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.
Thursday, October 29, 2009
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.
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.
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."
"Why?"
"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.
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."
"Why?"
"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.
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.
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.
Credit Suisse Made a Franc or Two (CHF 2.4 billion to be exact) with Surprising Efficiency
The Swiss can churn out chocolate, craft precise watches, and apparently, once in awhile, make a few billion CHF in banking. Of course, UBS is likely to report another loss this quarter, but its Zurich counterpart, CS, turned in respectable Q3 results. On the trading side, CS continued to deliver in equities (with almost $1.9 billion in revenue) and put in a decent showing in fixed income (with about $2.5 billion in ducats). Surely, neither of these results comes close to Goldman’s, but CS shouldn’t be written off as a second-bit player.
Actually, I found their results pretty impressive given how little risk they claim to be taking, at least as illustrated by the notorious value-at-risk measure. Now, I don’t want to use this post to go into the problems with VaR, so I’ll just say that for a given degree of confidence, VaR is a proxy for the maximum amount a firm can reasonably expect to lose in a given day. Once again, ignoring the pitfalls of the measure (and there are indeed many), you can basically think of VaR as an all encompassing measure of exposure – the higher the VaR, the higher the risk.
CS, to its credit (pardon the pun), actually broke its VaR down by product in its Q3 report. Though other institutions do this internally, they seldom do it for the public, and certainly not as clearly as our friends in Zurich have. Based on the third quarter numbers reported so far, I come up with the following VaR ranking across the Street:
Trading VaR in Q3 (across products)
Goldman Sachs: $208 million
JP Morgan: $206 million
Morgan Stanley: $118 million
Credit Suisse: $95 million
From this somewhat naïve ranking, it’s pretty clear that Goldman and JP take far more risk than their competitors. Indeed, both banks actually cut their VaR this quarter and MS increased it, yet the latter is still taking only about 50% of the risk of its more profitable competitors.
But taking a lot of risk isn’t necessarily a good idea, and even if added exposure can lead to added profits, it, by definition, also increases the possibility of problems. After all, risk is risky – excuse the tautology. So, I like a somewhat different measure, which I’ll call “Efficiency,” calculated as dollars of trading revenue per unit of VaR. On this assessment, CS comes out a lot better.
Efficiency in Q3 ($/unit VaR)
Credit Suisse: 46
Goldman Sachs: 42
JP Morgan: 29
Morgan Stanley: 27
If anybody from Credit Suisse is reading this blog, take heart – this may be the only list in recorded history where your firm ranks higher than Goldman. I guess the Swiss really are efficient.
Actually, I found their results pretty impressive given how little risk they claim to be taking, at least as illustrated by the notorious value-at-risk measure. Now, I don’t want to use this post to go into the problems with VaR, so I’ll just say that for a given degree of confidence, VaR is a proxy for the maximum amount a firm can reasonably expect to lose in a given day. Once again, ignoring the pitfalls of the measure (and there are indeed many), you can basically think of VaR as an all encompassing measure of exposure – the higher the VaR, the higher the risk.
CS, to its credit (pardon the pun), actually broke its VaR down by product in its Q3 report. Though other institutions do this internally, they seldom do it for the public, and certainly not as clearly as our friends in Zurich have. Based on the third quarter numbers reported so far, I come up with the following VaR ranking across the Street:
Trading VaR in Q3 (across products)
Goldman Sachs: $208 million
JP Morgan: $206 million
Morgan Stanley: $118 million
Credit Suisse: $95 million
From this somewhat naïve ranking, it’s pretty clear that Goldman and JP take far more risk than their competitors. Indeed, both banks actually cut their VaR this quarter and MS increased it, yet the latter is still taking only about 50% of the risk of its more profitable competitors.
But taking a lot of risk isn’t necessarily a good idea, and even if added exposure can lead to added profits, it, by definition, also increases the possibility of problems. After all, risk is risky – excuse the tautology. So, I like a somewhat different measure, which I’ll call “Efficiency,” calculated as dollars of trading revenue per unit of VaR. On this assessment, CS comes out a lot better.
Efficiency in Q3 ($/unit VaR)
Credit Suisse: 46
Goldman Sachs: 42
JP Morgan: 29
Morgan Stanley: 27
If anybody from Credit Suisse is reading this blog, take heart – this may be the only list in recorded history where your firm ranks higher than Goldman. I guess the Swiss really are efficient.
Wednesday, October 21, 2009
Das isn’t Sehr Gut
In a surprise move, Deutsche Bank pre-announced its Q3 earnings, gloriously declaring that its net profit more than tripled to $2.1 billion. In an unsurprising move, Deutsche dressed its results with one-time gains to offset underlying weaknesses. This quarter the German bank was helped by tax benefits. Tax benefits? Oh, right, the things that DB used in Q3 of 2007 to report a $2.3 billion profit. To its credit, this time around, the bank didn’t engage in any asset sales, as it did in Q2 of 2009 (dumping some of its holdings of Daimler and Linde for a tidy profit exceeding $500 million) and Q1 of 2008 (hawking Daimler, Allianz, and Linde for a gain of more than $1 billion) – to name just a few offending quarters.
To be fair, a lot of banks paint their results around the edges, and Deutsche clearly hasn’t done anything wrong. But it does seem that the bank is quite concerned about proving to the market that it doesn’t need any more capital to meet regulatory requirements. The bank’s chief executive, Joe Ackermann, famously told the German government in November 2008 to fuck off, declaring that Deutsche didn’t want any part of the Bundes-bailout.
