The lead staff editorial in Thursday's Wall Street Journal provides a nice overview of what's wrong with federal regulation of the banking and securities sector.
The piece details how, once Jon Corzine became CEO of MF Global, the Fed reconsidered and reversed its earlier decision to deny the firm its request to become a primary dealer.
The Journal notes that MF Global had posted six losses in the past seven quarters, but drew no extra regulatory scrutiny. It was more than halfway through that period when the Fed granted MF Global its primary dealer status.
What the editorial explains, correctly, I believe, is that it's not quite correct to simply say that Dodd-Frank and the overall federal regulatory scheme worked, because MF Global failed without larger consequences or incidence. But the apparent misuse of customer funds, and outsized position risks taken by the firm, were completely overlooked by regulators.
Isn't that what the system is supposed to prevent? The actual illegal and overly risky types of actions which MF Global is suspected to have taken?
Gensler recused himself from the case, which tells you how much this is all about crony capitalism, which the Journal contends. Either Gensler shouldn't have had to recuse himself, or he should have admitted the cronyism back when Corzine took the helm of MF Global.
It's tempting to write off the MF Global collapse as a one-off, smallish, successful proof of Dodd-Frank. But, in reality, it's proof that our federal financial system regulations don't seem to have clear-cut objectives, or, quite likely, if they do, are not capable of actually implementing them and protecting anyone or anything- not customers, shareholders or the larger US financial system.
Showing posts with label Trading. Show all posts
Showing posts with label Trading. Show all posts
Monday, December 05, 2011
Tuesday, September 20, 2011
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.
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.
Friday, September 16, 2011
Regarding UBS, Their Rogue Trader, John Mack, Morgan Stanley & Howie Hubler
Yesterday's two big financial stories, outside of the continuing soap opera "As The Euro Implodes," were John Mack's retirement from Morgan Stanley and the revelation that UBS rogue trader Kweku Adoboli lost $2B for the bank. Both stories dutifully appeared as prominent pieces in this morning's Wall Street Journal.
There is, however, a deliciously ironic link between the two tales. For me, it took finishing Michael Lewis' The Big Short to realize the connection. Here's the clue from the Journal piece,
"But in 2007, it hit a rough patch, losing $9 billion on a proprietary mortgage bet that cost the jobs of several of Mr. Mack's lieutenants, including Zoe Cruz, who was widely viewed as a top candidate to succeed Mr. Mack."
Now, it's tempting to think of the Morgan Stanley loss as not caused by a rogue trader. In fact, elsewhere in the Journal article on Mack, it contends,
"He's a battlefield commander who knows how to lead troops......Mr. Mack pushed traders to take more risk and sell more esoteric but profitable mortgage products. Briefly, that move paid off. In 2006, the firm enjoyed record results."
Funny, that's not at all how Michael Lewis described Howie Hubler's calculated $9B loss on mortgage-backed derivatives.
How do you suppose UBS suffered only a $2B loss and blamed it on a rogue trader, whereas John Mack presided over a $9B loss in 2007 and kept his job? In fact, he essentially lost the firm, as it required a federal bailout, plead to convert to a chartered commercial bank, and had to arrange other financing to remain solvent.
Yet Mack kept his job and never called Hubler's loss a rogue trade.
We don't yet know precisely how Adoboli accomplished his allegedly-undetected losing trade(s). One assumes, like Nick Leeson who brought down Barings Bank, he somehow fooled the various electronic systems purporting to monitor positions, desk P&Ls and risk.
But here's how Michael Lewis explains Morgan Stanley's star fixed income trader Howie Hubler's stunning $9B loss. For those wishing to follow along, I'm synopsizing Lewis' Chapter 9 in The Big Short (Norton, 2010), entitled A Death of Interest, pages 200-225. I'm not going to retype the chapter, nor major parts of it, as that would, I think, be a waste of my time, and probably violate Michael Lewis' copyright. Instead, I'm going to abstract the highlights of what went on at John Mack's (and Zoe Cruz's) Morgan Stanley during 2006 & 2007. But I heartily recommend, if you find any of this of interest, that you run over to Amazon and buy a copy (new or, as I prefer, used but 'like new' for only about $6) of Lewis's book.
Howie Hubler was a star trader of mortgage-backed bonds. Sometime in 2004, Hubler begins to realize that a lot of the bonds he's selling, for which Morgan Stanley, like Goldman Sachs, has built its own origination system to capture the entire profit stream, are of highly suspect quality. So he, in conjunction with a colleague, Mike Edman, hatch a proprietary swap which they convince some of their clients to sell to Morgan Stanley. This allows Hubler's desk to own protection, for a small annual fee, on billions of dollars of dodgy subprime-backed mortgage bonds.
Lewis writes,
"It's now April 2006, and the subprime mortgage bond machine is roaring. Howie Hubler is Morgan Stanley's star bond trader, and his group of eight traders is generating, by their estimate, around 20 percent of Morgan Stanley's profits. Their profits have risen from roughly $400 million in 2004 to $700 million in 2005, on their way to $1 billion in 2006. Hubler will be paid $25 million at the end of the year, but he's no longer happy working as an ordinary bond trader......"
Along the lines of my long-expressed belief, Lewis notes that "the best and the brightest Wall Street traders are quitting their big firms to work at hedge funds, where they can make not tens but hundreds of millions."
So Hubler wangles a deal with Morgan Stanley to set up his own proprietary trading group, take his existing desk's swaps positions with him, and get a sweet deal for his group to own a stake in the group, to be subsequently spun out from Morgan Stanley. In short, Hubler extorts Mack and Cruz to give his group a semi-private business and stake in its future value, in return for not bolting from Morgan Stanley.
Here is where the story becomes interesting as it relates to today's WSJ articles about a rogue UBS trader and John Mack being paid homage as a wise senior Wall Street CEO.
Hubler's new group is given a profit bogey of $2B, but is paying about 10% of that, or $200MM, in fees to maintain its swaps, or shorts on bad mortgage bonds. Hubler wants to eliminate this drain, so he sells credit default swaps on a much larger amount of allegedly higher-quality mortgage bonds. About $16B of bonds.
As Lewis puts it,
"In effect, Howie Hubler was betting that some of the triple-B-rated subprime bonds would go bad, but not all of them. He was smart enough to be cynical about his market, but not smart enough to realize how cynical he needed to be."
For some perspective, the original credit default swaps which Hubler and his colleagues sold to their customers only required a 4% default rate among the subprime mortgages backing the bonds, which Lewis writes was expected in good times, to allow the swaps to pay off.
Next, Lewis writes about how Zoe Cruz' risk management people ask for stress tests of Hubler's aggregate positions under scenarios involving a default rate of 10%. A rate Hubler's people, who, remember, are just traders- not PhDs in economics or seasoned mortgage industry researchers (like, for example, Lew Ranieri's original Salomon group contained)- protested would never occur.
I need to make a brief side point here on which I'll elaborate in a subsequent post. Value-at-risk is the main component of most trading desk risk management systems. I've worked on and been around these systems since my days at what is now Accenture consulting back in 1995. One of the problems with VAR systems is that, since they require and assume variance in valuation to impute the capital required for a position, and, thus the losses possible at some probability level, they don't work well with bespoke instruments. Like, say, credit default swaps or so-called 'off the run' fixed income instruments.
Since the entire credit default swap market, as it evolved among AIG, Goldman Sachs, Deutsche Bank, Morgan Stanley, et.al, was a telephone bid/ask market in which valuation was an exercise in judgement, variation in values was meaningless. As my old, sometime-business partner Bob Mankin is fond of saying,
"A model can tell you what something was worth yesterday or may be worth tomorrow. But the only way to know what it's worth today is to sell a piece of it in the market to someone else."
Thus Morgan Stanley's risk group's slow realization that its VAR reports on Hubler's groups risks were also meaningless.
The 10% stress test showed that Hubler's group wasn't short subprime mortgage-backed bonds. It was long, and the 10% default scenario would create a $2.7B loss. Lewis notes that the actual eventual default rate on the bonds on which Hubler sold swaps, i.e., went long, became 40%.
Again, to synopsize, by mid-2007, Deutsche Bank, which had bought the swaps Hubler sold to get a $200MM income stream to offset his negative carry on his base position of being long credit default swaps on allegedly-worse subprime mortgage-backed bonds, called Hubler to demand payment on the shifting, now higher value of the swaps Hubler sold. Again, because they aren't exchange-traded or continuously-quoted instruments, their value was the subject of what, in effect, became a verbal pissing contest between Deutsche and Morgan Stanley. By later in 2007, Morgan Stanley had paid Deutsche Bank at least $3.7B, eventually losing the net $9.2B. Hubler had, as Lewis writes,
"...been allowed to resign in October 2007, with many millions of dollars the firm had promised him at the end of 2006. The total losses he left behind him were reported to the Morgan Stanley board as a bit more than $9 billion: the single largest trading loss in the history of Wall Street......Hubler and his traders thought they were smart guys put on earth to exploit the market's stupid inefficiencies. Instead, they simply contributed more inefficiency."
To further add to today's trading loss/John Mack retirement irony, Lewis continued, on page 216,
"The other, bigger, buyer was UBS- which took $2 billion in Howie Hubler's triple-A CDO's, along with a couple of hundred million dollars' worth of his short position in triple-B-rated bonds.....A few months later, seeking to explain to its shareholders the $37.4 billion it had lost in the U.S. subprime markets, UBS would publish a semi-frank report, in which it revealed that a small group of U.S. bond traders employed by UBS had lobbied hard right up until the end for the bank to buy even more of other Wall Street firms' subprime mortgage bonds.....said one UBS bond trader close to the action, "It was a very controversial trade in UBS. It was kept very, very secret.....He further explained that the traders at UBS who executed the trade were motivated mainly by their own models- which, at the moment of their trade, suggested they had turned a profit of $30 million." "
Small world, indeed, eh?
Now with all this information, stop and reflect with me for a moment.
You are John Mack. It is 2006. You meet with your chief risk officer, Zoe Cruz, to ask for a complete examination of Howie Hubler's group's positions, strategies, assumptions, forecasts, etc., because that single eight-person desk is generating, according to Lewis, roughly 20% of Morgan Stanley's profits. You tell Zoe to set aside an entire day- maybe two. You surely want to understand in detail how these eight traders are producing 20% of your firm's profits, and what concomitant risks they are taking to do so.
Or maybe you don't.
The same thing would seem to apply to Zoe Cruz, would it not? Wouldn't she want to protect herself by conducting such a thorough examination of Hubler's group's business, in order to brief Mack prior to presiding over a blow-up of that desk's business?
Evidently not.
Instead, Lewis quotes verbatim from Mack's December 19, 2007 investor phone call. I won't republish the detailed exchanges between Mack and his questioners, including Goldman Sachs analyst William Tanona. Instead, here's what Lewis wrote about Mack's statements,
"The meaningless flow of words might have left the audience with the sense that it was incapable of parsing the deep complexity of Morgan Stanley's bond trading business. What the words actually revealed was that the CEO himself didn't really understand the situation. John Mack was widely regarded among his CEO peers as relatively well informed about his bond firm's trading risks.....Yet not only had he failed to grasp what his traders were up to, back when they were still up to it; he couldn't even fully explain what they had done after they had lost $9 billion."
In a footnote to the verbatim exchange on page 218, Lewis also wrote,
"What John Mack's trying to say, without coming right out and saying that no one else at Morgan Stanley had a clue what risks Howie Hubler was running, is that no one else at Morgan Stanley had a clue what risks Howie Hubler was running- and neither did Howie Hubler."
In an earlier footnote on page 210, Lewis provides a brief discussion of the differing explanations offered by those close to Hubler and Cruz regarding who was ultimately responsible for Hubler's positions' losses- Hubler or Cruz? Lewis sides with those who believe Hubler hoodwinked Cruz into believing the positions' net risks were minimal.
So, what is my point at the end of this very long post involving today's WSJ articles about yesterday's two big breaking stories at UBS and Morgan Stanley, and their mortgage-backed credit default swaps losses four years ago?
It's that, to me, John Mack shouldn't be retiring now as chairman of Morgan Stanley. He should have been fired by his board in 2007 for allowing Hubler and Cruz to lose $9B on one desk. Then Cruz should have been fired, and Hubler, Cruz and Mack all sued by the Morgan Stanley for fraud and breach of fiduciary duty to the firm's shareholders.
