Tuesday, November 3, 2009

Like Clockwork…UBS Posts Another Loss

To those who utterly can’t live without daily blog posts from me, I apologize for my lackluster performance of late. Unfortunately, my activities aren’t limited to making the occasional snarky comment about finance, and I had to attend to a few non-blog related affairs. But, fear not, I’m back.

I’ll confess that I myself was a bit fearful, actually. Away from the Internet for a few days, I wondered whether I’d be missing some earth-shattering development in the real world or at the very least, the blogosphere. That fear was quashed by UBS’ announcement today of yet another loss – its fourth straight quarterly hit for those keeping score.

See, UBS delivering negative numbers has become a matter of routine for the hobbled Swiss bank. I can’t say that I’m all that surprised by its adherence to such a habit. After all, the Swiss place an emphasis on predictability – they are the crafters of some of the world’s finest watches, and you wouldn’t want to have a clock that erratically displayed the time, would you?

While UBS clearly isn’t the Rolex of the Swiss banking market, the numbers from Zurich this quarter actually weren’t as bad as they’ve been in the recent past. Then again, when you drop almost $10 billion in a three-month span (as UBS did in Q4 of 2008), you haven’t exactly set the bar very high. Still, I am moderately surprised that the bank is even standing at this point. As if its $50 billion in write downs weren’t bad enough, UBS has found itself at the center of a damaging tax evasion scandal, for which it paid the U.S. government nearly $1 billion in fines. Even worse than forcing it to pony up cash to Uncle Sam, the tax debacle has led to massive outflows from the firm’s once platinum asset and wealth management arms. After suffering well over $100 billion of outflows last year, the bank has already seen customers remove an additional $90 billion through the first three quarters of 2009. This trend is particularly problematic because of the weakness of the bank’s trading arm and the increasing extent to which financial institutions will need to rely on more stable earnings streams (from enterprises such as asset management) going forward.

During the early stages of the credit crisis, when UBS’ investment bank was causing all the trouble, there had been calls to break up the firm to better realize the value of the asset management side. But now that the former crowned jewel of the UBS franchise has itself become a thorn in the bank’s side, I am not sure whether a break up would make sense. Even so, it’s clear that management must do something to right the ship. I may not have a Rolex, but even I know that the clock is ticking and executives are running out of time.

Thursday, October 29, 2009

Chasing Tail

I don’t intend to get overly academic with this blog. For one, if I did, I think I’d have even fewer readers than I already do. Furthermore, many of the traditional theories spewed by tenured professors who’ve never stepped foot on a trading floor have consistently proven useless in the face of great financial calamities. And the futility of mainstream financial academia has become only more glaring during the credit crisis.

Among the cornerstones of financial economics is the Efficient Market Hypothesis (EMH), which basically holds that prices of financial assets incorporate all known information and adjust quickly to reflect new data. As a result, the theory goes, an investor won’t be able to outperform the relevant benchmark through anything other than pure luck. In other words, if you believe in the EMH, you shouldn’t be wasting your time sifting through individual stocks or even delegating the task to supposedly brilliant (and undoubtedly expensive) funds. No, the EMH suggests that if you’re going to invest in an asset class, invest in the wider market – instead of an individual stock, choose the S&P 500; instead of a particular bond, pour your money into a broad fixed income fund.

To be fair, there’s much to be said for this advice. Insofar as it prevents investors from not diversifying and paying excessive fees for investment managers, the EMH is a good thing. Indeed, countless studies (see, for example, this one) suggest that mutual funds do not reliably beat indices, and when fees are taken into account, they often fall well short. In fact, even the (once) revered class of investment vehicles otherwise known as hedge funds probably don’t outperform their benchmarks net of fees. Admittedly, for a variety of reasons, historical hedge fund performance data can be unreliable, but the preponderance of evidence indicates that on average, hedge funds aren’t as magical as they’d lead some investors to believe. And, whether you believe academic studies or not, the abysmal performance of the class in 2008 should raise some serious questions. In case they don’t, I’ll raise one – how was it that equity long-short hedge funds finished down almost 40% last year, exceeding the loss of the S&P 500, when they were supposed to have next to no market exposure?