Now, I doubt Deutsche will need to raise more capital since it has fared much better than most competitors (ahem, UBS), but the market isn’t so sure. The stock opened down several percent this morning on a day when another announcer, MS, has risen more than 5%. At least DB has one thing going for it – the Euro is crushing the dollar. Das ist gut if you’re holding the ADR.
To be fair, a lot of banks paint their results around the edges, and Deutsche clearly hasn’t done anything wrong. But it does seem that the bank is quite concerned about proving to the market that it doesn’t need any more capital to meet regulatory requirements. The bank’s chief executive, Joe Ackermann, famously told the German government in November 2008 to fuck off, declaring that Deutsche didn’t want any part of the Bundes-bailout.
Now, I doubt Deutsche will need to raise more capital since it has fared much better than most competitors (ahem, UBS), but the market isn’t so sure. The stock opened down several percent this morning on a day when another announcer, MS, has risen more than 5%. At least DB has one thing going for it – the Euro is crushing the dollar. Das ist gut if you’re holding the ADR.
Hooray, Morgan Stanley Ekes out a Small Profit!
…and further proves it’s no Goldman Sachs.
Let me begin by congratulating those at 1585 Broadway for doing what many deemed impossible – actually turning a quarterly profit in 2009. Okay, to be fair, earnings expectations had been around 27 cents per share, and MS came in at 38 cents for a whopping total of $757 million.
Now, $757 million is better than a large negative number, which MS had posted during the three preceding quarters. However, it’s a far cry from the $3.6 billion that emerged from 85 Broad. While GS and MS had often been mentioned in the same sentence, the credit crisis has put a chasm between the two, with Goldman ending up on the better side.
The problem isn’t that MS has suddenly become a crappy franchise with inept management and incompetent employees across the board. No, the problem is that global investment banks make their money off two operations: banking and trading. MS remains quite good at the former. In fact, according to Thomson Reuters, Morgan overtook GS as the top-ranked M&A adviser through the third quarter of 2009.
Unfortunately, on the trading side, Morgan’s results continue to disappoint, and in an environment where M&A remains slow, trading weakness is an extremely bad thing for the bottom line. "Weakness" may seem like an overstatement since this quarter, MS notched $2.1 billion in fixed income revenue and $1.1 billion in equity trading gains. While $3.2 billion in sales and trading revenue isn't a drop in the bucket, it is more than $5 billion behind Goldman's number and even less than Citi's. Accounting for the large gap are Morgan's fixed income results, more than $2 billion lower than Citi's and almost $4 billion lower than Goldman's.
What explains this poor showing? Since Lehman’s collapse, MS has cut back its trading exposure in favor of less risky activities like private wealth management (hence, the joint venture with Citigroup’s Smith Barney). However, competitors like GS have upped the ante, and so far, the decision has yielded great gains.
Perhaps Morgan’s more cautious attitude will ultimately prove prudent. But if MS wants to once again be mentioned in the same breath as its downtown rival, it will somehow need to turn in much better trading results. And with a new chief that has no trading background, something tells me the boys at 1585 Broadway will have a hard time.
Let me begin by congratulating those at 1585 Broadway for doing what many deemed impossible – actually turning a quarterly profit in 2009. Okay, to be fair, earnings expectations had been around 27 cents per share, and MS came in at 38 cents for a whopping total of $757 million.
Now, $757 million is better than a large negative number, which MS had posted during the three preceding quarters. However, it’s a far cry from the $3.6 billion that emerged from 85 Broad. While GS and MS had often been mentioned in the same sentence, the credit crisis has put a chasm between the two, with Goldman ending up on the better side.
The problem isn’t that MS has suddenly become a crappy franchise with inept management and incompetent employees across the board. No, the problem is that global investment banks make their money off two operations: banking and trading. MS remains quite good at the former. In fact, according to Thomson Reuters, Morgan overtook GS as the top-ranked M&A adviser through the third quarter of 2009.
Unfortunately, on the trading side, Morgan’s results continue to disappoint, and in an environment where M&A remains slow, trading weakness is an extremely bad thing for the bottom line. "Weakness" may seem like an overstatement since this quarter, MS notched $2.1 billion in fixed income revenue and $1.1 billion in equity trading gains. While $3.2 billion in sales and trading revenue isn't a drop in the bucket, it is more than $5 billion behind Goldman's number and even less than Citi's. Accounting for the large gap are Morgan's fixed income results, more than $2 billion lower than Citi's and almost $4 billion lower than Goldman's.
What explains this poor showing? Since Lehman’s collapse, MS has cut back its trading exposure in favor of less risky activities like private wealth management (hence, the joint venture with Citigroup’s Smith Barney). However, competitors like GS have upped the ante, and so far, the decision has yielded great gains.
Perhaps Morgan’s more cautious attitude will ultimately prove prudent. But if MS wants to once again be mentioned in the same breath as its downtown rival, it will somehow need to turn in much better trading results. And with a new chief that has no trading background, something tells me the boys at 1585 Broadway will have a hard time.