That if Howie Hubler was allowed to exit with tens of millions of dollars, and no criminal charges, after putting a $9B hole in Morgan Stanley's 2007 balance sheet, maybe UBS' Adibolo isn't guilty of anything, either.
Maybe both Hubler and Adibolo are rogue traders, or neither one is.
Now, I know that the foregoing story paints Adibolo as a trader trying to hide his known losses, whereas Hubler is portrayed as just too inept to realize what he thought was a net short position in derivatives was actually a net long position.
Personally, I have some trouble really belieiving Hubler was that stupid. Or, if he was, are we actually to believe that people that stupid can make $25MM a year? Plus, Cruz's people did the stress test which alerted them, and Hubler, to just how risky his positions actually were. So, from that point on, it seems unarguable that all concerned at Morgan Stanley could or should have known the truth about Hubler's positions.
But Lewis' book provides details of how Morgan Stanley dithered over exiting the worsening parts of the group's positions. Was that rogue behavior? By Hubler? Cruz?
Something doesn't add up. That's why I don't see a real difference between Adibolo and Hubler. They both were given license to risk their firms' shareholders' capital, and both lost it in positions which should never apparently ever been allowed to exist.
And, yes, Zoe Cruz did lose her job. But not quite the way I suggested above. And neither she, nor Mack, nor, of course, Hubler were sued for violating their fiduciary duty to their firm's shareholders through either gross incompetence, given their compensation and senior positions, or calculated deceit.
I think Lewis' account puts this week's comparatively paltry $2B UBS loss in perspective. And suggests that UBS has an evidently continuing cultural blind spot that makes it vulnerable to rogue trading, however you choose to define the term.
Lewis' book also begs the question, in my view, that Hubler was also a rogue trader. And perhaps Mack was a rogue CEO all the while.
I suspect, if you asked him, that Michael Lewis would say the whole lot- Mack, Cruz, Hubler, Adibolo, UBS's senior management, the boards of Morgan Stanley and UBS- are rogues.
And that anybody who buys shares in those firms, or any of their Wall Street ilk, are foolish and deserve what happens to them. Because for less than twenty bucks, any of those shareholders could buy both of Lewis' appropriately well-regarded books, Liar's Poker and The Big Short, and thus be warned of the risks of owning shares of formerly-private investment banks or brokerage firms.
There is, however, a deliciously ironic link between the two tales. For me, it took finishing Michael Lewis' The Big Short to realize the connection. Here's the clue from the Journal piece,
"But in 2007, it hit a rough patch, losing $9 billion on a proprietary mortgage bet that cost the jobs of several of Mr. Mack's lieutenants, including Zoe Cruz, who was widely viewed as a top candidate to succeed Mr. Mack."
Now, it's tempting to think of the Morgan Stanley loss as not caused by a rogue trader. In fact, elsewhere in the Journal article on Mack, it contends,
"He's a battlefield commander who knows how to lead troops......Mr. Mack pushed traders to take more risk and sell more esoteric but profitable mortgage products. Briefly, that move paid off. In 2006, the firm enjoyed record results."
Funny, that's not at all how Michael Lewis described Howie Hubler's calculated $9B loss on mortgage-backed derivatives.
How do you suppose UBS suffered only a $2B loss and blamed it on a rogue trader, whereas John Mack presided over a $9B loss in 2007 and kept his job? In fact, he essentially lost the firm, as it required a federal bailout, plead to convert to a chartered commercial bank, and had to arrange other financing to remain solvent.
Yet Mack kept his job and never called Hubler's loss a rogue trade.
We don't yet know precisely how Adoboli accomplished his allegedly-undetected losing trade(s). One assumes, like Nick Leeson who brought down Barings Bank, he somehow fooled the various electronic systems purporting to monitor positions, desk P&Ls and risk.
But here's how Michael Lewis explains Morgan Stanley's star fixed income trader Howie Hubler's stunning $9B loss. For those wishing to follow along, I'm synopsizing Lewis' Chapter 9 in The Big Short (Norton, 2010), entitled A Death of Interest, pages 200-225. I'm not going to retype the chapter, nor major parts of it, as that would, I think, be a waste of my time, and probably violate Michael Lewis' copyright. Instead, I'm going to abstract the highlights of what went on at John Mack's (and Zoe Cruz's) Morgan Stanley during 2006 & 2007. But I heartily recommend, if you find any of this of interest, that you run over to Amazon and buy a copy (new or, as I prefer, used but 'like new' for only about $6) of Lewis's book.
Howie Hubler was a star trader of mortgage-backed bonds. Sometime in 2004, Hubler begins to realize that a lot of the bonds he's selling, for which Morgan Stanley, like Goldman Sachs, has built its own origination system to capture the entire profit stream, are of highly suspect quality. So he, in conjunction with a colleague, Mike Edman, hatch a proprietary swap which they convince some of their clients to sell to Morgan Stanley. This allows Hubler's desk to own protection, for a small annual fee, on billions of dollars of dodgy subprime-backed mortgage bonds.
Lewis writes,
"It's now April 2006, and the subprime mortgage bond machine is roaring. Howie Hubler is Morgan Stanley's star bond trader, and his group of eight traders is generating, by their estimate, around 20 percent of Morgan Stanley's profits. Their profits have risen from roughly $400 million in 2004 to $700 million in 2005, on their way to $1 billion in 2006. Hubler will be paid $25 million at the end of the year, but he's no longer happy working as an ordinary bond trader......"
Along the lines of my long-expressed belief, Lewis notes that "the best and the brightest Wall Street traders are quitting their big firms to work at hedge funds, where they can make not tens but hundreds of millions."
So Hubler wangles a deal with Morgan Stanley to set up his own proprietary trading group, take his existing desk's swaps positions with him, and get a sweet deal for his group to own a stake in the group, to be subsequently spun out from Morgan Stanley. In short, Hubler extorts Mack and Cruz to give his group a semi-private business and stake in its future value, in return for not bolting from Morgan Stanley.
Here is where the story becomes interesting as it relates to today's WSJ articles about a rogue UBS trader and John Mack being paid homage as a wise senior Wall Street CEO.
Hubler's new group is given a profit bogey of $2B, but is paying about 10% of that, or $200MM, in fees to maintain its swaps, or shorts on bad mortgage bonds. Hubler wants to eliminate this drain, so he sells credit default swaps on a much larger amount of allegedly higher-quality mortgage bonds. About $16B of bonds.
As Lewis puts it,
"In effect, Howie Hubler was betting that some of the triple-B-rated subprime bonds would go bad, but not all of them. He was smart enough to be cynical about his market, but not smart enough to realize how cynical he needed to be."
For some perspective, the original credit default swaps which Hubler and his colleagues sold to their customers only required a 4% default rate among the subprime mortgages backing the bonds, which Lewis writes was expected in good times, to allow the swaps to pay off.
Next, Lewis writes about how Zoe Cruz' risk management people ask for stress tests of Hubler's aggregate positions under scenarios involving a default rate of 10%. A rate Hubler's people, who, remember, are just traders- not PhDs in economics or seasoned mortgage industry researchers (like, for example, Lew Ranieri's original Salomon group contained)- protested would never occur.
I need to make a brief side point here on which I'll elaborate in a subsequent post. Value-at-risk is the main component of most trading desk risk management systems. I've worked on and been around these systems since my days at what is now Accenture consulting back in 1995. One of the problems with VAR systems is that, since they require and assume variance in valuation to impute the capital required for a position, and, thus the losses possible at some probability level, they don't work well with bespoke instruments. Like, say, credit default swaps or so-called 'off the run' fixed income instruments.
Since the entire credit default swap market, as it evolved among AIG, Goldman Sachs, Deutsche Bank, Morgan Stanley, et.al, was a telephone bid/ask market in which valuation was an exercise in judgement, variation in values was meaningless. As my old, sometime-business partner Bob Mankin is fond of saying,
"A model can tell you what something was worth yesterday or may be worth tomorrow. But the only way to know what it's worth today is to sell a piece of it in the market to someone else."
Thus Morgan Stanley's risk group's slow realization that its VAR reports on Hubler's groups risks were also meaningless.
The 10% stress test showed that Hubler's group wasn't short subprime mortgage-backed bonds. It was long, and the 10% default scenario would create a $2.7B loss. Lewis notes that the actual eventual default rate on the bonds on which Hubler sold swaps, i.e., went long, became 40%.
Again, to synopsize, by mid-2007, Deutsche Bank, which had bought the swaps Hubler sold to get a $200MM income stream to offset his negative carry on his base position of being long credit default swaps on allegedly-worse subprime mortgage-backed bonds, called Hubler to demand payment on the shifting, now higher value of the swaps Hubler sold. Again, because they aren't exchange-traded or continuously-quoted instruments, their value was the subject of what, in effect, became a verbal pissing contest between Deutsche and Morgan Stanley. By later in 2007, Morgan Stanley had paid Deutsche Bank at least $3.7B, eventually losing the net $9.2B. Hubler had, as Lewis writes,
"...been allowed to resign in October 2007, with many millions of dollars the firm had promised him at the end of 2006. The total losses he left behind him were reported to the Morgan Stanley board as a bit more than $9 billion: the single largest trading loss in the history of Wall Street......Hubler and his traders thought they were smart guys put on earth to exploit the market's stupid inefficiencies. Instead, they simply contributed more inefficiency."
To further add to today's trading loss/John Mack retirement irony, Lewis continued, on page 216,
"The other, bigger, buyer was UBS- which took $2 billion in Howie Hubler's triple-A CDO's, along with a couple of hundred million dollars' worth of his short position in triple-B-rated bonds.....A few months later, seeking to explain to its shareholders the $37.4 billion it had lost in the U.S. subprime markets, UBS would publish a semi-frank report, in which it revealed that a small group of U.S. bond traders employed by UBS had lobbied hard right up until the end for the bank to buy even more of other Wall Street firms' subprime mortgage bonds.....said one UBS bond trader close to the action, "It was a very controversial trade in UBS. It was kept very, very secret.....He further explained that the traders at UBS who executed the trade were motivated mainly by their own models- which, at the moment of their trade, suggested they had turned a profit of $30 million." "
Small world, indeed, eh?
Now with all this information, stop and reflect with me for a moment.
You are John Mack. It is 2006. You meet with your chief risk officer, Zoe Cruz, to ask for a complete examination of Howie Hubler's group's positions, strategies, assumptions, forecasts, etc., because that single eight-person desk is generating, according to Lewis, roughly 20% of Morgan Stanley's profits. You tell Zoe to set aside an entire day- maybe two. You surely want to understand in detail how these eight traders are producing 20% of your firm's profits, and what concomitant risks they are taking to do so.
Or maybe you don't.
The same thing would seem to apply to Zoe Cruz, would it not? Wouldn't she want to protect herself by conducting such a thorough examination of Hubler's group's business, in order to brief Mack prior to presiding over a blow-up of that desk's business?
Evidently not.
Instead, Lewis quotes verbatim from Mack's December 19, 2007 investor phone call. I won't republish the detailed exchanges between Mack and his questioners, including Goldman Sachs analyst William Tanona. Instead, here's what Lewis wrote about Mack's statements,
"The meaningless flow of words might have left the audience with the sense that it was incapable of parsing the deep complexity of Morgan Stanley's bond trading business. What the words actually revealed was that the CEO himself didn't really understand the situation. John Mack was widely regarded among his CEO peers as relatively well informed about his bond firm's trading risks.....Yet not only had he failed to grasp what his traders were up to, back when they were still up to it; he couldn't even fully explain what they had done after they had lost $9 billion."
In a footnote to the verbatim exchange on page 218, Lewis also wrote,
"What John Mack's trying to say, without coming right out and saying that no one else at Morgan Stanley had a clue what risks Howie Hubler was running, is that no one else at Morgan Stanley had a clue what risks Howie Hubler was running- and neither did Howie Hubler."
In an earlier footnote on page 210, Lewis provides a brief discussion of the differing explanations offered by those close to Hubler and Cruz regarding who was ultimately responsible for Hubler's positions' losses- Hubler or Cruz? Lewis sides with those who believe Hubler hoodwinked Cruz into believing the positions' net risks were minimal.
So, what is my point at the end of this very long post involving today's WSJ articles about yesterday's two big breaking stories at UBS and Morgan Stanley, and their mortgage-backed credit default swaps losses four years ago?