One of the reasons relates to a key deficiency of the EMH, which in a curious WSJ editorial, Professor Jeremy Siegel entirely overlooks. Before proceeding to bash Siegel, I will say that he’s smarter than I am, has more standing than I do, and has penned a finance book that’s actually worth reading (surely an admirable feat in a sector dominated by Rich Dad, Poor Dad) – pick up Stocks for the Long Run if you don’t have a copy. With that said, I find his defense of the EMH bewildering. Siegel’s essential point is that the massive losses banks incurred during the credit crisis don’t reflect any weakness in the EMH but rather a weakness in risk management.

Superficially, he’s right. In fact, I would go so far as to say that his reasoning is tautological – because banks lost loads of money, by definition they weren’t managing risk effectively. And, in a proximate sense, the EMH can’t be at fault since nobody at any institution I know of gives a shit about the theory. There’s a good chance that most don’t even know what it is. While knowledge of advanced financial math may be important in some trading functions, knowledge of broad theories about market efficiency generally isn’t.

Still, I think it’s worth noting that the credit crisis has dealt a major blow to the EMH because it’s underscored the degree to which risk is systematically mispriced. To put it in a less academic fashion, market participants tend to underweight the chance of really bad shit happening (e.g., house prices collapsing). Nassim Taleb has made a career off this observation. Noting that really bad shit goes down a lot more often than most models predict, Taleb points to the importance of what he calls “black swans,” extreme outliers that can burn holes in banks’ coffers. Eschewing the zoological definition, financial economists would explain this phenomenon by declaring that most of us don’t accurately estimate “tail risk,” the risk at the tail of a mathematical distribution.

In an efficient market, the estimation of outliers, or tail events, wouldn’t be biased. This is to say, over the long run, you couldn’t consistently make money by betting on or against extreme occurrences. And Siegel suggests that you can’t, implying that high yields on subprime securities (which would blow up if bad shit went down) appropriately compensated investors for the inherent risk of the products. Of course, this wasn’t true, and it shouldn’t take a Wharton professor to realize that subprime securities were overpriced, offering yields that were too low relative to their risk.

Yet, an astute reader may claim, perhaps subprime yields do make sense when viewed over a longer time horizon. I beg to differ, and Taleb would certainly agree. As he and his followers have noted, even over the long run, investors can profit by buying assets that will pay off only under extreme occurrences. Put another way, banks inefficiently price insurance, selling it too cheap. As a result, few financial institutions have been able to survive in their current form for more than a half century. Yes, the credit crisis was undoubtedly a seminal series of events, but it wasn’t the first and likely won’t be the last apocalyptic era on Wall Street.

Unless markets do suddenly validate the EMH and institutions begin appropriately pricing extreme events, the financial world will continue to be beset by periodic collapses. Personally, I doubt anything will change. So, I advise you to chase some tail.

Wednesday, October 28, 2009

B of A Got 99 Problems But a Chief Ain’t One

Ok, I don’t rap and seldom listen to others who do. Having grown up in the “ghetto” of Manhattan’s Upper East Side, I can’t say I really identify with the struggle on the streets. But, fresh off my Notorious B.I.G. reference, I figured I’d give a shout out to Jay-Z. The shout out wouldn’t be necessary if it weren’t for one Jay-T, that is, John Thain. After orchestrating the sale of the century – dumping Merrill Lynch into the arms of Ken Lewis and Bank of America – Thain was supposed to be the heir apparent to the B of A empire. Of course, the coronation wouldn’t happen for some time since Lewis had ostensibly navigated B of A through the credit crisis with a fair amount of success.

Alas, things changed quickly. Thain did some decorating, Merrill paid some bonuses, and soon enough, Lewis found himself on the way out with no obvious person to take his place. With Thain now decorating offices beyond B of A, the now beleaguered bank finds itself in an unexpected situation – having to search far and wide for a new CEO.

Now, I know B of A wasn’t exactly the employer of choice at Harvard (at least before the world fell apart and reduced the number of large investment banks in the US to a paltry 5). Still, I would’ve thought somebody would’ve wanted to run the place. But apparently nobody does. In fact, the antipathy towards the top job at the hobbled Charlotte giant seems to be so strong that even the NY Post has gotten wind of it.