Rich Fools?...More Like Poor Buffoons
The NY Times has an interesting article this morning about the extent of Galleon's insider trading savvy, or lack thereof. In its final complaint against the now fully sunk fund, the SEC alleges that Galleon amassed a long position in AMD off insider information about the company's pending transaction with two Abu Dhabi entities. However, as the NY Times astutely notes, the SEC sweeps one small fact about these transactions under the rug: they ended up losing Galleon close to $30 million, an amount larger than all of the fund's alleged ill-gotten gains combined. The fact that Galleon didn't profit (and heavily lost) from certain material nonpublic information doesn't blow a hole in the government's case, but it does weaken it. The SEC should've just left the AMD matter out of the complaint altogether. After all, Judge Rakoff, no fan of the organization, may not be so keen to side with the SEC against a fund that on net lost $10 million from insider dealing.
Tuesday, October 20, 2009
A Ship of Fools?
First, I’ll preemptively apologize for the nautical allusion – yes, Galleon is a hedge fund named after a boat as basically every media outlet has realized, and yes, it is now sinking (couldn’t resist that last double entendre, sorry).
After reading the SEC complaint in full, I wanted to call attention to an earlier post about my surprise regarding the paltry size of the alleged insider trading. Noting that $20 million was an infinitesimal fraction of Galleon’s assets under management and Rajaratnam’s wealth, I gave three possible explanations for the activities. At the time, having not read the complaint, I forgot to mention a fourth possible cause – perhaps the companies in question were too small to permit large scale insider trading. As several insiders have found out, attempting to commit large scale fraud with small stocks is very stupid. The SEC isn’t run by rocket scientists, but they will catch you.
To be more specific, when people have insider information, they often try to maximize gains by trading options. As I noted in an earlier post, options provide leverage, magnifying wins and losses. If you know what’s going to happen to a stock on account of insider information, trading options therefore seems like a great bet – you’ll get the best bang for your buck. Indeed, it can be quite lucrative. However, in many cases, it can be a big red flag to the SEC. Many stocks don’t support very liquid options markets. This is to say, the open interest (number of existing options contracts on a stock) and volume are often very small, so it takes only a few extra trades to cause a big spike in activity. And the SEC will catch such volume spikes as Reza Saleh recently found out the hard way when he bought 9,332 Perot Systems call options on insider knowledge of a buyout.
So, returning to the Galleon case, I’m not that surprised that some of the reported gains were quite small. For example, options on Polycom (one of the companies in question) have very low open interest and rarely trade. The complaint alleges that one of the parties purchased 200 Polycom calls from April 13 to April 18, 2006 at $1.35 a piece. Now, this was a very small outlay (resulting in a profit of only $22,000), but anything larger could have tipped off regulators then and there since on average only about 200 calls trade per day in the stock.
But the same can’t be said for some of the other companies in the complaint. Google, for example, supports a much more liquid market. One of the parties purchased 566 put options in the two weeks leading up to Google’s 2007 second quarter earnings announcement. While this trade led to more than $500,000 in profits, the party probably could’ve put on much more of it without alerting regulators. By my estimates, roughly 7500 puts on Google exchange hands every day. Now I don’t know how the SEC’s volume spike algorithm works, but I see no reason why the party couldn’t have bought 500 puts (across strikes) per day without tipping off regulators. If the party had amassed 2500 puts in total, it would still probably account for less than a quarter of the open interest across strikes and would’ve made several million dollars more in the process.
Was this person just overly concerned about getting caught or simply a fool?
After reading the SEC complaint in full, I wanted to call attention to an earlier post about my surprise regarding the paltry size of the alleged insider trading. Noting that $20 million was an infinitesimal fraction of Galleon’s assets under management and Rajaratnam’s wealth, I gave three possible explanations for the activities. At the time, having not read the complaint, I forgot to mention a fourth possible cause – perhaps the companies in question were too small to permit large scale insider trading. As several insiders have found out, attempting to commit large scale fraud with small stocks is very stupid. The SEC isn’t run by rocket scientists, but they will catch you.
To be more specific, when people have insider information, they often try to maximize gains by trading options. As I noted in an earlier post, options provide leverage, magnifying wins and losses. If you know what’s going to happen to a stock on account of insider information, trading options therefore seems like a great bet – you’ll get the best bang for your buck. Indeed, it can be quite lucrative. However, in many cases, it can be a big red flag to the SEC. Many stocks don’t support very liquid options markets. This is to say, the open interest (number of existing options contracts on a stock) and volume are often very small, so it takes only a few extra trades to cause a big spike in activity. And the SEC will catch such volume spikes as Reza Saleh recently found out the hard way when he bought 9,332 Perot Systems call options on insider knowledge of a buyout.
So, returning to the Galleon case, I’m not that surprised that some of the reported gains were quite small. For example, options on Polycom (one of the companies in question) have very low open interest and rarely trade. The complaint alleges that one of the parties purchased 200 Polycom calls from April 13 to April 18, 2006 at $1.35 a piece. Now, this was a very small outlay (resulting in a profit of only $22,000), but anything larger could have tipped off regulators then and there since on average only about 200 calls trade per day in the stock.
But the same can’t be said for some of the other companies in the complaint. Google, for example, supports a much more liquid market. One of the parties purchased 566 put options in the two weeks leading up to Google’s 2007 second quarter earnings announcement. While this trade led to more than $500,000 in profits, the party probably could’ve put on much more of it without alerting regulators. By my estimates, roughly 7500 puts on Google exchange hands every day. Now I don’t know how the SEC’s volume spike algorithm works, but I see no reason why the party couldn’t have bought 500 puts (across strikes) per day without tipping off regulators. If the party had amassed 2500 puts in total, it would still probably account for less than a quarter of the open interest across strikes and would’ve made several million dollars more in the process.