It's that, to me, John Mack shouldn't be retiring now as chairman of Morgan Stanley. He should have been fired by his board in 2007 for allowing Hubler and Cruz to lose $9B on one desk. Then Cruz should have been fired, and Hubler, Cruz and Mack all sued by the Morgan Stanley for fraud and breach of fiduciary duty to the firm's shareholders.
That if Howie Hubler was allowed to exit with tens of millions of dollars, and no criminal charges, after putting a $9B hole in Morgan Stanley's 2007 balance sheet, maybe UBS' Adibolo isn't guilty of anything, either.
Maybe both Hubler and Adibolo are rogue traders, or neither one is.
Now, I know that the foregoing story paints Adibolo as a trader trying to hide his known losses, whereas Hubler is portrayed as just too inept to realize what he thought was a net short position in derivatives was actually a net long position.
Personally, I have some trouble really belieiving Hubler was that stupid. Or, if he was, are we actually to believe that people that stupid can make $25MM a year? Plus, Cruz's people did the stress test which alerted them, and Hubler, to just how risky his positions actually were. So, from that point on, it seems unarguable that all concerned at Morgan Stanley could or should have known the truth about Hubler's positions.
But Lewis' book provides details of how Morgan Stanley dithered over exiting the worsening parts of the group's positions. Was that rogue behavior? By Hubler? Cruz?
Something doesn't add up. That's why I don't see a real difference between Adibolo and Hubler. They both were given license to risk their firms' shareholders' capital, and both lost it in positions which should never apparently ever been allowed to exist.
And, yes, Zoe Cruz did lose her job. But not quite the way I suggested above. And neither she, nor Mack, nor, of course, Hubler were sued for violating their fiduciary duty to their firm's shareholders through either gross incompetence, given their compensation and senior positions, or calculated deceit.
I think Lewis' account puts this week's comparatively paltry $2B UBS loss in perspective. And suggests that UBS has an evidently continuing cultural blind spot that makes it vulnerable to rogue trading, however you choose to define the term.
Lewis' book also begs the question, in my view, that Hubler was also a rogue trader. And perhaps Mack was a rogue CEO all the while.
I suspect, if you asked him, that Michael Lewis would say the whole lot- Mack, Cruz, Hubler, Adibolo, UBS's senior management, the boards of Morgan Stanley and UBS- are rogues.
And that anybody who buys shares in those firms, or any of their Wall Street ilk, are foolish and deserve what happens to them. Because for less than twenty bucks, any of those shareholders could buy both of Lewis' appropriately well-regarded books, Liar's Poker and The Big Short, and thus be warned of the risks of owning shares of formerly-private investment banks or brokerage firms.
Tuesday, May 24, 2011
Holman Jenkins, Jr. On The Missing Rajaratnam Fallout
The Wall Street Journal's Holman Jenkins, Jr. wrote a recent column concerning the Rajaratnam trial and verdict.
Leaving aside the allegations of Jenkins and others that Rajaratnam's crimes were more or less victimless, he rightly expressed outrage that, so far, the real crimes unveiled have gone unpunished.
Specifically, a McKinsey consultant leaking client information, Intel being betrayed by one of its executives and Goldman board meetings being compromised.
Whether or not these are prosecuted, they seem to have paled besides what remains problematic insider trading rules. And how those rules seem to run counter to the principle of wanting as much information represented in stock prices as possible.
It's pretty clear that Rajaratnam knew he was almost certainly violating SEC rules and existing law. It remains unclear whether those laws do much more than occasionally make people feel better by seeing someone prosecuted for violating laws that have dubious value in the first place.
But knowing that these other business people fed Rajaratnam information which was clearly wrongly disclosed is distressing.
As Jenkins noted, those, at least, are the real crimes we can all agree should be wrongful behavior and prosecuted.
Leaving aside the allegations of Jenkins and others that Rajaratnam's crimes were more or less victimless, he rightly expressed outrage that, so far, the real crimes unveiled have gone unpunished.
Specifically, a McKinsey consultant leaking client information, Intel being betrayed by one of its executives and Goldman board meetings being compromised.
Whether or not these are prosecuted, they seem to have paled besides what remains problematic insider trading rules. And how those rules seem to run counter to the principle of wanting as much information represented in stock prices as possible.
It's pretty clear that Rajaratnam knew he was almost certainly violating SEC rules and existing law. It remains unclear whether those laws do much more than occasionally make people feel better by seeing someone prosecuted for violating laws that have dubious value in the first place.
But knowing that these other business people fed Rajaratnam information which was clearly wrongly disclosed is distressing.
As Jenkins noted, those, at least, are the real crimes we can all agree should be wrongful behavior and prosecuted.
Wednesday, October 27, 2010
Tyler Mathisen's Stupidity Is Showing On CNBC Today
Tyler Mathisen managed to demonstrate his incredibly stupidity and failure to grasp the difference between trading and investing this afternoon on CNBC.
It's about 1:40PM as I write this, and Ol' Ty just made a monkey out of himself.
Beginning an on-site report from a conference in Boston, he sputtered, to paraphrase,
'With all these sophisticated, fast trading algorithms, a staid old mutual fund doesn't stand a chance!'
For a guy who has ostensibly been reporting on financial markets for years, Ol' Ty really showed his lack of knowledge in that statement.
One thing which needs to be understood is that no matter how fast and complex the methods that trading desks use will become, they don't have appreciable effects on investments which are not fast-trading strategies.
It's not to say that buy-and-hold for years still works. But failure to buy an equity at the same price as some institutional trader, and paying a few cents more, won't matter much over months.
Of course, if you're Ol' Ty, and work for a network, CNBC, which insists on characterizing every investment decision with the nearly-trademarked phrase,
"So, what's the trade?!"
you wouldn't realize this.
It's bad enough that Ol' Ty can no longer distinguish between institutional trading and retail investing. It's worse when his ignorance and stupidity cause retail investors to misunderstand the markets and panic.
Good job, Ty. Looks like you've earned your money today.
It's about 1:40PM as I write this, and Ol' Ty just made a monkey out of himself.
Beginning an on-site report from a conference in Boston, he sputtered, to paraphrase,
'With all these sophisticated, fast trading algorithms, a staid old mutual fund doesn't stand a chance!'
For a guy who has ostensibly been reporting on financial markets for years, Ol' Ty really showed his lack of knowledge in that statement.
One thing which needs to be understood is that no matter how fast and complex the methods that trading desks use will become, they don't have appreciable effects on investments which are not fast-trading strategies.
It's not to say that buy-and-hold for years still works. But failure to buy an equity at the same price as some institutional trader, and paying a few cents more, won't matter much over months.
Of course, if you're Ol' Ty, and work for a network, CNBC, which insists on characterizing every investment decision with the nearly-trademarked phrase,
"So, what's the trade?!"
you wouldn't realize this.
It's bad enough that Ol' Ty can no longer distinguish between institutional trading and retail investing. It's worse when his ignorance and stupidity cause retail investors to misunderstand the markets and panic.
Good job, Ty. Looks like you've earned your money today.
Friday, June 04, 2010
A New Exodus of Traders From Banks To Hedge Funds
Right on cue, with the recent passage by both Houses of Congress of some form of FINREG bill, traders at publicly-held firms are heading for the exits. The exodus was heralded by yesterday's Wall Street Journal's Money & Investing section's lead article, Hotshot Traders Leave Street.
Seasoned traders at several large commercial banks are now leaving to either start their own hedge funds, or take seed capital from established private funds, such as Citadel.
According to the Journal article, several existing hedge funds have created new structures to fund and, thus, capture some of the newly-fleeing talent from the publicly-held banks.
The only comment I would add is that these hotshots are, in reality, something like a third wave of such an exodus. There haven't been that many stellar performers remaining in the publicly-owned finance sector for some years. What we are now seeing is merely the latest purging of top, young talent following a well-worn path to the shadowy world of hedge funds.
This phenomenon ought to give legislators and would-be regulators pause. After all, doesn't that leave commercial bank trading in the hands of lesser talent? And push the better traders into a less-regulated part of the industry, where oversight is far scarcer, and leverage potentially much greater?
Sounds like a recipe for more counterparty risk and heavy sector losses, as the latest batch of smart young things head off to risk other people's money and pay themselves handsomely in the process, doesn't it?
Seasoned traders at several large commercial banks are now leaving to either start their own hedge funds, or take seed capital from established private funds, such as Citadel.
According to the Journal article, several existing hedge funds have created new structures to fund and, thus, capture some of the newly-fleeing talent from the publicly-held banks.
The only comment I would add is that these hotshots are, in reality, something like a third wave of such an exodus. There haven't been that many stellar performers remaining in the publicly-owned finance sector for some years. What we are now seeing is merely the latest purging of top, young talent following a well-worn path to the shadowy world of hedge funds.
This phenomenon ought to give legislators and would-be regulators pause. After all, doesn't that leave commercial bank trading in the hands of lesser talent? And push the better traders into a less-regulated part of the industry, where oversight is far scarcer, and leverage potentially much greater?
Sounds like a recipe for more counterparty risk and heavy sector losses, as the latest batch of smart young things head off to risk other people's money and pay themselves handsomely in the process, doesn't it?
Tuesday, May 11, 2010
Who's Minding Our Markets?
This morning, CNBC's morning program is still beating a loud drum regarding the sudden drop in equity prices on Thursday afternoon. To facilitate the process, they invited Pennsylvania Democrat Representative Paul Kanjorski to be a guest host. Kanjorski is a member of the House Financial Services Committee, thus, his attraction for CNBC. Talk about one hand washing the other......
It's ironic for CNBC to have Kanjorski guest host to discuss Thursday's alleged trading scandal, because Kanjorski is actually a scandal-tainted legislator, himself. I found this out due to an accident a month or so ago. At the time, I had written a post on one of my blogs involving Kanjorski. Reading through my Sitemeter details of visits, I found that one reader had found my post from a search for 'Kanjorski scandal.'
Sure enough, Kanjorski, a Representative since 1984, has a big earmarking scandal in his past apparently involving using millions of dollars of federal money to enrich his family. Wasn't Kanjorski's regionally-close, Pennsylvania Democratic House colleague John Murtha, also known for excessive, often self-serving earmarks, too? Must be something in the water up in Northeast Pennsylvania.
Anyway, knowing this makes Kanjorski's earnest-looking, solemn attitude regarding finding and punishing equity market traders and 'insiders' much more of a joke. After all, it seems Kanjorski is a veteran 'insider' himself.
But, back to the issue. Kanjorski has been spewing all manner of hot air this morning, no doubt to make ideal campaign sound bites and video clips. Particularly, he went to great lengths to extol the current financial market regulatory personnel as just the best "in 25 years." Really. Honestly.
No matter that a Democratic administration staffed those agencies. And Democratically-controlled committees are taking a 'hands off' approach with Mary Shapiro in the wake of the incident.
And, as I'm writing this, Kanjorski is lampooning voters who blame CRAs, Fannie and Freddie for causing much of the recent mortgage-backed financial meltdown. That, alone, should tell you that Kanjorski is living in an alternative universe where Congress has never done anything to damage our financial system.
By now, though, it's pretty clear what happened on Thursday. The NYSE used its human specialists to engage a trading slowdown. Claiming that a two minute pause in trading does not constitute 'stepping away' from the market, the NYSE chief and his colleagues and defenders all claim they were merely bringing 'order' to markets run amok from too much electronics.
When the NYSE's specialists essentially took a hike on selected equities, the order flow immediately went to the NASDAQ, which, because of the NYSE's absence, had to order match in a less-liquid market. With more sell orders than buy orders, the 'real,' instant market prices fell.
I really don't think what happened is much more complicated than that.
You can conjure up all manner of conspiracy theories, but, in reality, it does seem to be a case of the regulatory authorities allowing for one exchange to engage equity-specific trading halts, while allowing another exchange to trade through.
What do you think will happen in cases where this differential treatment of individual equities occurs? In down markets, prices will gap down. If Thursday had been an up day, prices would have been skipping up discontinuously, and buyers would have complained about missing bids and being filled at what they considered to be ridiculously high prices.
The truth is, the definition of a "market" involves several dimensions. No one buyer or seller can set prices. Prices must be continuous. Price discovery has to be ubiquitous.
If any of these tenets are violated, it's not a 'market' anymore. Therefore, 'market' orders aren't really going to have their desired effect.