To be sure, Bank of America has some problems, probably more than 99 actually. For one, the bank just reported another quarter of disappointing earnings, or rather losses. And if dropping $1.0 billion (or as much as $2.2 billion if you count dividend payments) isn’t bad enough, it’s not clear that the situation will get much better anytime soon given the bank’s massive exposure to the U.S. consumer. Having already set aside nearly $36 billion for bad loans and leases, the firm may have to write off even more consumer debt as unemployment breaches 10%. Indeed, the company’s colossal credit card portfolio may be as subprime as the CDO holdings of the investment bank it took over.

Yet, precisely because of its acquisition of Merrill Lynch, I think B of A may not be as bad off as some critics claim. Subprime write downs and bonus largesse aside, the Merrill purchase has already begun to yield dividends. In wealth management and trading particularly, B of A has quickly become a force to be reckoned with thanks to the Merrill move. No longer some second-rate trading institution on the order of JT Marlin, B of A is now the country’s second largest holder of derivatives (with more than $75 trillion in total notional), just a hair behind JP Morgan according to the OCC’s Q2 report (and anyway, what’s a few trillion between friends?).

It’s true that B of A’s burgeoning derivatives business may not be an unequivocally positive thing – after all, Merrill had a huge derivatives portfolio, and look what good that did. But if B of A really isn’t sitting pretty in any area, I think that’s all the more reason to want to run the place. Actually, in my view, B of A’s weakness should be the chief motivation for a would-be chief to move to Charlotte.

Quite simply, Lewis has set a pretty low bar. Facing more than 99 problems, the new B of A CEO will get credit for cleaning up just a few. And frankly, even if Lewis’s successor can’t make matters any better, he should look forward to a healthy pay package should he too be given the boot (though, if Ken Feinberg does his job, the golden parachute won’t be on the scale of Lewis’s $69 million life preserver). So, as I see it, existence atop B of A surely isn’t the hard knock life the bard Jay-Z crooned about in his ghetto anthem.

Tuesday, October 27, 2009

Mo Money Mo Problems?

It’s like the more money we come across
The more problems we see

Chances are, Notorious B.I.G. wouldn’t be welcomed with open arms by the House Financial Services Committee. Of course, Notorious B.I.G. is dead, but I think it’s safe to say that Barney Frank and colleagues don’t know who the guy was, let alone whether somebody bust a cap in his ass. To be fair, the members of the House Financial Services Committee can’t be bothered with a dead rapper because they need to be concerned with an even more infamous moribund entity: Notorious A.I.G.

To stave off financial Armageddon in 2008, the government lent a total of $182.5 billion to a company that had transformed itself from a staid insurer into an irresponsible speculator. Now, I don’t want to go into the specifics of the bailout or why AIG needed the cash to stay alive, but to those who desperately seek answers, fear not – some time in the near future I will give a more detailed treatment of what exactly AIG Financial Products was doing with all those derivatives and how the government stepped in (in the meantime, if you really can't wait, see this article hot off the presses from Bloomberg, which delivers a less than heartening account of intrigue surrounding AIG's bailout).

In this post, I call attention to AIG because $182.5 billion is a lot of taxpayer money, and while a government transfer may have been necessary (though the actual largess was perhaps too large; again, see this bad boy) to prevent the fall of capitalism, Barney Frank isn’t interested in letting Washington make a similar gesture anytime soon. For once, I can proudly say that I wholeheartedly agree. After all, the government shouldn’t be in the business of risking 2% of GDP on behalf of a private company. And to those who think otherwise, I say move to China or India.

In an attempt to prevent another AIG-style taxpayer-led bailout, the White House and Barney Frank are apparently working on a proposal that would shift the burden of a rescue from Uncle Sam to Uncle Lloyd (Blankfein) and the rest of Wall Street. I don’t think that Blankfein and his cohorts would disagree with the need for such a shift. The real question (and source of conflict) will be how the administration plans to pull it off.

Since the full details of the scheme haven’t emerged, it would be premature of me to deliver an all-out attack on the government’s proposed course of action. Still, I will say that I fear the administration may end up unfairly penalizing certain firms for the benefit of others. The WSJ article implies that in the event of a rescue, the government will levy fees on all institutions with more than $10 billion in assets. While big institutions should pay to save the financial framework they rely on, it’s important that the punishment fits the crime.