Was this person just overly concerned about getting caught or simply a fool?
Credit where Credit (Suisse) is Due?
I’ll preface this post by saying that Credit Suisse (CS), the Swiss financial services giant, is by no means the bellwether of the financial industry, but it is a place worth paying attention to. Compared to its Zurich-based counterpart, CS has fared relatively well during the credit crisis. Of course, it doesn’t take all that much to beat UBS, which dropped the paltry sum of $18 billion last year. Still, of all the global investment banks headquartered in Europe, CS and Barclays have probably fared the best since Lehman collapsed.
If you disagree or simply don’t give a shit about banks across the Atlantic, fear not since the point of this post is not to survey the competitive landscape beyond our borders. Rather, I bring up CS because the bank made headlines today with an announcement to more closely link bonuses to firm profitability. In doing so, the bank will follow Morgan Stanley, UBS, and Citigroup by awarding a greater portion of executive pay in salaries as opposed to bonuses.
As CS is now the fourth major investment bank to make such a move, I am not calling attention to the decision on account of its originality. I do, however, think it’s important because CS wasn’t under as much pressure as either UBS or Citigroup to make any changes. Unlike UBS and Citigroup, which together lost nearly $50 billion last year, CS kept its annual loss to only about $7 billion. Okay, -$7 billion isn’t chump change, but it did make CS the most profitable global investment bank in Switzerland in 2008.
The real question is whether a move to alter compensation practices will matter. At this point, I think it’s too early to tell. Clearly, though, something has to be done, and in the upcoming months, I expect even better positioned banks to make similar announcements. A bonus system that encourages traders to bet the house (if not the country) is a system that no doubt needs to be reformed. And with a framework that better aligns the incentives of employee and employer, perhaps the most profitable Swiss bank going forward will actually make a franc or two.
If you disagree or simply don’t give a shit about banks across the Atlantic, fear not since the point of this post is not to survey the competitive landscape beyond our borders. Rather, I bring up CS because the bank made headlines today with an announcement to more closely link bonuses to firm profitability. In doing so, the bank will follow Morgan Stanley, UBS, and Citigroup by awarding a greater portion of executive pay in salaries as opposed to bonuses.
As CS is now the fourth major investment bank to make such a move, I am not calling attention to the decision on account of its originality. I do, however, think it’s important because CS wasn’t under as much pressure as either UBS or Citigroup to make any changes. Unlike UBS and Citigroup, which together lost nearly $50 billion last year, CS kept its annual loss to only about $7 billion. Okay, -$7 billion isn’t chump change, but it did make CS the most profitable global investment bank in Switzerland in 2008.
The real question is whether a move to alter compensation practices will matter. At this point, I think it’s too early to tell. Clearly, though, something has to be done, and in the upcoming months, I expect even better positioned banks to make similar announcements. A bonus system that encourages traders to bet the house (if not the country) is a system that no doubt needs to be reformed. And with a framework that better aligns the incentives of employee and employer, perhaps the most profitable Swiss bank going forward will actually make a franc or two.
Monday, October 19, 2009
Interest Rate Swaps Turning Harvard Crimson
Bloomberg has another article about Harvard’s financial bets gone awry, with a focus on interest rate swaps. As I’m closely tied to Harvard and traded billions of these financial instruments, I thought I might as well weigh in.
First, some background. Interest rate swaps themselves are a derivative. In fact, by overall notional (face value) outstanding, they’re the most common derivative. According to the Bank of International Settlements (the organization that has the enviable task of keeping track of this stuff), at the end of December 2008, there was approximately $600 trillion of notional outstanding in the over-the-counter (OTC) derivatives market. Interest rate swaps accounted for about $330 trillion of this amount, more than 50%. And the net present value of these swaps, about $16.5 trillion, was around 50% of the total net present value of all outstanding derivatives contracts (I’ll go into the difference between notional outstanding and net present value a little later for those interested).
Though a swap is classified as a derivative, at a basic level, it’s nothing more than a bond. One party agrees to pay a fixed interest rate tied to a notional, and the other party agrees to pay a floating rate in return for the fixed payment. Usually, the floating rate is linked to LIBOR, the London Interbank Offered Rate (a daily rate at which large banks make unsecured loans to one another).
Since this can get abstract pretty quickly, let me give some examples that should shed some light on how Harvard lost money (Note: I myself wasn’t involved in any of the Harvard transactions but am well aware of what they did). Suppose Party A and Party B have different views on interest rates at the long end of the yield curve: Party A thinks rates will rise, and Party B thinks they will fall. So, the two enter an interest rate swap, whereby for 30 years, Party A will pay 4% of $1 billion notional to Party B every six months (i.e., 2% per half year) and in return Party A will receive LIBOR on $1 billion every three months. For now, assume that 4% is the fair 30-year swap rate, meaning that the current net present value of this transaction is $0 for both parties. This is to say, the net present value of the expected quarterly LIBOR settings in the future will exactly offset the semi-annual payments of 4% on $1 billion.
Let me just summarize the terms of this swap for your reference.
Notional: $1 billion
Maturity: 30 years
Fixed Rate: 4% (Party A pays, Party B receives)
Floating Rate: LIBOR (Party A receives, Party B pays)
Because we’re assuming 4% is the fair rate today (and parties generally only enter into swaps at the fair rate), neither Party A nor Party B has to pay anything to enter into the contract. But, because interest rates move, the swap will not be worth $0 for more than a few seconds. To be more precise, when interest rates rise, Party A will make money and Party B will lose an equal and opposite amount. Conversely, when interest rates fall, Party A will lose money, and Party B will gain.