Funny how it's become pretty obvious that the cause of Thursday's ultra-sharp sell-off is a regulatory mistake of keeping exchanges in step with each other. But, because it was a regulatory lapse, the party in power is looking elsewhere for someone to blame.
It's ironic for CNBC to have Kanjorski guest host to discuss Thursday's alleged trading scandal, because Kanjorski is actually a scandal-tainted legislator, himself. I found this out due to an accident a month or so ago. At the time, I had written a post on one of my blogs involving Kanjorski. Reading through my Sitemeter details of visits, I found that one reader had found my post from a search for 'Kanjorski scandal.'
Sure enough, Kanjorski, a Representative since 1984, has a big earmarking scandal in his past apparently involving using millions of dollars of federal money to enrich his family. Wasn't Kanjorski's regionally-close, Pennsylvania Democratic House colleague John Murtha, also known for excessive, often self-serving earmarks, too? Must be something in the water up in Northeast Pennsylvania.
Anyway, knowing this makes Kanjorski's earnest-looking, solemn attitude regarding finding and punishing equity market traders and 'insiders' much more of a joke. After all, it seems Kanjorski is a veteran 'insider' himself.
But, back to the issue. Kanjorski has been spewing all manner of hot air this morning, no doubt to make ideal campaign sound bites and video clips. Particularly, he went to great lengths to extol the current financial market regulatory personnel as just the best "in 25 years." Really. Honestly.
No matter that a Democratic administration staffed those agencies. And Democratically-controlled committees are taking a 'hands off' approach with Mary Shapiro in the wake of the incident.
And, as I'm writing this, Kanjorski is lampooning voters who blame CRAs, Fannie and Freddie for causing much of the recent mortgage-backed financial meltdown. That, alone, should tell you that Kanjorski is living in an alternative universe where Congress has never done anything to damage our financial system.
By now, though, it's pretty clear what happened on Thursday. The NYSE used its human specialists to engage a trading slowdown. Claiming that a two minute pause in trading does not constitute 'stepping away' from the market, the NYSE chief and his colleagues and defenders all claim they were merely bringing 'order' to markets run amok from too much electronics.
When the NYSE's specialists essentially took a hike on selected equities, the order flow immediately went to the NASDAQ, which, because of the NYSE's absence, had to order match in a less-liquid market. With more sell orders than buy orders, the 'real,' instant market prices fell.
I really don't think what happened is much more complicated than that.
You can conjure up all manner of conspiracy theories, but, in reality, it does seem to be a case of the regulatory authorities allowing for one exchange to engage equity-specific trading halts, while allowing another exchange to trade through.
What do you think will happen in cases where this differential treatment of individual equities occurs? In down markets, prices will gap down. If Thursday had been an up day, prices would have been skipping up discontinuously, and buyers would have complained about missing bids and being filled at what they considered to be ridiculously high prices.
The truth is, the definition of a "market" involves several dimensions. No one buyer or seller can set prices. Prices must be continuous. Price discovery has to be ubiquitous.
If any of these tenets are violated, it's not a 'market' anymore. Therefore, 'market' orders aren't really going to have their desired effect.
Funny how it's become pretty obvious that the cause of Thursday's ultra-sharp sell-off is a regulatory mistake of keeping exchanges in step with each other. But, because it was a regulatory lapse, the party in power is looking elsewhere for someone to blame.
Friday, May 07, 2010
The NYSE vs. NASDAQ
Quite the interesting remote boxing match this morning on CNBC between the heads of the NYSE and NASDAQ.
Distilled to its essence, the mudslinging between the two chiefs consisted of Duncan Niederauer claiming that the "other exchange," i.e., NASDAQ, had insufficient liquidity to support market orders, while NASDAQ's Bob Greifield accused the NYSE's specialists of, once again, stepping away from filling orders for 90 seconds in an already-plunging market.
Who's right?
It matters, because the NYSE is voiding many trades which rewarded buyers at the very-low prices available once the NYSE's specialists abdicated their role.
Worse, as various pundits noted, many of the institutional buyers brave enough to step in at the bottom and buy, sold out before 4PM for nice gains. Now, they entered this morning short and had to cover.
Whether retail or institutional, investors don't need this sort of game being played. I'm not talking about the plunge in prices, but the arbitrary post-hoc decision to void selective trades. The most profitable, of course.
Funny how that worked, isn't it?
My feeling is that Niederauer's NYSE is the culprit here, not Greifield's NASDAQ. People want to trade, and often allow existing routing systems to "find" the best price. If the NYSE is effectively taking a break, those orders will go to the NASDAQ. If that means lower volume, and automated programs are stepping away lower with bids to buy as sell volume builds, so be it.
Whether it's 1987 or now, using a "market order" during a panic is an invitation to disaster. You have knowingly surrendered to uncontrollable market pricing forces.
If anything, this shows, again, for the zillionth time, that NYSE specialists will violate their duty and step away rather than do their job and provide market liquidity when it goes against them.
Distilled to its essence, the mudslinging between the two chiefs consisted of Duncan Niederauer claiming that the "other exchange," i.e., NASDAQ, had insufficient liquidity to support market orders, while NASDAQ's Bob Greifield accused the NYSE's specialists of, once again, stepping away from filling orders for 90 seconds in an already-plunging market.
Who's right?
It matters, because the NYSE is voiding many trades which rewarded buyers at the very-low prices available once the NYSE's specialists abdicated their role.
Worse, as various pundits noted, many of the institutional buyers brave enough to step in at the bottom and buy, sold out before 4PM for nice gains. Now, they entered this morning short and had to cover.
Whether retail or institutional, investors don't need this sort of game being played. I'm not talking about the plunge in prices, but the arbitrary post-hoc decision to void selective trades. The most profitable, of course.
Funny how that worked, isn't it?
My feeling is that Niederauer's NYSE is the culprit here, not Greifield's NASDAQ. People want to trade, and often allow existing routing systems to "find" the best price. If the NYSE is effectively taking a break, those orders will go to the NASDAQ. If that means lower volume, and automated programs are stepping away lower with bids to buy as sell volume builds, so be it.
Whether it's 1987 or now, using a "market order" during a panic is an invitation to disaster. You have knowingly surrendered to uncontrollable market pricing forces.
If anything, this shows, again, for the zillionth time, that NYSE specialists will violate their duty and step away rather than do their job and provide market liquidity when it goes against them.
Tuesday, May 04, 2010
Just What Is "Proprietary Trading" Anyway?
Much has been made recently of the belief that "proprietary trading" did not actually cause the demise of Bear Stearns or Lehman Brothers, and, thus, is of no consequence in the evolving FINREG bill.
I believe this is wrong. It takes too narrow a view of just what proprietary trading actually entails.
To me, proprietary trading may technically define or describe only those as-principal activities on an investment or commercial bank's trading desks which risk the firm's own capital.
However, the broader notion meant by people like Paul Volcker, in articulating his Volcker Rule is, I believe, that of the risking of a bank's capital on any underwriting, long term investments or high-frequency trading for its own account.
The key common element isn't the duration, which could rule out proprietary trading as the culprit of some now-defunct banks' woes, but, rather, the risking of the bank's own capital in market-valued instruments and activities.
When banks which do this are also in the business of taking insured deposits, then they are implicitly being backed by the FDIC and, ultimately, taxpayers.
Lehman was brought low, in part, by the poor quality of the commercial mortgage assets it chose to hold on its books. That was proprietary investment.
Bear Stearns was believed, by its commercial bank lenders, to have asset quality problems which made those overnight loans too risky.
Were the assets the result of trading, or underwriting, or investment? Doesn't really matter.
They were owned by the firm, and lost more value than there was equity to back them.
Trading...investment.....really, what's in a word, in this case? The time dimension isn't what is important when considering the reform of financial regulations and structure regarding a bank's risk exposure while also taking insured deposits.
The source of the risk capital is.
I believe this is wrong. It takes too narrow a view of just what proprietary trading actually entails.
To me, proprietary trading may technically define or describe only those as-principal activities on an investment or commercial bank's trading desks which risk the firm's own capital.
However, the broader notion meant by people like Paul Volcker, in articulating his Volcker Rule is, I believe, that of the risking of a bank's capital on any underwriting, long term investments or high-frequency trading for its own account.
The key common element isn't the duration, which could rule out proprietary trading as the culprit of some now-defunct banks' woes, but, rather, the risking of the bank's own capital in market-valued instruments and activities.
When banks which do this are also in the business of taking insured deposits, then they are implicitly being backed by the FDIC and, ultimately, taxpayers.
Lehman was brought low, in part, by the poor quality of the commercial mortgage assets it chose to hold on its books. That was proprietary investment.
Bear Stearns was believed, by its commercial bank lenders, to have asset quality problems which made those overnight loans too risky.
Were the assets the result of trading, or underwriting, or investment? Doesn't really matter.
They were owned by the firm, and lost more value than there was equity to back them.
Trading...investment.....really, what's in a word, in this case? The time dimension isn't what is important when considering the reform of financial regulations and structure regarding a bank's risk exposure while also taking insured deposits.
The source of the risk capital is.
Friday, April 16, 2010
The Need For A Simple Glass-Steagal Replacement Now
My friend, colleague and periodic business partner B sent me an email the other day including this passage,
"Yesterday, Morgan Stanley was reported to be bulking up its trading staff (adding about 350 people). Its major competition in trading is seen as JP Morgan Chase and Goldman. Today, the Journal headlined, “Property Loss Pounds Morgan Stanley Bank Says Battered $8.8 Billion Real-Estate Fund Stands to Lose Nearly Two-Thirds of Its Value”. "
B's point is that Morgan Stanley could, quite easily and quickly, now that it's a commercial bank, become a major systemic liability and source of risk- again.
When I had lunch with B on Tuesday, he remarked approvingly on the Volcker Rule. Like me, he sees it as a necessary step to segregate federally-, that is, taxpayer-insured banking activities from any financial activities in the areas of underwriting, proprietary trading or investment in non-Treasury assets.
B noted that, having narrowly escaped destruction under John Mack's questionable leadership, Morgan Stanley is far from chastened. Instead, it's hiring literally hundreds of traders and re-entering the proprietary trading arena. Meanwhile, the Wall Street Journal hails Morgan Stanley's leftover troubles with the headline announcing the sizable losses in its real estate investment funds.
Do you, as a taxpayer, really want a gang that lost so much money in real estate investing to be jumping back into proprietary trading in such a major way?
Forget the complex, mistake-riddled omnibus financial regulation bill discredited Senator Chris Dodd is trying to ram through Congress.
What we need, right now, is a simple, clear reenactment of Glass Steagal, as currently articulated by the Volcker Rule.
If this doesn't happen, there's no reason to doubt a repeat of Morgan Stanley's catastrophic, nearly-lethal risky behavior of earlier this decade. After all, it's not their money they are betting- it's yours. You just don't get the upside if they win. Only the downside, when they eventually lose it all.
"Yesterday, Morgan Stanley was reported to be bulking up its trading staff (adding about 350 people). Its major competition in trading is seen as JP Morgan Chase and Goldman. Today, the Journal headlined, “Property Loss Pounds Morgan Stanley Bank Says Battered $8.8 Billion Real-Estate Fund Stands to Lose Nearly Two-Thirds of Its Value”. "
B's point is that Morgan Stanley could, quite easily and quickly, now that it's a commercial bank, become a major systemic liability and source of risk- again.
When I had lunch with B on Tuesday, he remarked approvingly on the Volcker Rule. Like me, he sees it as a necessary step to segregate federally-, that is, taxpayer-insured banking activities from any financial activities in the areas of underwriting, proprietary trading or investment in non-Treasury assets.
B noted that, having narrowly escaped destruction under John Mack's questionable leadership, Morgan Stanley is far from chastened. Instead, it's hiring literally hundreds of traders and re-entering the proprietary trading arena. Meanwhile, the Wall Street Journal hails Morgan Stanley's leftover troubles with the headline announcing the sizable losses in its real estate investment funds.
Do you, as a taxpayer, really want a gang that lost so much money in real estate investing to be jumping back into proprietary trading in such a major way?
Forget the complex, mistake-riddled omnibus financial regulation bill discredited Senator Chris Dodd is trying to ram through Congress.
What we need, right now, is a simple, clear reenactment of Glass Steagal, as currently articulated by the Volcker Rule.