More specifically, if, as was the case with AIG, some type of derivatives exposure is the cause of a financial firm’s collapse, the government should levy the largest fees on the banks that trade the most derivatives, not the banks that have the most assets. The distinction is an important one because in the United States, the relationship between total assets and the total notional amount of derivatives is somewhat tenuous. In other words, the biggest derivatives players aren’t necessarily the biggest banks. For example, according to the Q2 report of the Office of the Comptroller of the Currency (OCC), Wells Fargo is the nation’s fourth largest bank by assets (with about $1.3 trillion), but the total notional amount of its derivatives holdings is only about 10% of that of Goldman Sachs, which possesses 25% less in assets.

In fact, in the United States, derivatives exposure is almost entirely concentrated among just five firms (listed from most to least exposed): JP Morgan, Bank of America, Goldman Sachs, Morgan Stanley, and Citigroup. Together, these five institutions account for more than 95% of all derivatives contracts but under 60% of all assets among the top 25 derivatives holding companies in the country.

Yes, as hard as it may be for some on Wall Street to fathom, the banking system in general extends well beyond the likes of Goldman and Morgan (JP or Stanley). But, in terms of derivatives exposure, it really doesn’t. So, if another AIG came along and threatened to destroy our financial fabric with an ill-advised portfolio of credit derivatives, it would be insane to levy a higher bailout fee on Wells Fargo (which holds about $220 billion in credit derivatives) than on Goldman (which possesses over $6 trillion).

Surely, derivatives will not be the only cause of financial problems down the line, and in some senses, with its mammoth mortgage portfolio, Wells Fargo is riskier than Goldman. I am just calling attention to derivatives disparities to highlight the folly of applying an inflexible asset test to shift the bailout burden from taxpayers to financial firms. I am not saying the government will do this. Indeed, I hope they don’t since when it comes to Wall Street, Notorious B.I.G. may be wrong. It’s not clear that mo money does mean mo problems.

Sunday, October 25, 2009

What's the Problem with Insider Trading...and the Old Kristin?

So, I was going to deliver the second of my lighthearted jabs about the engines of Wall Street, but something got in my way. A stray comment uttered by the Ex (not the financial instrument, the person), of all people.

It was over eggs this weekend. In the midst of one of my grand, interminable Shakespearean soliloquies about the state of Wall Street, I was stopped dead in my tracks. I was speaking about the Galleon case and the way in which I thought the SEC was using it to make a point when the Ex suddenly interrupted me. To be honest, I was surprised that I hadn't yet put her to sleep, but I guess, whether she liked it or not, all that brunch tea was keeping her up.

"So, you're saying these guys were arrested for insider trading?"
"Yes," I replied, not sure what she was getting at.
"Well, what's so bad about that?"
"It's illegal."
"I don't know. It's against the law," I said, attempting to overpower her with the full force of my tautological reasoning.
"Seems like a stupid rule to me."

On that note, the conversation ended, and we turned to more important matters, like whether the new, emaciated Kristin (of The Hills and Laguna Beach fame) looked better than the original, plumper girl-next-door Kristin (for what it's worth, I preferred the original). Yet, I couldn't help thinking about the Ex's comment long after we'd finished the discussion: what was so bad about insider trading anyway?

Coincidentally enough, as we were watching The Hills later that afternoon and I'd become bored with the skinny Kristin, I turned to my phone to read an article on the WSJ online about the very topic that had been troubling me.

Though the Ex doesn't care about finance and doesn't pretend to know much about it, she was amidst some impressive company in believing that insider trading shouldn't be regulated. The Journal editorial, penned by Economics Department Chair Donald Boudreaux of George Mason and featuring the comments of Professor Jeffrey Miron of Harvard, supplied some arguments in support of the Ex's view. None of them were very convincing.

The main argument advanced in the article was that insider trading would lead to greater market efficiency -- as prices would reflect all information, not merely all publicly available news. I must admit that on the face of it, this type of claim is appealing. After all, who doesn't want more efficient markets? There's just a small problem -- it's not at all clear that more insider trading would meaningfully improve efficiency. For one, insiders account for a very small share of overall stock ownership, particularly among the largest and most widely held stocks. According to one study based on a sample of 1300 large firms covered by the Value Line Investment Survey, the median percentage of insider ownership is less than 5%. So, for the stocks that count, it takes a large (and arguably unwarranted) leap to conclude that insiders have the market power to significantly move prices.