To see why this is true intuitively, it helps to view the matter from one party’s perspective (and then apply the opposite logic to the other party). I’ll choose Party B. As Party B is currently receiving a fixed amount, when rates fall, the net present value of what Party B will receive rises because the payments are being discounted at a lower rate. In this way, you can think of Party B as being long a bond, and perhaps you remember the basic principle that when interest rates fall, bond prices rise and vice versa. Actually, despite all the complicated terminology, there’s no need to think of anything other than a bond: Party B is long a bond, Party A is short; Party B wants rates to fall, Party A wants them to rise.
So, where does fair Harvard fit in?
Like Party A, Harvard was paying fixed on a long-dated swap. It therefore stood to gain if rates rose and stood to lose if they fell. Once again, the basic logic here isn’t complicated. While commentators often speak of innocent counterparties being “fooled” by swaps, even the most unsophisticated parties realize the fundamentals – you pay fixed, you pray rates rise; you receive fixed, you hope they fall.
So, as far as the swap was concerned (and ignoring the possibility of whether the school had anything to offset this swap), Harvard was no doubt hoping rates would rise. And they didn’t. No, they fell hard and fast. To give you a sense of how this precipitous collapse led to hemorrhaging at Harvard, I’ll briefly walk through a trade comparable to the ones put on in Cambridge.
Thinking that rates will rise, on January 2, 2007, I entered into a swap where I agree to pay fixed and receive floating on $3 billion notional for 30 years. The fair 30-year swap rate on that date was around 5.3%, so I had to make payments of roughly $100 million per year (split in two installments) in return for quarterly payments tied to LIBOR. Since I entered into the swap at the then fair rate, the value of the swap to me and my counterparty, Bank A, was $0.
Fast forward to January 2, 2009. A lot happened in the intervening two years – many of Bank A’s competitors went bust, the world’s very financial framework teetered on the brink of collapse, and, worst of all for me, rates fell across the board. The fair 30-year swap on that date was about 2.95%, 2.35% (235 basis points) lower than it was when I entered the agreement. Now, 235 basis points may not seem like a lot, but on a $3 billion 30-year swap, it’s gargantuan.
Roughly speaking (I am taking some liberties to hammer home the basic point but the calculation is essentially correct), in the intervening two years I stood to make about $4.5 million for every basis point the 30-year swap rate rose and stood to lose about $4.5 million for every basis point the rate fell. 235 basis points multiplied by $4.5 million per basis point is more than $1 billion. That’s a fair amount of coin for any place, including a school with an endowment exceeding the GDP of more than 90 countries (even after the fund’s 30% fall!).
If it's not that difficult for people within the university or beyond to see how Harvard could have lost so much money from an interest rate swap, I am somewhat perplexed as to why the institution amassed such a large amount of outright rate exposure. While the endowment is in the business of taking some (and perhaps too much) risk, I can't imagine why anybody at the university would just dump several billion dollars into illiquid long-dated swaps if not to hedge another obligation. Perhaps the university did put on the swaps to insulate against other rate risk. But if the swaps were meant to be a hedge, the institution's net losses suggest the instruments didn't do a very good job.
Indeed, the swaps did a far better job of making breakfast offerings colder, free cookies sparser, and endowment managers' faces redder.
First, some background. Interest rate swaps themselves are a derivative. In fact, by overall notional (face value) outstanding, they’re the most common derivative. According to the Bank of International Settlements (the organization that has the enviable task of keeping track of this stuff), at the end of December 2008, there was approximately $600 trillion of notional outstanding in the over-the-counter (OTC) derivatives market. Interest rate swaps accounted for about $330 trillion of this amount, more than 50%. And the net present value of these swaps, about $16.5 trillion, was around 50% of the total net present value of all outstanding derivatives contracts (I’ll go into the difference between notional outstanding and net present value a little later for those interested).
Though a swap is classified as a derivative, at a basic level, it’s nothing more than a bond. One party agrees to pay a fixed interest rate tied to a notional, and the other party agrees to pay a floating rate in return for the fixed payment. Usually, the floating rate is linked to LIBOR, the London Interbank Offered Rate (a daily rate at which large banks make unsecured loans to one another).
Since this can get abstract pretty quickly, let me give some examples that should shed some light on how Harvard lost money (Note: I myself wasn’t involved in any of the Harvard transactions but am well aware of what they did). Suppose Party A and Party B have different views on interest rates at the long end of the yield curve: Party A thinks rates will rise, and Party B thinks they will fall. So, the two enter an interest rate swap, whereby for 30 years, Party A will pay 4% of $1 billion notional to Party B every six months (i.e., 2% per half year) and in return Party A will receive LIBOR on $1 billion every three months. For now, assume that 4% is the fair 30-year swap rate, meaning that the current net present value of this transaction is $0 for both parties. This is to say, the net present value of the expected quarterly LIBOR settings in the future will exactly offset the semi-annual payments of 4% on $1 billion.
Let me just summarize the terms of this swap for your reference.