If this doesn't happen, there's no reason to doubt a repeat of Morgan Stanley's catastrophic, nearly-lethal risky behavior of earlier this decade. After all, it's not their money they are betting- it's yours. You just don't get the upside if they win. Only the downside, when they eventually lose it all.
Friday, February 12, 2010
More On Scott Patterson's "The Quants"
I last wrote about Wall Street Journal reporter Scott Patterson's new book, The Quants, here on Monday of this week. At the time, I'd read less than a third of the book.
Yesterday morning I finished it. I'd still recommend it as a very useful read. However, as I made my way through more and more of the book, it began to feel not only like a cross between Tom Wolfe and Michael Lewis, but Ayn Rand began to appear, as well.
By that I mean the following. When I read Atlas Shrugged, it took very little time to realize that Rand was a poor writer when it came to doing much more than espousing her philosophies. Character development and, in particular, romantic scenes in her book were so poorly written that I learned to just optically scan over those passages and return to full reading comprehension when they had ended.
Another major annoyance, and what I would call a glaring defect, is Patterson's apparent need to label certain phenomena with cute names. Perhaps it stems from post-The Right Stuff style requirements. When Tom Wolfe coined that term, it was a relatively new idea. And, anyway, Wolfe made somewhat of a career, as a leading writer of the new school of the late '60s, labeling phenomena.
Patterson calls the interconnected financial markets of the modern era The Money Grid, while the much-sought after inefficiencies in financial markets, when found and implemented to create wealth for the quants, becomes The Truth.
By the book's end, I'd become sickened by the word "truth," he'd employed it in so many predictable, silly passages.
I like Patterson's WSJ columns, and even his book. But he's no Tom Wolfe. Not yet, anyway.
Patterson does, however, a truly wonderful job cataloging the roots of modern quantitative trading in financial markets. That's why the first third of the book is so captivating.
When he turns his focus to the books four main contemporary characters- Peter Muller (Morgan Stanley's PDT) , Boaz Weinstein (Deutsche Bank) , Cliff Asness (AQR) and Ken Griffin (Citadel)- he becomes infatuated with their personal lives, idiosyncrasies and immense wealth.
As a result, the last third of the book can be read quite quickly, because so much of it cites all manner of numbers of total fund assets, losses, equity, and personal fortunes of the protagonists. Plus their various romantic couplings, births of children, latest expensive mansion purchase, etc.
To put Patterson's book in perspective, let me express it thus. He provides deep and numerous empirical confirmations that several things which I have long contended, and expressed in prior posts on various related topics, are, according to Patterson, true of this class of quantitative traders:
1. They all exhibit a shallower comprehension for the human behavioral aspects of financial markets than their mentors.
2. With each succeeding generation of acolytes, the belief that pure mathematical and statistical methods can apply, sans contextual understanding, to financial markets grows stronger, and the awareness of key underlying, limiting assumptions grows weaker.
3. Crucial dimensions of risk management for both the hedge funds, and the instruments they often trade, e.g., leverage, collateral, and ability to meet an instrument's, such as a credit derivative swap's obligations, are profoundly separated from the actual trading activities.
4. As such, both senior managers of the firms engaging in these activities, as well as counterparties, bear significant responsibility for having little understanding of the pragmatic aspects of risks which were undertaken by these quantitative traders.
5. Perhaps most ironically, all of the current generation of quantitative traders believed in exceptions to Eugene Fama's general EMH model, yet, in a fallacy of composition, when, together, they exploit commonly-observed inefficiencies, they become the very agents of EMH, obliterating the profitable inefficiencies they so recently observed and on which they traded.
At the book's end, Patterson brings back several historical figures from the earlier part, including Ed Thorp, Nassim Taleb and Benoit Mandelbrot. He has them voicing knowing sentiments concerning the eventual meltdown of the quants' funds from over-leveraged, commonly-held positions which were all simultaneously undone by the behavior of other investors which had not been modeled by the quants' research.
However, my fourth point is distressingly not explicitly driven home by Patterson. He succeeds marvelously in providing all the supporting evidence. He has the salient characters, including Fama and his ilk, in the book. The stage is magnificently set for Patterson to coyly spring the ultimate irony.
But he never delivers on it.
You have to figure that one out for yourself. Which is a pity.
Because if there is any one, over-arching, ultimate Truth (my bad- I can't resist mocking his label) to the book, it is the totality of the book's contemporary content in proving that, even when quantitative mavens find and exploit market inefficiencies, to the contradiction of the Chicago School's contention, they are, in reality, simply becoming players in that school's EMH world, pushing values back in line and eliminating the profitable inefficiencies.
That so few of these quants expected this is somewhat shocking. That they persisted, and persist, still, in believing they can escape this self-fulfilling prophecy is perhaps more shocking.
After a bit more reflection, I'm going to write a post discussing, from the viewpoint of Patterson's book, the folly of the TARP, government intervention, and implicit saving of the quant funds by the federal government.
Yesterday morning I finished it. I'd still recommend it as a very useful read. However, as I made my way through more and more of the book, it began to feel not only like a cross between Tom Wolfe and Michael Lewis, but Ayn Rand began to appear, as well.
By that I mean the following. When I read Atlas Shrugged, it took very little time to realize that Rand was a poor writer when it came to doing much more than espousing her philosophies. Character development and, in particular, romantic scenes in her book were so poorly written that I learned to just optically scan over those passages and return to full reading comprehension when they had ended.
Another major annoyance, and what I would call a glaring defect, is Patterson's apparent need to label certain phenomena with cute names. Perhaps it stems from post-The Right Stuff style requirements. When Tom Wolfe coined that term, it was a relatively new idea. And, anyway, Wolfe made somewhat of a career, as a leading writer of the new school of the late '60s, labeling phenomena.
Patterson calls the interconnected financial markets of the modern era The Money Grid, while the much-sought after inefficiencies in financial markets, when found and implemented to create wealth for the quants, becomes The Truth.
By the book's end, I'd become sickened by the word "truth," he'd employed it in so many predictable, silly passages.
I like Patterson's WSJ columns, and even his book. But he's no Tom Wolfe. Not yet, anyway.
Patterson does, however, a truly wonderful job cataloging the roots of modern quantitative trading in financial markets. That's why the first third of the book is so captivating.
When he turns his focus to the books four main contemporary characters- Peter Muller (Morgan Stanley's PDT) , Boaz Weinstein (Deutsche Bank) , Cliff Asness (AQR) and Ken Griffin (Citadel)- he becomes infatuated with their personal lives, idiosyncrasies and immense wealth.
As a result, the last third of the book can be read quite quickly, because so much of it cites all manner of numbers of total fund assets, losses, equity, and personal fortunes of the protagonists. Plus their various romantic couplings, births of children, latest expensive mansion purchase, etc.
To put Patterson's book in perspective, let me express it thus. He provides deep and numerous empirical confirmations that several things which I have long contended, and expressed in prior posts on various related topics, are, according to Patterson, true of this class of quantitative traders:
1. They all exhibit a shallower comprehension for the human behavioral aspects of financial markets than their mentors.
2. With each succeeding generation of acolytes, the belief that pure mathematical and statistical methods can apply, sans contextual understanding, to financial markets grows stronger, and the awareness of key underlying, limiting assumptions grows weaker.
3. Crucial dimensions of risk management for both the hedge funds, and the instruments they often trade, e.g., leverage, collateral, and ability to meet an instrument's, such as a credit derivative swap's obligations, are profoundly separated from the actual trading activities.
4. As such, both senior managers of the firms engaging in these activities, as well as counterparties, bear significant responsibility for having little understanding of the pragmatic aspects of risks which were undertaken by these quantitative traders.
5. Perhaps most ironically, all of the current generation of quantitative traders believed in exceptions to Eugene Fama's general EMH model, yet, in a fallacy of composition, when, together, they exploit commonly-observed inefficiencies, they become the very agents of EMH, obliterating the profitable inefficiencies they so recently observed and on which they traded.
At the book's end, Patterson brings back several historical figures from the earlier part, including Ed Thorp, Nassim Taleb and Benoit Mandelbrot. He has them voicing knowing sentiments concerning the eventual meltdown of the quants' funds from over-leveraged, commonly-held positions which were all simultaneously undone by the behavior of other investors which had not been modeled by the quants' research.
However, my fourth point is distressingly not explicitly driven home by Patterson. He succeeds marvelously in providing all the supporting evidence. He has the salient characters, including Fama and his ilk, in the book. The stage is magnificently set for Patterson to coyly spring the ultimate irony.
But he never delivers on it.
You have to figure that one out for yourself. Which is a pity.
Because if there is any one, over-arching, ultimate Truth (my bad- I can't resist mocking his label) to the book, it is the totality of the book's contemporary content in proving that, even when quantitative mavens find and exploit market inefficiencies, to the contradiction of the Chicago School's contention, they are, in reality, simply becoming players in that school's EMH world, pushing values back in line and eliminating the profitable inefficiencies.
That so few of these quants expected this is somewhat shocking. That they persisted, and persist, still, in believing they can escape this self-fulfilling prophecy is perhaps more shocking.
After a bit more reflection, I'm going to write a post discussing, from the viewpoint of Patterson's book, the folly of the TARP, government intervention, and implicit saving of the quant funds by the federal government.
Monday, January 25, 2010
Excerpt from Scott Paterson's New Book "The Quants"
The weekend edition of the Wall Street Journal contained a very thought-provoking excerpt of its reporter, Scott Paterson's, new book, "The Quants."
Based on the lengthy piece in the Journal, this is one book that promises to be worth reading.
The review provides a synopsis of some of Paterson's reporting results, primarily from the viewpoint of a secretive quantitative proprietary hedge fund known as the Process Driven Trading group, within Morgan Stanley.
Describing the group, Paterson writes,
"Instead of looking at individual companies and their performance, management and competitors, they use math formulas to make bets on which stocks were going up or down. By the early 2000s, such tech-savvy investors had come to dominate Wall Street, helped by theoretical breakthroughs in the application of mathematics to financial markets, advances that had earned their discoverers several shelves of Nobel Prizes."
Sound familiar?
It should. Paterson's description of Morgan Stanley's PDT group is almost identical to the image and composition of another infamous hedge fund, John Meriwether's Long Term Capital Management. That group, which was largely composed of an exodus of talent from then-independent Salomon Brothers, plus a helping of Nobel Laureates, including Myron Scholes and Robert Merton, attempted to exploit the same sorts of arbitrage opportunities in global securities markets.
LTCM didn't pan out as expected, shutting its doors in bankruptcy after only six years. And causing concern that its failure would bring down global capital markets.
What Paterson's teasing sample reveals is that, well, there really is nothing much new in financial markets.
Back in 1987, the then-experts in trading and risk management were convinced "portfolio insurance" strategies would avoid catastrophic losses. They didn't. Instead, identically-designed risk management systems all dumped the same types of securities amidst a sudden downdraft of equity prices, causing a torrential selloff.
Then again, in 1998, LTCM triggered the same phenomenon. Of course, that time, the underlying hedges were much, much more sophisticated than those of 1987. Back then, the big fad was lightning-fast trading of baskets of S&P components to exploit minute, fleeting price differentials.
By 1998, with tremendous advances in computing power and speed of data communications, LTCM's traders were able to construct far more elaborate, incomprehensible hedges which unwound in almost completely-opaque fashion. Opaque even to their designers.
Now, thanks to Paterson's brief excerpt in Saturday's Journal, we see that the quants were at it again. It's always the same. Bright young 20+ and 30+ year olds who've never seen a market meltdown apply the latest mathematical and physics advances to series of securities market data.
They may have read the fundamental papers on portfolio theory from the 1950s, but probably not. They may be familiar with the pesky, annoying details of minimum assumptions underlying the existence and behavior of liquid securities markets, but probably not.
What they are familiar with is how to take many series of data and extract measures of variance and covariance. Nevermind that what they 'discover' are temporal relationships of abstruse complexity underpinned by then-existing market environments.
To the latest generation of quant trading jockeys, it's all a straightforward application of math to securities markets prices.
The field you never see plumbed nor represented on the hot Wall Street hedge fund trading desks is..... catastrophe theory. The body of work exploring what happens when there are profoundly discontinuous changes in environments which cause rapid and extreme dislocations in outcomes of some system.
From my own background in statistics, I can assure you that the sorts of statistical methods most commonly applied by quants tend to require assumptions of continuity in pricing inputs and behaviors.