This isn't to suggest that insiders don't matter at all. But if insiders can meaningfully affect efficiency, they can do so under the present regime, which permits company officers to buy and sell their firm's stock provided they report their transactions (usually through Form 4). I am somewhat surprised the editorial makes such scant mention of the legal ways in which insiders can now express their views. Yes, a discussion of currently allowed insider practices would weaken the efficiency argument, yet it would highlight a far more powerful critique of the present system. The fact is insider trading is actually permitted, so if the SEC is so concerned about leveling the playing field, why doesn't it force all company officers to hold their company stock in blind trusts? To the extent the present regulatory regime is flawed, I think it's impaired by inconsistency in application.

To his credit, Boudreaux does make this point (in a roundabout way), but he spends far too much time on an inconsistency argument of a different sort. Boudreaux asserts that insider trading enforcement is inherently biased since it's far easier to prosecute a wrongdoer for conducting a transaction on the basis of insider information than for choosing to forego a trade because of insider knowledge. However, given the SEC’s reliance on informants (as in the Galleon case), it wouldn't be out of the realm of possibility for the organization to uncover credible evidence linking insider information to the decision not to trade. Still, Boudreaux’s point is a fair one since, whether the SEC has the ability to or not, I don’t think the enforcement organization has ever prosecuted somebody for using insider information as the basis for a choice not to trade. But I don’t think this shortcoming matters that much, or at least it’s not significant enough to warrant the abolition of insider trading regulations. To be sure, it would be nice if the SEC could easily catch all acts of insider trading (or non-trading, as it were), but the fact that certain instances of wrongdoing are quite difficult to detect doesn’t mean that we should throw in the towel and give up on prosecuting the instances that are much easier to catch.

While I have a problem with this argument advanced by Boudreaux, it’s Miron’s defense of insider trading that baffles me the most. I took his class on libertarian economics at Harvard, and when I decided to show up every now and then, I heard him make a number of provocative but strong claims. Miron’s arguments about insider trading aren’t among this number -- they may be provocative, yet they aren’t very strong. One of his main points is that insider trading will lead individual investors to diversify their holdings. The reasoning is that individuals will become wary about putting all their eggs in one basket out of fear that insiders will have a decisive advantage in a regime without regulations. Yet, if individuals fear that insiders will have an advantage, why will they invest at all (either in one stock or a basket of them)? Indeed, in making the argument, Miron acknowledges a problem with an entirely unregulated system -- insiders will be seen as having a significant investing advantage, an even greater one than they hold now. As Miron himself unwittingly suggests, it’s hard to believe that a non-insider in his right mind would participate in such a market.

And, I guess, when it comes down to it, that’s the reason we need at least some rules against insider trading (imposed by the government, not corporations). There are no doubt problems with our existing framework, but further tipping the scales in favor of insiders would dissuade individuals and institutions from making much needed investments in the nation’s capital markets. I wish I’d been able to tell the Ex something along those lines following our conversation. In all honesty, I’m not sure it would’ve mattered. After telling her that I preferred the old Kristin over the new one, I lost every bit of her confidence.

Thursday, October 22, 2009

So, where does the money come from?

Part I: Life of a Salesman (and Saleswoman, for those who care about political correctness)

In response to some of my recent posts on bank earnings, one of my many (and by “many,” I mean two) followers said the following, “Dude, I really don’t care what you have to say about VaR or some Swiss bank’s equity trading results. Tell me where the money’s coming from, or at least give me a colorful story.”

I think I’ll do both. In the next few posts, I’m going to explore the engines behind Wall Street – that is, the employees who call the trading floor of investment banks home. I’ll begin with salespeople, not because they’re important but rather precisely because they’re irrelevant and it’s a Thursday night. Simply put, I’m too lazy to make a more substantive post.

Still, I’ll do my best to organize the topic in a semi-coherent fashion. Currently, the job of salesperson on Wall Street involves five main activities (listed in no particular order):

1) Looking attractive
2) Forwarding Bloomberg messages to traders
3) Taking clients out to dinner/getting hammered with said clients
4) Ordering lunch after spending several hours opining on the day’s dining options
5) Discussing plans for the weekend, which begins at 1 pm on Friday

To be fair, all of these activities tend to be closely connected, but for the sake of simplicity, I’ll deal with each separately.