Notional: $1 billion
Maturity: 30 years
Fixed Rate: 4% (Party A pays, Party B receives)
Floating Rate: LIBOR (Party A receives, Party B pays)
Because we’re assuming 4% is the fair rate today (and parties generally only enter into swaps at the fair rate), neither Party A nor Party B has to pay anything to enter into the contract. But, because interest rates move, the swap will not be worth $0 for more than a few seconds. To be more precise, when interest rates rise, Party A will make money and Party B will lose an equal and opposite amount. Conversely, when interest rates fall, Party A will lose money, and Party B will gain.
To see why this is true intuitively, it helps to view the matter from one party’s perspective (and then apply the opposite logic to the other party). I’ll choose Party B. As Party B is currently receiving a fixed amount, when rates fall, the net present value of what Party B will receive rises because the payments are being discounted at a lower rate. In this way, you can think of Party B as being long a bond, and perhaps you remember the basic principle that when interest rates fall, bond prices rise and vice versa. Actually, despite all the complicated terminology, there’s no need to think of anything other than a bond: Party B is long a bond, Party A is short; Party B wants rates to fall, Party A wants them to rise.
So, where does fair Harvard fit in?
Like Party A, Harvard was paying fixed on a long-dated swap. It therefore stood to gain if rates rose and stood to lose if they fell. Once again, the basic logic here isn’t complicated. While commentators often speak of innocent counterparties being “fooled” by swaps, even the most unsophisticated parties realize the fundamentals – you pay fixed, you pray rates rise; you receive fixed, you hope they fall.
So, as far as the swap was concerned (and ignoring the possibility of whether the school had anything to offset this swap), Harvard was no doubt hoping rates would rise. And they didn’t. No, they fell hard and fast. To give you a sense of how this precipitous collapse led to hemorrhaging at Harvard, I’ll briefly walk through a trade comparable to the ones put on in Cambridge.
Thinking that rates will rise, on January 2, 2007, I entered into a swap where I agree to pay fixed and receive floating on $3 billion notional for 30 years. The fair 30-year swap rate on that date was around 5.3%, so I had to make payments of roughly $100 million per year (split in two installments) in return for quarterly payments tied to LIBOR. Since I entered into the swap at the then fair rate, the value of the swap to me and my counterparty, Bank A, was $0.
Fast forward to January 2, 2009. A lot happened in the intervening two years – many of Bank A’s competitors went bust, the world’s very financial framework teetered on the brink of collapse, and, worst of all for me, rates fell across the board. The fair 30-year swap on that date was about 2.95%, 2.35% (235 basis points) lower than it was when I entered the agreement. Now, 235 basis points may not seem like a lot, but on a $3 billion 30-year swap, it’s gargantuan.
Roughly speaking (I am taking some liberties to hammer home the basic point but the calculation is essentially correct), in the intervening two years I stood to make about $4.5 million for every basis point the 30-year swap rate rose and stood to lose about $4.5 million for every basis point the rate fell. 235 basis points multiplied by $4.5 million per basis point is more than $1 billion. That’s a fair amount of coin for any place, including a school with an endowment exceeding the GDP of more than 90 countries (even after the fund’s 30% fall!).
If it's not that difficult for people within the university or beyond to see how Harvard could have lost so much money from an interest rate swap, I am somewhat perplexed as to why the institution amassed such a large amount of outright rate exposure. While the endowment is in the business of taking some (and perhaps too much) risk, I can't imagine why anybody at the university would just dump several billion dollars into illiquid long-dated swaps if not to hedge another obligation. Perhaps the university did put on the swaps to insulate against other rate risk. But if the swaps were meant to be a hedge, the institution's net losses suggest the instruments didn't do a very good job.
Indeed, the swaps did a far better job of making breakfast offerings colder, free cookies sparser, and endowment managers' faces redder.
Drunken Sailor?
I was about to go into a several post-long detour on sales and trading performance in Q3 and 2009 as a whole. But, prone as I am to distractions, I am taking yet another turn off the highway. With all the attention that this whole Galleon insider-trading thing is getting, I thought I might as well put in my two cents. If you somehow haven’t heard about the matter, check out one of the billion articles that have been written over the last four days. Here is a link to the NY Times piece and for the more sexually adventurous, the WSJ article, titled Colleagues Finger Billionaires.
For those too lazy or conservative to read about fingering, here’s the brief overview: very rich and ostensibly successful hedge fund honcho gets in trouble for supposedly relying on an intricate network of other important people to obtain and profit off insider information. On the face of it, we have the standard insider trading theatrics – there’s the non-public information, the foul-mouthed characters, and the ill-gotten gains.
But something strikes me as rather odd about this affair. Galleon is a BIG hedge fund, with almost $4 billion in assets under management. Yet the numbers being thrown around here are extremely small. The government accuses Raj Rajaratnam (props to anyone who can pronounce that name, by the way) of illegally making $20 million. $20 million? Is that a joke?
Raj is a big dude, and not just in girth. The guy is listed on Forbes as having a net worth of $1.8 billion (which made him the 262 richest American) and producing a 21% return net of fees since 1997. Last time I checked, $20 million is about 1% of $1.8 billion and about 0.50% of $4 billion – in other words, a very small number in Raj’s life. So, he’d have to do a lot more insider trading to make a meaningful impact on his fund’s (and thereby his) bottom line. Why would somebody risk so much (in the way of jail time, ill repute, career suicide) for so little in the grand scheme of things?
I can think of three answers:
1) Mr. Rajaratnam thought he could get away with it either because the SEC wouldn’t catch him or because his case would be difficult to prosecute (it very well might be despite the preponderance of evidence against him).