Precisely the conditions which send prices moving discontinuously are what tend to be unquantifiable. Especially when those conditions are triggered and amplified by a few dozen hedge funds operating similarly-based quant trading systems.
I've written about this before in posts under the 'Risk Management' label.
What happened in 2007-08 was, it appears, nothing more than the latest version of the application of the most current mathematical methods to series of securities prices which are, in reality, not naturally-occurring forces of nature, but the varying outcomes of human behaviors.
It's telling that, at the end of Paterson's excerpt, Peter Muller, head of PDT, has only two options: hold or fold/sell. He opts to sell.
That's another common element of quant strategies. They assume plentiful capital, or some sort of calm, VAR-based orderly loss of position values which allows a methodical unwinding of desk positions. But that's not what happens in a market meltdown.
Instead, position values melt away and erode capital, triggering risk alarms, margin calls and the need to sell positions in order to conform to capital requirements.
Ah, those pesky day-to-day operating assumptions and details.
If only....if only.....
By now, anyone my age or older, or even a decade younger, should understand that simply because hedge funds are run by people with names like Cliff Asness or Peter Muller, or John Meriweither, with pedigrees from Goldman Sachs, Morgan Stanley or Salomon Brothers, hardly means they will survive the test of a market collapse.
Sure, they'll no doubt do very well in a reasonably calm, or even frothy upward-moving market. Or a prolonged, gradual market decline.
But the sort of market conditions which are the specialty of Nassim Taleb, the market composed of sudden shear forces, seems to cripple these quant hedging strategies every time. Every decade, in fact.
No, there really doesn't seem to be much new in financial markets when it comes to advanced risk management, complex hedging strategies and quant models. They work really well- until they don't. Then they fail spectacularly, in concert, and turn ordinary market downturns into market panics.
Based on the lengthy piece in the Journal, this is one book that promises to be worth reading.
The review provides a synopsis of some of Paterson's reporting results, primarily from the viewpoint of a secretive quantitative proprietary hedge fund known as the Process Driven Trading group, within Morgan Stanley.
Describing the group, Paterson writes,
"Instead of looking at individual companies and their performance, management and competitors, they use math formulas to make bets on which stocks were going up or down. By the early 2000s, such tech-savvy investors had come to dominate Wall Street, helped by theoretical breakthroughs in the application of mathematics to financial markets, advances that had earned their discoverers several shelves of Nobel Prizes."
Sound familiar?
It should. Paterson's description of Morgan Stanley's PDT group is almost identical to the image and composition of another infamous hedge fund, John Meriwether's Long Term Capital Management. That group, which was largely composed of an exodus of talent from then-independent Salomon Brothers, plus a helping of Nobel Laureates, including Myron Scholes and Robert Merton, attempted to exploit the same sorts of arbitrage opportunities in global securities markets.
LTCM didn't pan out as expected, shutting its doors in bankruptcy after only six years. And causing concern that its failure would bring down global capital markets.
What Paterson's teasing sample reveals is that, well, there really is nothing much new in financial markets.
Back in 1987, the then-experts in trading and risk management were convinced "portfolio insurance" strategies would avoid catastrophic losses. They didn't. Instead, identically-designed risk management systems all dumped the same types of securities amidst a sudden downdraft of equity prices, causing a torrential selloff.
Then again, in 1998, LTCM triggered the same phenomenon. Of course, that time, the underlying hedges were much, much more sophisticated than those of 1987. Back then, the big fad was lightning-fast trading of baskets of S&P components to exploit minute, fleeting price differentials.
By 1998, with tremendous advances in computing power and speed of data communications, LTCM's traders were able to construct far more elaborate, incomprehensible hedges which unwound in almost completely-opaque fashion. Opaque even to their designers.
Now, thanks to Paterson's brief excerpt in Saturday's Journal, we see that the quants were at it again. It's always the same. Bright young 20+ and 30+ year olds who've never seen a market meltdown apply the latest mathematical and physics advances to series of securities market data.
They may have read the fundamental papers on portfolio theory from the 1950s, but probably not. They may be familiar with the pesky, annoying details of minimum assumptions underlying the existence and behavior of liquid securities markets, but probably not.
What they are familiar with is how to take many series of data and extract measures of variance and covariance. Nevermind that what they 'discover' are temporal relationships of abstruse complexity underpinned by then-existing market environments.
To the latest generation of quant trading jockeys, it's all a straightforward application of math to securities markets prices.
The field you never see plumbed nor represented on the hot Wall Street hedge fund trading desks is..... catastrophe theory. The body of work exploring what happens when there are profoundly discontinuous changes in environments which cause rapid and extreme dislocations in outcomes of some system.
From my own background in statistics, I can assure you that the sorts of statistical methods most commonly applied by quants tend to require assumptions of continuity in pricing inputs and behaviors.
Precisely the conditions which send prices moving discontinuously are what tend to be unquantifiable. Especially when those conditions are triggered and amplified by a few dozen hedge funds operating similarly-based quant trading systems.
I've written about this before in posts under the 'Risk Management' label.
What happened in 2007-08 was, it appears, nothing more than the latest version of the application of the most current mathematical methods to series of securities prices which are, in reality, not naturally-occurring forces of nature, but the varying outcomes of human behaviors.
It's telling that, at the end of Paterson's excerpt, Peter Muller, head of PDT, has only two options: hold or fold/sell. He opts to sell.
That's another common element of quant strategies. They assume plentiful capital, or some sort of calm, VAR-based orderly loss of position values which allows a methodical unwinding of desk positions. But that's not what happens in a market meltdown.
Instead, position values melt away and erode capital, triggering risk alarms, margin calls and the need to sell positions in order to conform to capital requirements.
Ah, those pesky day-to-day operating assumptions and details.
If only....if only.....
By now, anyone my age or older, or even a decade younger, should understand that simply because hedge funds are run by people with names like Cliff Asness or Peter Muller, or John Meriweither, with pedigrees from Goldman Sachs, Morgan Stanley or Salomon Brothers, hardly means they will survive the test of a market collapse.
Sure, they'll no doubt do very well in a reasonably calm, or even frothy upward-moving market. Or a prolonged, gradual market decline.
But the sort of market conditions which are the specialty of Nassim Taleb, the market composed of sudden shear forces, seems to cripple these quant hedging strategies every time. Every decade, in fact.
No, there really doesn't seem to be much new in financial markets when it comes to advanced risk management, complex hedging strategies and quant models. They work really well- until they don't. Then they fail spectacularly, in concert, and turn ordinary market downturns into market panics.
Monday, October 26, 2009
Boudreaux On Insider Trading
In this weekend's Wall Street Journal, Donald Boudreaux wrote an excellent piece defending much insider trading while lampooning attempts to regulate it, over and above measures which corporations take to limit it.
Simply put, Boudreaux distinguishes between coming events which corporations will wish to keep secret, such as corporate acquisitions, and continuing situations and processes, such as accounting irregularities or incorrect investor expectations, of which anyone with full knowledge of the situation can take advantage, leading to more fully-informed market pricing.
Boudreaux makes a persuasive case that companies know better which information they want to protect, such as event-oriented acquisition information, far more so than federal regulators.
However, citing the Enron case, Boudreaux notes that insiders who would have had knowledge of Enron's fraudulent accounting and practices, and sold Enron shares on that basis, would have helped the market more correctly price the firm's shares lower.
Further, Boudreaux notes, current attempts to ferret out insider trading is biased. Regulators can only look for those who trade on generally-unknown news, not those who do not trade, but would have, absent generally-unknown news.
It's a very interesting and valid point. Insider knowledge of a failed drug certification, new product, etc., could lead someone to not buy shares. But this lack of otherwise-planned action will never be detected, leading to asymmetrical, unfair enforcement of the misguided federal notion of insider trading.
Boudreaux helpfully reminds us that markets serve to efficiently price securities by virtue of incorporating as much news as possible into their prices. The so-called 'price discovery' process.
Insider trading, he notes, contributes to this objective, rather than corrupts it. So why would we want to punish those who help make markets more efficient?
Simply put, Boudreaux distinguishes between coming events which corporations will wish to keep secret, such as corporate acquisitions, and continuing situations and processes, such as accounting irregularities or incorrect investor expectations, of which anyone with full knowledge of the situation can take advantage, leading to more fully-informed market pricing.
Boudreaux makes a persuasive case that companies know better which information they want to protect, such as event-oriented acquisition information, far more so than federal regulators.
However, citing the Enron case, Boudreaux notes that insiders who would have had knowledge of Enron's fraudulent accounting and practices, and sold Enron shares on that basis, would have helped the market more correctly price the firm's shares lower.
Further, Boudreaux notes, current attempts to ferret out insider trading is biased. Regulators can only look for those who trade on generally-unknown news, not those who do not trade, but would have, absent generally-unknown news.
It's a very interesting and valid point. Insider knowledge of a failed drug certification, new product, etc., could lead someone to not buy shares. But this lack of otherwise-planned action will never be detected, leading to asymmetrical, unfair enforcement of the misguided federal notion of insider trading.
Boudreaux helpfully reminds us that markets serve to efficiently price securities by virtue of incorporating as much news as possible into their prices. The so-called 'price discovery' process.
Insider trading, he notes, contributes to this objective, rather than corrupts it. So why would we want to punish those who help make markets more efficient?
Monday, September 15, 2008
Trading Counterparties, Systemic Risk & Investment Bank Collapses
The weekend edition of the Wall Street Journal contained an article bemoaning the lack of a centralized exchange for various derivative and swap transactions, in the wake of March's crisis involving Bear Stearns, and the current worries over Lehman's solvency.
What strikes me as odd is how apparently fragile and susceptible to counterparty risk our financial system is, a full ten years after the LTCM meltdown.
I notice that, although 'investment banks' are involved in recent troubles, it's always their trading desks which are the cause, through the use of over-the-counter, or non-exchanged cleared instruments.
It gives me great pause to wonder how we can continue to let our financial system appear to be hostage to one mid-sized trading operation failing to make good on its obligations?
Isn't the current environment one in which each trading operation is expected to manage the risk of its counterparties? Why should the Federal government have to intercede for so many questionable positions?
Perhaps what we should acknowledge is that, when instruments are traded without an exchange which requires deposits for positions, the entire system is liable to the degree of the worst party's risk management practices.
If one trading house exercises sloppy, inadequate risk management, and thereby loses money due to a counterparty's failure to perform, and, thus, sets off a chain reaction, then even the best-run, risk-managed party is at risk.
I suppose that, over the past 10-20 years, trading volumes ballooned in off-exchange instruments, and trading function managers, as so many financial executives, have not seriously considered the systemic component of counterparty risk in their derivatives and swaps positions.
Perhaps the lack of a serious default of a counterparty has blinded the risk-allocation and -assessment models used by many trading houses to the actual losses which would occur in that event.
This is quite troubling to me, because common sense would have you expect that Lehman's demise should not cause all that much loss. By now, one would hope that either writedowns are taken on the positions, by the counterparties, or collateral increases are required.
Why should the mere bankruptcy of Lehman cause such concern in the financial community, if it is composed of competent traders, trading and risk managers? Are we in such short supply of competent financial service executives that this is really an issue?
I don't recall this sort of concern when Drexel Burnham Lambert was pushed into dissolution. Why is it so different, and more urgent, now?
Have non-exchange trading markets really grown so large and risky that any counterparty's demise will cause a systemic disaster?
What strikes me as odd is how apparently fragile and susceptible to counterparty risk our financial system is, a full ten years after the LTCM meltdown.
I notice that, although 'investment banks' are involved in recent troubles, it's always their trading desks which are the cause, through the use of over-the-counter, or non-exchanged cleared instruments.
It gives me great pause to wonder how we can continue to let our financial system appear to be hostage to one mid-sized trading operation failing to make good on its obligations?
Isn't the current environment one in which each trading operation is expected to manage the risk of its counterparties? Why should the Federal government have to intercede for so many questionable positions?
Perhaps what we should acknowledge is that, when instruments are traded without an exchange which requires deposits for positions, the entire system is liable to the degree of the worst party's risk management practices.
If one trading house exercises sloppy, inadequate risk management, and thereby loses money due to a counterparty's failure to perform, and, thus, sets off a chain reaction, then even the best-run, risk-managed party is at risk.
I suppose that, over the past 10-20 years, trading volumes ballooned in off-exchange instruments, and trading function managers, as so many financial executives, have not seriously considered the systemic component of counterparty risk in their derivatives and swaps positions.
