the last few years and limiting their exposure to instruments which they either don't understand, on which they can't easily verify valuation, or where counterparties are less than acceptable in terms of risk.

I guess freely-operating markets and agents in them, given time and experience, work after all. On their own.

Oliver Wyman's Role In Citigroup Mess Comes To Light

The Federal Crisis Inquiry Commission has been busy this week. Former Citigroup chairman Bob Rubin and CEO Chuck Prince have been 'guests' of the panel, and, boy, have they provided some entertainment.


And, according to this piece in the Financial Times, some interesting revelations,


"It emerged on Wednesday in testimony before the Financial Crisis Inquiry Commission in Washington that, partly on the back of a 2005 Oliver Wyman analysis of potential growth in the fixed-income market, Citi decided to ramp up its business in collateralised debt obligations, or CDOs, backed by high-risk or “subprime” mortgage loans.

This ultimately led to a US government bail-out after Citi racked up more than $50bn in losses in the wake of the implosion of the subprime market.

In the heady pre-crisis years, firms such as Oliver Wyman and McKinsey were frequently called in to assess how banks could bolster profits in underperforming divisions, as bank executives looked to stave off shareholder complaints about lagging returns.

Oliver Wyman, for example, marketed a yearly analysis of how banks were faring relative to each other in hard-to-measure areas such as fixed income and commodities, offering previously unavailable competitive intelligence.


Relying in part on the Oliver Wyman study, Robert Rubin, then chairman of Citi’s executive committee, and Thomas Maheras, head of capital markets, conducted a review of the fixed-income business. They then sought Mr Prince’s approval for an ambitious investment plan to ensure Citi would keep its edge as the debt markets evolved.

Citi would end up spending more than $300m in 2006 to hire traders, bankers and cutting-edge software systems. CDOs and other structured credit products were a part of that buildout.

“Based in part on a careful study from outside consultants hired by our senior-most management, the company decided to expand certain areas of our fixed income business that we believed at the time offered opportunities for long-term growth,” Mr Maheras told the Financial Inquiry Crisis Commission on Wednesday."


I recall, back when I was the first Director of Research at the then-independent Oliver, Wyman, that we produced and marketed a financial services sector "revenue map" each year. It sounds as if, over the years, the firm added data from its consulting engagements, in which it would get proprietary views of various firms' actual business data, to provide comparative information.


According to Prince's and Rubin's testimony, we see, once again, how a senior management team paid millions of dollars per year can't seem to have its own sense of direction. Instead, they hired Oliver, Wyman to do their thinking for them, with unfortunate consequences.

Rather like the unfortunate experience of Meg Whitman of eBay received from McKinsey some years ago with regard to Google as a competitive threat.

Or the consequences of an earlier Oliver Wyman team on Advanta, which left to join that once-thriving, premier credit card firm. Thanks to those young, inexperienced risk-management sharpies, Advanta blew up about a year later from excessive risks in its card portfolio.

It's understandable, and a good idea, for senior or business managers to use consultants who have some particular informational expertise or knowledge about a product/market. It's rather surprising to me, however, that in the clubby, competitive world of fixed income trading and origination, a firm like Citigroup, composed, in part, of the old bond king, Salomon Brothers, wouldn't already know quite a bit about the market in competitive terms.

Further, there's a point at which management has to do its own thinking, beyond the data.

As I wrote in this post, way back in September of 2008, about the "fallacy of composition" in risk management,

"This is a topic on which I have seen almost no ink, whether physical or electronic, spilled. The tendency of major financial service trading houses to employ similarly-vintaged and -featured risk management systems virtually guarantees the fallacy of composition with respect to sudden windshears in markets.


When one model sees a need to dump a security, due to excessive risk, they all do. And what the models don't account for is other desks, using similar risk metrics, piling on with similar actions, all of which rapidly accentuate the pricing moves that first triggered the sales of risky instruments.


What people outside the financial services industry fail to understand is that, like most industries, vendors supply products and services- data, software, information, risk management methodologies- to as many industry competitors as possible. Further, there is a constant flow of people back and forth between vendors, consultants and financial services firms. For example, a former investment management business partner and one-time colleague at Oliver, Wyman & Co., recently left a senior position at Mercer Management Consulting, which acquired Oliver Wyman a few years ago, to join some of his former OWC colleagues at a risk management consulting firm in California. This will speed the dissemination of his observations on industry risk management practices, and weaknesses, to another major sector consultant."