2) He didn’t think what he was doing was truly illegal. The evidence suggests that the cast of characters involved certainly wanted to keep their operations quiet, but there’s a big difference between doing something sketchy and committing a crime.
3) He is an idiot, a drunken sailor at the helm of a large ship, who simply never weighed the costs against the benefits. Now, I’m not saying that you should engage in securities fraud when the potential benefits loom large, but there is clearly no reason to when they don’t.
For those too lazy or conservative to read about fingering, here’s the brief overview: very rich and ostensibly successful hedge fund honcho gets in trouble for supposedly relying on an intricate network of other important people to obtain and profit off insider information. On the face of it, we have the standard insider trading theatrics – there’s the non-public information, the foul-mouthed characters, and the ill-gotten gains.
But something strikes me as rather odd about this affair. Galleon is a BIG hedge fund, with almost $4 billion in assets under management. Yet the numbers being thrown around here are extremely small. The government accuses Raj Rajaratnam (props to anyone who can pronounce that name, by the way) of illegally making $20 million. $20 million? Is that a joke?
Raj is a big dude, and not just in girth. The guy is listed on Forbes as having a net worth of $1.8 billion (which made him the 262 richest American) and producing a 21% return net of fees since 1997. Last time I checked, $20 million is about 1% of $1.8 billion and about 0.50% of $4 billion – in other words, a very small number in Raj’s life. So, he’d have to do a lot more insider trading to make a meaningful impact on his fund’s (and thereby his) bottom line. Why would somebody risk so much (in the way of jail time, ill repute, career suicide) for so little in the grand scheme of things?
I can think of three answers:
1) Mr. Rajaratnam thought he could get away with it either because the SEC wouldn’t catch him or because his case would be difficult to prosecute (it very well might be despite the preponderance of evidence against him).
2) He didn’t think what he was doing was truly illegal. The evidence suggests that the cast of characters involved certainly wanted to keep their operations quiet, but there’s a big difference between doing something sketchy and committing a crime.
3) He is an idiot, a drunken sailor at the helm of a large ship, who simply never weighed the costs against the benefits. Now, I’m not saying that you should engage in securities fraud when the potential benefits loom large, but there is clearly no reason to when they don’t.
Break out the Champagne?
The point of this blog is to first provide some basics on derivatives and then begin commenting on current events where these financial instruments loom large. But, seeing as third quarter earnings for the banking sector are trickling in, I can’t resist a brief detour. Below is the round up so far:
Some banks are making money
JP Morgan: $3.6 billion
Goldman Sachs: $3.2 billion
Others not so much
Bank of America (or is it Banc of America?): -$1.0 billion
Citigroup: -$3.2 billion
But I don’t care about these top line numbers since they reflect the sum total of a wide range of businesses, many of which I know nothing about. I am interested in trading results, and you may be too.
Revenue from non-equity (bonds, currencies, and commodities) and equity trading units
Goldman: $6.0 billion (non-equity) + $2.8 billion (equity) = $8.8 bn
JP Morgan: $5.0 billion (non-equity) + $0.9 billion (equity) = $5.9 bn
B of A: $4.4 billion (non-equity) + $1.4 billion (equity) = $5.8 bn
Citi: $3.9 billion (non-equity) + $0.4 billion (equity) = $4.3 bn
Not surprisingly, Goldman has turned in the strongest trading results however you cut it. Somewhat surprisingly (given the amount of negative attention the Merrill Lynch acquisition produced), Bank of America is right up there with JP Morgan, thanks to Ken Lewis’ corralling of the thundering herd. The Merrill purchase may have sent Lewis packing, but it has made Bank of America’s once laughable sales and trading franchise a force to be reckoned with, particularly on the equity side.
At this point, I don’t even think Vikram Pandit would disagree that Citigroup is now the clear sales and trading laggard among the full-service banking troika of Bank of America, Citigroup, and JP Morgan. Thankfully, I dumped Citigroup stock when it was at $50 – I don’t expect it to return to that level in my lifetime.
Yet, even Citigroup’s non-equity numbers aren’t half bad if you consider where we were just a year ago. Of course, Q3 2008 was an absolute shit show as the financial world all but collapsed in September 2008 (the end of Q3 for all financial institutions except the soon-to-be-extinct pure play investment banks Goldman Sachs and Morgan Stanley)
Q3 2008 revenue from non-equity and equity trading units
Goldman*: $1.6 billion (non-equity) + $1.6 billion (equity) = $3.2 bn
JP Morgan: $0.8 billion (non-equity) + $1.7 billion (equity) = $2.5 bn
B of A: -$0.4 billion (non-equity) + $0.2 billion (equity) = -$0.2 bn
Citi: -$2.4 billion (non-equity) + $0.5 billion (equity) = -$1.9 bn
*Goldman’s quarter ended August 29, 2008, not September 30, 2008, unlike that of the other three banks.
It’s interesting to note that at least by sales and trading revenue, the ranking of the four banks in Q3 2008 was the same as that in Q3 2009 and the gap between highest and lowest was quite similar (nearly $5 billion in each case).
Clearly, 2009 has been a much better year for banks in general, and in subsequent posts, I will go into some of the reasons for the turnaround. One thing that stands out, or rather no longer stands out, is the write down issue. Now that banks are no longer marking down billions worth of credit-related assets, they are actually printing some serious cash on the non-equity front. Given the significance of fixed income write downs in 2008, the non-equity side has been the clear driver of the performance difference between this year and last for every bank on the list. In fact, even during the heart of the credit crunch last year, some banks were then reporting stronger equity numbers than they are now.