Perhaps the lack of a serious default of a counterparty has blinded the risk-allocation and -assessment models used by many trading houses to the actual losses which would occur in that event.
This is quite troubling to me, because common sense would have you expect that Lehman's demise should not cause all that much loss. By now, one would hope that either writedowns are taken on the positions, by the counterparties, or collateral increases are required.
Why should the mere bankruptcy of Lehman cause such concern in the financial community, if it is composed of competent traders, trading and risk managers? Are we in such short supply of competent financial service executives that this is really an issue?
I don't recall this sort of concern when Drexel Burnham Lambert was pushed into dissolution. Why is it so different, and more urgent, now?
Have non-exchange trading markets really grown so large and risky that any counterparty's demise will cause a systemic disaster?
Wednesday, June 25, 2008
George Soros' World-Class Ego
This past weekend's Wall Street Journal edition carried a piece on George Soros' latest warning- an asset 'superbubble.'
Like Julian Robertson and Michael Steinhardt, George Soros seems to get lavish attention long after his period of successful trading, or investing, if you prefer, has ended.
The Journal article notes that Soros made large fortunes in 1992 and 1997 by betting, respectively, against the pound and the bhat. While never proven, rumors have always swirled around Soros concerning whether or not he was the recipient of insider leaks about the British financial authority's intentions regarding the pound.
Now, writes Greg Ip, Soros,
"wants to be remembered most as a philosopher. Since he was a student in 1952, he has been promoting his economic theory, which he calls 'reflexivity.'
In essence, he argues that markets don't simply reflect fundamental determinants but can change those determinants in a way that causes asset prices to go to extremes. In his latest book, "The New Paradigm for Financial Markets," he argues a "superbubble" has developed in the past 25 years and it is now collapsing."
Ip notes that Soros' predictions have routinely falled wide of the mark. He prematurely sounded the death of the US dollar in 1987, yet neither the world-wide depression, nor global conflict of which he warned have arrived. In 1998, he claimed that
"The global capitalist system....is coming apart at the seams."
Actually, it would seem that in the decade since Soros wrote that somber prediction, global capitalism has contributed to more trade, wealth creation and freedom than ever before in man's history.
Believe it or not, Soros actually alleges that, because in the story about 'the boy who cried wolf,' the wolf really arrived after three warnings, his three most recent books warning of global economic catastrophe mean he is now probably correct.
I'm serious. Greg Ip's piece quotes that comparison by Soros. You cannot make up stories this silly.
To prove how important his ideas are, Soros notes,
"The most popular reaction to my philosophy is....success has gone to his head and he wants to be more than what he is....But I would like my ideas to be judged on their own merit. I think I'm on the verge. For the first time, this book is a best seller. I was asked to testify (before the Senate Commerce Committee) because a staff member read the book."
Well, if I told George Soros that I happened to see a copy of his book in the garbage, would he promptly declare it to be garbage, too?
If he seriously believes that because some no-name staffer to some Senatorial windbag read his book, it now is important, his long-ago success has gone to his head.
I laughed when I read the next passage, where Soros answers Ip's question about whether policy or academic heavyweights are noticing his ideas,
"It has certainly not penetrated academia, and not policy makers, either. I wish I could engage in a discussion with (the Federal Reserve). I'm waiting for a phone call. I'm (meeting with) Alan Greenspan."
These days, I don't think Greenspan's such a hot economic ticket, George.
At the end of Ip's piece, he quotes Soros actually saying something interesting,
"This is, of course, [Joseph] Schumpeter's creative destruction idea. However ... going overboard in generating change is not necessarily a good thing. Financial innovation may not be an unmixed blessing because it really prevents proper regulation.
If you look at the 19th century, you had creative destruction going on, one financial crisis after another. But each time you had a crisis, you had an examination of what went wrong, and you put in some instrument or some institution to prevent it from happening.
I'm not advocating ... central planning because that's worse than markets. But the regulators need to learn from the mistakes that they have made. I think it's pretty clear that you've got to accept responsibility for moderating asset bubbles. ... That involves regulating credit as well as [interest rates]."
It's not clear what Soros is actually saying here beyond the existing awareness that some regulation of financial services is a beneficial activity. He does not speak to the perennial difficulty of staffing such governmental entities with employees who are as motivated and intelligent as those whom they would regulate.
Perhaps what would satisfy Soros, and it would satisfy me, is to regulate certain classes of financial services activities, such as insured deposit-taking, residential mortgage, consumer and conventional business lending, and transactions processing, very strictly and heavily, so as to safeguard these core economic activities.
Non-commercial banking practices involving riskier investments will always be subject to loss of capital and liquidity risks, to name just two. It's unclear how much regulation can function effectively, other than to try to herd over the counter markets, such as swaps, into exchanges. The Treasury, under Paulson, is already headed that way.
As I wrote here a while ago, in response to Henry Kaufman's tirade against financial innovation, I think, over time, we've been far better served by the phenomenon than we've been hurt by it.
I think Soros' thinking here is muddled, if it's anything relevant at all.
Why does anyone pay attention to him? Because, I guess, like Robertson and Steinhardt, once, years ago, in different market conditions, George Soros made a lot of money. And even he confirms it was due in no small measure to luck.
So on this basis, we should all listen to his personal crackpot theory of 'reflexivity?'
God help us if that's what we've sunk to in the US.
Like Julian Robertson and Michael Steinhardt, George Soros seems to get lavish attention long after his period of successful trading, or investing, if you prefer, has ended.
The Journal article notes that Soros made large fortunes in 1992 and 1997 by betting, respectively, against the pound and the bhat. While never proven, rumors have always swirled around Soros concerning whether or not he was the recipient of insider leaks about the British financial authority's intentions regarding the pound.
Now, writes Greg Ip, Soros,
"wants to be remembered most as a philosopher. Since he was a student in 1952, he has been promoting his economic theory, which he calls 'reflexivity.'
In essence, he argues that markets don't simply reflect fundamental determinants but can change those determinants in a way that causes asset prices to go to extremes. In his latest book, "The New Paradigm for Financial Markets," he argues a "superbubble" has developed in the past 25 years and it is now collapsing."
Ip notes that Soros' predictions have routinely falled wide of the mark. He prematurely sounded the death of the US dollar in 1987, yet neither the world-wide depression, nor global conflict of which he warned have arrived. In 1998, he claimed that
"The global capitalist system....is coming apart at the seams."
Actually, it would seem that in the decade since Soros wrote that somber prediction, global capitalism has contributed to more trade, wealth creation and freedom than ever before in man's history.
Believe it or not, Soros actually alleges that, because in the story about 'the boy who cried wolf,' the wolf really arrived after three warnings, his three most recent books warning of global economic catastrophe mean he is now probably correct.
I'm serious. Greg Ip's piece quotes that comparison by Soros. You cannot make up stories this silly.
To prove how important his ideas are, Soros notes,
"The most popular reaction to my philosophy is....success has gone to his head and he wants to be more than what he is....But I would like my ideas to be judged on their own merit. I think I'm on the verge. For the first time, this book is a best seller. I was asked to testify (before the Senate Commerce Committee) because a staff member read the book."
Well, if I told George Soros that I happened to see a copy of his book in the garbage, would he promptly declare it to be garbage, too?
If he seriously believes that because some no-name staffer to some Senatorial windbag read his book, it now is important, his long-ago success has gone to his head.
I laughed when I read the next passage, where Soros answers Ip's question about whether policy or academic heavyweights are noticing his ideas,
"It has certainly not penetrated academia, and not policy makers, either. I wish I could engage in a discussion with (the Federal Reserve). I'm waiting for a phone call. I'm (meeting with) Alan Greenspan."
These days, I don't think Greenspan's such a hot economic ticket, George.
At the end of Ip's piece, he quotes Soros actually saying something interesting,
"This is, of course, [Joseph] Schumpeter's creative destruction idea. However ... going overboard in generating change is not necessarily a good thing. Financial innovation may not be an unmixed blessing because it really prevents proper regulation.
If you look at the 19th century, you had creative destruction going on, one financial crisis after another. But each time you had a crisis, you had an examination of what went wrong, and you put in some instrument or some institution to prevent it from happening.
I'm not advocating ... central planning because that's worse than markets. But the regulators need to learn from the mistakes that they have made. I think it's pretty clear that you've got to accept responsibility for moderating asset bubbles. ... That involves regulating credit as well as [interest rates]."
It's not clear what Soros is actually saying here beyond the existing awareness that some regulation of financial services is a beneficial activity. He does not speak to the perennial difficulty of staffing such governmental entities with employees who are as motivated and intelligent as those whom they would regulate.
Perhaps what would satisfy Soros, and it would satisfy me, is to regulate certain classes of financial services activities, such as insured deposit-taking, residential mortgage, consumer and conventional business lending, and transactions processing, very strictly and heavily, so as to safeguard these core economic activities.
Non-commercial banking practices involving riskier investments will always be subject to loss of capital and liquidity risks, to name just two. It's unclear how much regulation can function effectively, other than to try to herd over the counter markets, such as swaps, into exchanges. The Treasury, under Paulson, is already headed that way.
As I wrote here a while ago, in response to Henry Kaufman's tirade against financial innovation, I think, over time, we've been far better served by the phenomenon than we've been hurt by it.
I think Soros' thinking here is muddled, if it's anything relevant at all.
Why does anyone pay attention to him? Because, I guess, like Robertson and Steinhardt, once, years ago, in different market conditions, George Soros made a lot of money. And even he confirms it was due in no small measure to luck.
So on this basis, we should all listen to his personal crackpot theory of 'reflexivity?'
God help us if that's what we've sunk to in the US.
Friday, August 10, 2007
Risk Week: All Risks Are Not Alike- Lessons From Hershey Park
As this week has worn on, and I have written about risk each day, the US equity markets have exhibited incredible volatility, while probably ending today up as much as 1%. Our equity portfolio has demonstrated similar performance.
We're not down in the double digits of percentage return this week, or this month. We hold large-cap, S&P500 equities, and call options thereon.
We don't sell calls. We don't sell puts. We don't buy or sell on margin. We don't try to hedge different instruments, in hopes of taking advantage of relationships which are, in general, predictable, but perhaps not so during times of financial uncertainty. We buy no bundles of mixed securities, such as mortgage CDOs, or other CDOs, nor do we buy or sell them in pairs, to hedge their returns.
A few weeks ago, as I spent several days with my daughters at a well-known amusement park in the next state, I mused about how my behavior at that park was rather like the investment behaviors my partner and I evince in the equity markets.
Since we only deal in listed US equities, or call options for them, that means we eschew some very unpredictable instruments which lend themselves to pricing and demand irregularities with frightening frequency.
Similarly, I don't take my children to just any amusement park. Some are rather lax in their admissions security checks and general behavior requirements. Others are less well-known, and subject to my concerns about the safety of some of their rides.
For instance, my daughters and I love to ride roller coasters. We are addicted. Thus, we've spent at least a few days during each of the last few summers at Hershey Park. As I am being rocketed around one of the older, more exciting wooden coasters, I regularly consider how little would be left of all of us if the cars left the track. You basically have no chance of survival whatsoever. None.
Thus, while I engage in the, to some, risky behavior of riding roller coasters, I only do it at a park where I trust the management to operate totally safe roller coaster rides. I never worry about boarding any ride at Hershey. Between the park's long reputation for cleanliness and safety, and the related food operations of the parent, I am confident the company's management of the park brooks absolutely no lapses which could lead to any fatalities or serious injuries on the rides.
Each year, there's a story about someone dying while riding and, falling out of or from, some ride at some amusement park somewhere in the US. But never Hershey.
The lesson I draw from my amusement park behavior, and apply to my investment behavior, is that it is important to set hierarchical, conditional criteria for risk.
We don't invest in instruments other than large-cap, US equities, and the purchase of options thereon (calls in markets expected to remain strong, puts in markets expected to remain weak).
Having set that initial criterion, we remain invested through market turmoil such as these past few weeks. My partner and I monitor the conditions that affect the companies whose equities we may purchase, but we don't worry unnecessarily about the trouble other investors create for themselves through injudicious trading and investing in various esoteric instruments.
That is very germane to this week's market activity. Although some extremists, such as Jim Cramer or Gary Shilling, believe there is a global liquidity and capital contraction which is of systemic proportions, I do not share that view.