Apparently, this occurred in the area of simple revenue generation and business expansion, too, for Citigroup. It evidently never occurred to Prince, Rubin and Maheras that if Oliver, Wyman were peddling the idea of jumping into exotic fixed income origination and trading to Citi, they were probably also walking the concept up and down the investment and commercial banking community.

After all, everyone in financial services knew, or should have known, that this has always been the manner in which OWC does its business. One by one, they sold essentially the same risk management technology to every major commercial bank in the 1990s.

Now, though, Oliver, Wyman's role has been brought into the national spotlight in the context of a federal panel investigating the roots of the recent financial crisis. This can't be good for the firm's image or subsequent business.

Perhaps, though, it will serve as a cautionary tale for future financial business executives. Rather than simply seize on a consultant's juicy picture of a market, and plunge in, they'll do some game theory and strategy work to consider the ramifications of multiple competitors entering the same product/markets with similar strategies, technologies, personnel, etc.

Oh, by the way? The other major discipline that OWC prides itself on possessing is....strategy consulting!

Guess they didn't get around to selling that strategy engagement to Citigroup, did they? Maybe Rubin and Maheras ran out of the room after the fixed income market presentation so fast, heading for the board room to recommend jumping into CDO trading and origination, that there wasn't time.....

Chase's Private Equity Deals

This morning's Wall Street Journal contained a small piece highlighting Chase's private equity group bidding $6/share for the outfit that produces American Idol.

The article was attempting to be wry in its scepticism over the price and proposed deal. The quasi-analysis focused on the production company's contract with Fox to air a few more seasons of the program, and Simon Cowell's recent departure from the firm.

Bottom line, concluded the piece, is that Chase may be overpaying for the small firm's current assets and management.

That's not what struck me about the article, though.

No, what I saw was yet another case of a federally-, meaning taxpayer-insured financial institution playing roulette with our money.

First, why on earth should taxpayers even allow a federally-insured bank to have a private equity unit? Private equity is all about risk. About bidding on existing firms, typically with more debt than is in the current structure. That's the easiest way for a private equity firm to bid over current market valuations, i.e., put in less equity, borrow more money and toss it to current owners.

Fine if you're, say, TPG. Or Cerberus.

Ooops! Not Cerberus, actually, after the GMAC and Chrysler fiascoes.

And that's my point.

Dress it up any way you like, Chase's private equity group is essentially taking on obligations, by way of borrowed money, used to pay off the current owners of CKX. If the deal doesn't work as envisioned, shareholder equity is the first call for repayment of the debt.

But, ultimately, the last resort is you and me, via the FDIC and Treasury.

This is why the Volcker Rule makes so much sense. And causes such outraged opposition in the banking sector.

Jamie Dimon obviously would love to keep this sweet, one-way risk spreading deal.

You and I should not want that.

And don't be fooled by the implication that Chase is so large that it can absorb the risk. If their private equity group is too small for the risk to matter, it's too small to really affect earnings or valuations.

If it's not, it's too risky for a taxpayer-guaranteed bank.

Period.

At a minimum Chase should be forced to separately organize and incorporate the private equity group, with equity capital that is off-limits for use against the bank's other activities. Further, the private equity unit shouldn't be allowed any leverage whatsoever. Of course, in today's private equity world, that would make it extremely disadvantaged. It would, could be little more than an investor in the deals of others, because it would never be able to offer competitive bids for companies based on all-equity funding. But to allow such an entity to borrow is to basically recreate the flawed Citigroup SIVs of several years ago.

In effect, this little thought experiment demonstrates why allowing a federally insured bank to gamble with businesses like private equity or proprietary trading is nothing more than playing with taxpayer funds. Heads, Chase wins. Tails, taxpayers lose.

How is it, two years after Bear Stearns' collapse, we still allow taxpayer-backed financial institutions to take large leveraged investment bets?