Looking attractive

For better or worse, we’re not in the 1980s any more, so banks don’t place as much of a premium on looks as they once did. In fact, at my bank, most of the salespeople were male, and most of the female salespeople were aesthetically challenged. Still, a few made attempts to look attractive. Some put on a lot of makeup; others not a lot of clothes. Traders within the bank and beyond no doubt appreciated the efforts. But, when push came to shove, many preferred strippers. Trader preferences aside, all salespeople need to look presentable to impress clients. So, whether male or female, most in the sales force are far more put together than the traders they receive prices from and send inquiries to.

Forwarding Bloomberg messages

Speaking of sending inquiries, salespeople must be familiar with the all-important “Forward” key on Bloomberg, the chief messaging system that banks use to communicate internally and externally. See, while banks may cull employees from some of the finest institutions of higher learning in the world, at the end of the day, the function of a salesperson comes down to one skill – forwarding an inquiry from a client to a trader and on occasion, forwarding a price from a trader to a client. This complicated series of actions can take quite a while to get used to and surely, salespeople have been known to screw it up. But, once they’ve mastered the art of forwarding Bloombergs without reading them or otherwise making an attempt to understand what’s going on, they’re all set.

Taking clients out to dinner

The great thing about being in sales is that you get paid to spend the bank’s money on fancy dinners for clients. To be fair, at the beginning of these dinners, some clients expect you to deliver a few coherent words on some aspect of the market. But, once you’ve spewed some incomprehensible “market color” and the drinks start flowing, everybody gets too drunk to figure out what’s happening. Of course, you never knew what was happening, but that doesn’t matter. If you concentrate on beating your hangover and somehow getting in by 7 am the next morning, you’ll be golden.

Ordering lunch

No matter what’s happening, lunch tends to be the focal point of a salesperson’s daily routine at the bank. In fact, the very day that Lehman collapsed, I remember the salesforce debating the ramifications of an important decision that would no doubt affect all their lives – Mexican or pizza? They ended up choosing the latter. Fortunately, on that day and many others, they ordered enough to feed a whole army of worried traders. As I discovered, it makes sense to befriend a salesperson. You’ll likely pick up some free lunch and at the very least, will develop a fine sense of the dining options in the area.

The weekend

If lunch is the focal point of a salesperson’s day, the weekend comes a close second. And it comes early. When many people think about life on Wall Street, in addition to great riches, they envision bad hours. While it’s true that young guns on the corporate finance side can put in as many as 100 hours a week copying and recopying pitch books for deals that will never happen, on the trading floor, the hours really aren’t all that bad. Particularly, for salespeople, and particularly, in the summer. At times during the summer, I wondered whether Friday had been officially added to the weekend by one of those many government fiats emerging from Geithner’s office. Indeed, the sight of a salesperson on the trading floor after 1 pm on a Friday was about as common as a subprime loan that hasn’t defaulted. Once the day’s pressing business had been effectively disposed of – all of the lunch orders had been deposited in the trash – salespeople tended to make a rush for the exits, usually en route to a Hamptons hideaway. Don’t get me wrong, the Hamptons are nice, but the whole trip had to be anticlimactic for the bank’s most dedicated laborers. After all, nothing can be good enough to justify a mention every other sentence. Still, I’d take the beaches of the Long Island Sound over a musty trading floor carpet any day.

Stop the Presses…Fed Looking at Banker Pay

In an unprecedented move, at least according to The Wall Street Journal, the Federal Reserve today unveiled a plan to regulate compensation practices at major financial institutions (even those beyond Feinberg’s hit parade). Sorry, am I missing something here? In once again making a few vague statements about the need to better align incentives on Wall Street, has the Fed actually done anything meaningful today? Methinks not.

And it doesn’t seem like the Fed will do anything meaningful on the matter going forward. Practically by its own admission, the Fed is likely to favor fuzzy guidelines as opposed to formulaic approaches. Don’t get me wrong, I think there’s something to be said for eschewing a one size fits all approach. Frankly, universal pay caps strike me as idiotic. At the same time, I worry that by not promulgating specific, clear cut rules, the Fed may be wasting its time.