Global economic growth and corporate activity remain healthy and robust. Profits are up. Most financial instruments- equities, corporate debt, Treasuries- are in good shape.
The genesis of the current financial volatility and perceived liquidity problems lie primarily with those parties who have chosen to buy, hold, and/or depend upon other parties with positions in relatively high risk instruments involving sub-prime residential US mortgages.
Just a week ago, James Cayne, Chairman of Bear Stearns, got the denial ball rolling by alleging that this is the 'worst debt market in twenty years.'
Only if you happen to dabble significantly in the riskiest, least creditworthy, shallow and illiquid parts of it. Which Bear did.
By Tuesday of this week, other scorched trading and portfolio players, also guilty of expecting constant profit from sub-prime debt, echoed Cayne's claim that the market was unraveling, and, therefore, they had not done anything extreme, greedy or unwise. They were merely victims of a bad market.
Someone would have to fix that bad market. Oh, yes, and, in the process, bail out those who chose to play with that brand of fire labelled 'sub-prime.'
As the French swung into action yesterday, with Paribas' idiotic suspension of redemptions in several of its sub-prime-related funds, and the EuroBank loudly announced its provision of liquidity to their markets, the panic began. Cayne, Cramer & Co. had accomplished their objectives, by causing sufficient uncertainty that counterparties to known holders of sub-prime-related issues stampeded out of positions.
As my partner has pointed out, the actual expected loss on sub-prime mortgages, were they simply to be written off, is far, far less than the total amount of market value destruction seen over the past week in the global financial markets.
Over very, very short periods of time, like the past few weeks, the mass of mediocre, poorly-informed and -reasoning investors, analysts, money managers and pundits can cause temporary market behaviors to depart radically from what more reasoned, informed market participants believe is warranted.
As such, as we have seen recently, volatility can soar, and assets can appear to lose even their intrinsic values. But this is a purely short term effect when there is no serious, structural economic problem underpinning the behavior.
Right now, being in US large-cap equities and options has insulated our portfolio from egregiously magnified losses of those experienced in the S&P500. We still have risk exposure, but we feel it is far, far less than that of investors who have engaged in complex, hedged positions which rely on modeled behavior of prices for esoteric, thinly-traded debt instruments.
We're not down in the double digits of percentage return this week, or this month. We hold large-cap, S&P500 equities, and call options thereon.
We don't sell calls. We don't sell puts. We don't buy or sell on margin. We don't try to hedge different instruments, in hopes of taking advantage of relationships which are, in general, predictable, but perhaps not so during times of financial uncertainty. We buy no bundles of mixed securities, such as mortgage CDOs, or other CDOs, nor do we buy or sell them in pairs, to hedge their returns.
A few weeks ago, as I spent several days with my daughters at a well-known amusement park in the next state, I mused about how my behavior at that park was rather like the investment behaviors my partner and I evince in the equity markets.
Since we only deal in listed US equities, or call options for them, that means we eschew some very unpredictable instruments which lend themselves to pricing and demand irregularities with frightening frequency.
Similarly, I don't take my children to just any amusement park. Some are rather lax in their admissions security checks and general behavior requirements. Others are less well-known, and subject to my concerns about the safety of some of their rides.
For instance, my daughters and I love to ride roller coasters. We are addicted. Thus, we've spent at least a few days during each of the last few summers at Hershey Park. As I am being rocketed around one of the older, more exciting wooden coasters, I regularly consider how little would be left of all of us if the cars left the track. You basically have no chance of survival whatsoever. None.
Thus, while I engage in the, to some, risky behavior of riding roller coasters, I only do it at a park where I trust the management to operate totally safe roller coaster rides. I never worry about boarding any ride at Hershey. Between the park's long reputation for cleanliness and safety, and the related food operations of the parent, I am confident the company's management of the park brooks absolutely no lapses which could lead to any fatalities or serious injuries on the rides.
Each year, there's a story about someone dying while riding and, falling out of or from, some ride at some amusement park somewhere in the US. But never Hershey.
The lesson I draw from my amusement park behavior, and apply to my investment behavior, is that it is important to set hierarchical, conditional criteria for risk.
We don't invest in instruments other than large-cap, US equities, and the purchase of options thereon (calls in markets expected to remain strong, puts in markets expected to remain weak).
Having set that initial criterion, we remain invested through market turmoil such as these past few weeks. My partner and I monitor the conditions that affect the companies whose equities we may purchase, but we don't worry unnecessarily about the trouble other investors create for themselves through injudicious trading and investing in various esoteric instruments.
That is very germane to this week's market activity. Although some extremists, such as Jim Cramer or Gary Shilling, believe there is a global liquidity and capital contraction which is of systemic proportions, I do not share that view.
Global economic growth and corporate activity remain healthy and robust. Profits are up. Most financial instruments- equities, corporate debt, Treasuries- are in good shape.
The genesis of the current financial volatility and perceived liquidity problems lie primarily with those parties who have chosen to buy, hold, and/or depend upon other parties with positions in relatively high risk instruments involving sub-prime residential US mortgages.
Just a week ago, James Cayne, Chairman of Bear Stearns, got the denial ball rolling by alleging that this is the 'worst debt market in twenty years.'
Only if you happen to dabble significantly in the riskiest, least creditworthy, shallow and illiquid parts of it. Which Bear did.
By Tuesday of this week, other scorched trading and portfolio players, also guilty of expecting constant profit from sub-prime debt, echoed Cayne's claim that the market was unraveling, and, therefore, they had not done anything extreme, greedy or unwise. They were merely victims of a bad market.
Someone would have to fix that bad market. Oh, yes, and, in the process, bail out those who chose to play with that brand of fire labelled 'sub-prime.'
As the French swung into action yesterday, with Paribas' idiotic suspension of redemptions in several of its sub-prime-related funds, and the EuroBank loudly announced its provision of liquidity to their markets, the panic began. Cayne, Cramer & Co. had accomplished their objectives, by causing sufficient uncertainty that counterparties to known holders of sub-prime-related issues stampeded out of positions.
As my partner has pointed out, the actual expected loss on sub-prime mortgages, were they simply to be written off, is far, far less than the total amount of market value destruction seen over the past week in the global financial markets.
Over very, very short periods of time, like the past few weeks, the mass of mediocre, poorly-informed and -reasoning investors, analysts, money managers and pundits can cause temporary market behaviors to depart radically from what more reasoned, informed market participants believe is warranted.
As such, as we have seen recently, volatility can soar, and assets can appear to lose even their intrinsic values. But this is a purely short term effect when there is no serious, structural economic problem underpinning the behavior.
Right now, being in US large-cap equities and options has insulated our portfolio from egregiously magnified losses of those experienced in the S&P500. We still have risk exposure, but we feel it is far, far less than that of investors who have engaged in complex, hedged positions which rely on modeled behavior of prices for esoteric, thinly-traded debt instruments.
Monday, August 06, 2007
Risk Week: Jim Cramer Shills for Hedge Funds
In view of the salient events of the last few weeks in the credit markets, and their overwhelming effects on the equity markets, I'm making this week's posts all about risk.
Yes, it's "risk week." I will be writing posts about various aspects of the recent activities in the debt and equity markets, and risk, and its management.
To begin my posts, I want to discuss Jim Cramer's outrageous comments last week on CNBC while speaking one afternoon (Thursday?) with Erin Burnett.
He set himself up as a sort of God of the markets, claiming various Wall Street trading desk personnel were beseeching him to tell Ben Bernanke how bad the credit situation is. Cramer alleged that these traders told him,
'You're the only one they'll listen to. You can get through to them....'
Nice try, Jim. But you're just a shill for your trading desk and hedge fund friends. They are using you the same way you used to use CNBC and The Wall Street Journal when you managed a hedge fund, as you have admitted.
What is going on now is not a general credit market meltdown. And in no way is it remotely as bad as Bear Stearns Chairman, Jim Cayne, alleged, saying it is the worst credit market in 20 years.
All that is happening is that some investment banks and hedge funds have made poor risk management and investment decisions. They hold more sub-prime mortgage paper than is prudent, if holding any at all is, at this point. These institutions would love to have the market bail them out. Rather than admit they have made costly mistakes, they would prefer that others believe, instead, that the credit markets are in crisis.
Thus, as Cramer was shilling the other day, Ben Bernanke must cut rates. Damn inflation, let's rescue some overpaid, underperforming traders and fund managers!
There is no crisis. What there is, is a case of some greedy, opportunistic, short-sighted managers at some firms being caught with heavy losses on bad investments.
It pains me to see CNBC allow Cramer to openly shill for his friends, and other industry insiders. At least this morning, several commentators directly contradicted Cramer, though not naming him specifically. They simply reiterated my position, that this is not a credit market crisis, it's a problem for some firms.
What most people fail to grasp is that these traders and fund managers will do anything to escape the losses they now face for injudicious decisions. If crying "fire" in a market, and getting others to stampede and believe the market is in crisis, so be it. So long as it leads to the Fed cutting rates, pushing debt prices up, then these traders and hedge fund managers will be relieved of some of their losses. And can rapidly dump their trash onto the market before others catch on.
The truth is, credit market problems primarily lie with a sub-species of the collateralized mortgage obligations market. Not corporate debt, or Treasuries. Not equities. It's a weakness confined to those players who knowingly bought sub-prime mortgages, or sub-prime-based paper, knowing the greater risk these mortgages bore.
I don't think it merits a general hand-wringing over the credit, or equity markets. And it certainly does not merit Jim Cramer anointing himself God of the market, and imploring Ben Bernanke to quit doing his job as Fed Chairman, and just loosen the monetary spigots to bail out some overpaid Wall Street traders, fund and risk managers.
Tomorrow: when a market is not a market, and why that surprised this generation's risk management whiz kids on Wall Street.
Yes, it's "risk week." I will be writing posts about various aspects of the recent activities in the debt and equity markets, and risk, and its management.
To begin my posts, I want to discuss Jim Cramer's outrageous comments last week on CNBC while speaking one afternoon (Thursday?) with Erin Burnett.
He set himself up as a sort of God of the markets, claiming various Wall Street trading desk personnel were beseeching him to tell Ben Bernanke how bad the credit situation is. Cramer alleged that these traders told him,
'You're the only one they'll listen to. You can get through to them....'
Nice try, Jim. But you're just a shill for your trading desk and hedge fund friends. They are using you the same way you used to use CNBC and The Wall Street Journal when you managed a hedge fund, as you have admitted.
What is going on now is not a general credit market meltdown. And in no way is it remotely as bad as Bear Stearns Chairman, Jim Cayne, alleged, saying it is the worst credit market in 20 years.
All that is happening is that some investment banks and hedge funds have made poor risk management and investment decisions. They hold more sub-prime mortgage paper than is prudent, if holding any at all is, at this point. These institutions would love to have the market bail them out. Rather than admit they have made costly mistakes, they would prefer that others believe, instead, that the credit markets are in crisis.
Thus, as Cramer was shilling the other day, Ben Bernanke must cut rates. Damn inflation, let's rescue some overpaid, underperforming traders and fund managers!
There is no crisis. What there is, is a case of some greedy, opportunistic, short-sighted managers at some firms being caught with heavy losses on bad investments.
It pains me to see CNBC allow Cramer to openly shill for his friends, and other industry insiders. At least this morning, several commentators directly contradicted Cramer, though not naming him specifically. They simply reiterated my position, that this is not a credit market crisis, it's a problem for some firms.
What most people fail to grasp is that these traders and fund managers will do anything to escape the losses they now face for injudicious decisions. If crying "fire" in a market, and getting others to stampede and believe the market is in crisis, so be it. So long as it leads to the Fed cutting rates, pushing debt prices up, then these traders and hedge fund managers will be relieved of some of their losses. And can rapidly dump their trash onto the market before others catch on.
The truth is, credit market problems primarily lie with a sub-species of the collateralized mortgage obligations market. Not corporate debt, or Treasuries. Not equities. It's a weakness confined to those players who knowingly bought sub-prime mortgages, or sub-prime-based paper, knowing the greater risk these mortgages bore.
I don't think it merits a general hand-wringing over the credit, or equity markets. And it certainly does not merit Jim Cramer anointing himself God of the market, and imploring Ben Bernanke to quit doing his job as Fed Chairman, and just loosen the monetary spigots to bail out some overpaid Wall Street traders, fund and risk managers.
Tomorrow: when a market is not a market, and why that surprised this generation's risk management whiz kids on Wall Street.
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