Have we, and, most importantly, our pompous, pontificating Congressional members and federal regulators, learned nothing?

Evidently not.

Leverage Doesn't Equal Risk, But It Seems To Account For Much Of It

I wrote this post a few weeks ago discussing the use of the Kelly Criterion for scaling allocations to uncertain investments.

By following links in that post, you can read my reviews and discussions of Scott Patterson's recent book, The Quants.

That book, and Poundstone's Fortune's Formula, were the subject of some discussions with a colleague on Saturday morning, as we drove to the Washington, D.C., "Kill the Bill!" rally on the Capitol lawn.

As my friend and I revisited the topic of risk, risk management, and the Volcker Rule, I realized that, despite there being many aspects of risk, Kelly's work demonstrates that, of all of them, leverage is by far the greatest source of risk.

First, our fractional banking system exposes us to constant leverage. The reason you have an FDIC is due to US experience during the Depression with failed banks which had lost their capital through leveraged mortgage lending, and no longer could pay depositors their money.

Fractional-reserve banking provides much of the multiplier effect in our economy.

But we have explicitly allowed leverage in other areas, as well. Margin lending for selling securities short, for example. And, in effect, credit derivatives.

By exchanging risk without the use of exchange-traded instruments, as in those swaps, we learned in recent years that there can be unknown leverage borne by a counterparty.

Many pundits immediately derided the Volcker Rule. It's also no surprise that any bank CEOs who commented on it did so negatively and dismissively.

That, I observed to my friend, ought to tell you how necessary and effective Volcker's recommendation actually is.

Of course, if you are Jamie Dimon, Vik Pandit or Lloyd Blankfein, you want people to believe that a US investment or commercial bank simply must be allowed to engaged in leveraged, proprietary trading. These CEOs easily confuse legislators and regulators by citing a need to provide complete client solutions.

But leveraged proprietary trading isn't customer service.

Like it or not, despite what Jamie & Co. assert, when a financial institutions is highly-levered, and federally insured, and it is allowed to engage in proprietary trading and/or investing, by definition, that proprietary trading or investment is levered.

Why?

Because any proprietary activities' losses hit the institution's equity. And since financial institution equity is often only 5-8% of total assets, it won't take much, as we saw in late 2008, to bring investment banks as large as Morgan Stanley and Goldman to the edge of solvency.

This is what Patterson exposed in his book. By failing to heed the Kelly Criterion, billionaire hedge fund owners levered up and sustained crippling losses.

Imagine if those had been part of insured banks.

Wait, they were! Morgan Stanley's PDT group.

That's why Volcker is right. So long as any institution is implicitly or explicitly federally insured, and operating with leverage, any proprietary losses are, in effect, guaranteed by taxpayers.

Heads, they win. Tails, the rest of us lose.

That is the most frequently observed risk in our financial system in the last 30 years.

But you must notice there are two characteristics which must be separated. And only two.

Leverage and federally-insured deposits or businesses.

For example, suppose Blackstone invests billions of borrowed money in various ventures, and loses it all?

As a private equity firm, its partners/owners lose a lot. Its lenders, presumed to have analyzed Blackstone's balance sheet and operations, will probably take painful writedowns.

Losses like these could come from bad private equity deals, or even bad startup venture funding.

Or, they could come from Blackstone's own proprietary trading operations.

So long as only private sector counterparties risked their capital, whether as a creditor via loans to fund the balance sheet, or a creditor via counterparty risk, the rest of us aren't directly hurt.

It's only when federally-insured entities lose in leveraged proprietary trading that we all suffer directly.

That's why the Volcker Rule is so simple and effective. He identified the only two practices which should never occur together, i.e., proprietary leveraged trading and government guarantees of deposit insurance.

We shouldn't care if an unlevered Chase lost on proprietary trading, because those loses are limited to its own capital. But as soon as the bank is allowed to lever, implicitly, its losses can outstrip its capital.

Risk management is challenging enough without adding leverage to increase it. All the squawking over Paul Volcker's recommendations indicate that they address a serious problem. One which should be solved along the lines of his Rule, while ignoring the bleating and complaints of those in the sector who know they will lose valuable access to federal bailouts if his idea is put into practice.