I have a lot more to say on this matter and am curious to see what Morgan Stanley reports on Wednesday, October 21. My guess is that they will land somewhere between Bank of America and Citigroup in sales and trading revenue. Though Stanley has dialed down the risk and won’t come close to Goldman on the trading side any time soon, this should be their first positive earnings quarter of the year – cause for at least a modicum of celebration at 1585 Broadway.
Of course, Mack and his cronies won’t be able to do all that much in the way of celebrations. With the government still claiming to be scrutinizing the pay practices of banks, no institution will be popping the champagne corks – at least in public. But, Q3 2009 results, coming after strong Q2 numbers, will no doubt be cause for more muted revelry on Wall Street.
The Girl at the Bar
Derivatives come in all shapes and sizes, but at this juncture, it doesn't make sense to go into details. So, for my first pseudo-substantive post, I'll provide just enough ammunition for you to impress a girl at a bar. I mean a relatively nice watering hole, where an inebriated member of the opposite sex may actually be intrigued by the word "derivative." Though I wouldn't necessarily call myself Don Juan, I've found that at such establishments derivatives have an exotic, almost dangerous appeal. If talk of these instruments won't necessarily get you laid, it should get your foot in the door -- the rest, I'm afraid, is up to you.
"So what do you do?" the girl will ask after you'll accidentally bump into her and strike up a conversation.
"Derivatives."
"Ooh, sounds complicated," and then she'll flutter her eyes. At this point, if you're lucky, she'll just go home with you. But it usually doesn't work that way. "I've always wondered what those were."
"Well, you know, they really are complicated."
"It's okay. Explain to me."
For whatever reason, she thinks she's now in Continuous Finance and you're Robert Merton. Unfortunately, having brought up the topic, you'll have no choice but to throw something back at her. "Fine, but trust me when I say I'm a bad explainer."
"Don't worry." She'll wink. In all likelihood, she wouldn't be able to tell whether you were full of shit or not, so you just need to sound smart. Still, for the sake of intellectual honesty, you might as well deliver a half decent answer.
"A derivative is a fancy bet," you'll begin. "In fact, a derivative can be a bet on pretty much anything. You can trade a derivative on a stock, a bond, a commodity, and even your Prada purse if you want. What matters is that the value of your trade is derived from an underlying asset."
"Huh? You really are a shitty explainer."
"Sorry, let me give an example. It's probably easiest to do it with stocks. You have any stocks you like?"
"Yeah, Saks. I work there, and they gave me some stock. But I'd rather have shoes."
"Okay, suppose you own 1 share of Saks stock, and it's worth $10. Suppose further that you think the fall collection has a lot of promise and the stock will go up to $15 in the near future. Now, you could just buy another share, but you may not have $10 to spend. So, instead, you could contract with another party for the option to buy a share at a certain strike price -- let's say $15. This call option, a type of derivative, would work in the following way: if Saks rises to $16, you will profit because you have the right to buy the stock at $15 and can then immediately sell it for $16; however, if Saks never reaches $15 before your option expires, your contract will be worthless -- you wouldn't want to buy a share for $15 when the stock is trading below that. Am I going too fast?"
"No, this kind of makes sense. So, you're saying that with an option, I could get the right to buy a stock at a certain price, and if the stock ends up above that price, I will make money; otherwise, I won't."
"Yeah, you have the hang of it."
"That seems cool. Why doesn't everybody just do that?"
"Well, it's risky. Suppose the option to buy the Saks stock for $15 is trading at $2. $2 is a lot less than $10, the price of the stock now, but it can end up being a bigger outlay than you think. See, when you trade a stock, you don't generally have to worry about losing all of your money. Yeah, the thing may go up or down 5 or 10% over a few months, but unless the company goes bankrupt (not out of the question for Saks), your stock won't plunge to 0. With options, it's different. If Saks doesn't end up above $15, when your option expires, what you paid $2 for will in fact be worth 0. So, there's a very real chance that you could lose 100% of your money. See, with options, percentage gains and losses can be magnified."
"Oh, I get it. Kind of like shopping at one of those discount outlets. You could end up with a really great pair of Jimmy Choos but run the real risk of picking up fake heels instead."
"I guess you could say that. The financial term is 'leverage.' Like a bargain shopper, you don't put down a lot of cash for something that may make you very happy yet could produce more pain than a botched pedicure."
"I see. Thanks. I think that's enough for one night."
"Yeah, I'm getting kind of tired myself." Then, you'll look into her eyes and make the move. "Any plans for the rest of the night?"
"Heading over to my boyfriend's place actually. Thanks for all the info, though."
"So what do you do?" the girl will ask after you'll accidentally bump into her and strike up a conversation.
"Derivatives."
"Ooh, sounds complicated," and then she'll flutter her eyes. At this point, if you're lucky, she'll just go home with you. But it usually doesn't work that way. "I've always wondered what those were."
"Well, you know, they really are complicated."
"It's okay. Explain to me."
For whatever reason, she thinks she's now in Continuous Finance and you're Robert Merton. Unfortunately, having brought up the topic, you'll have no choice but to throw something back at her. "Fine, but trust me when I say I'm a bad explainer."
"Don't worry." She'll wink. In all likelihood, she wouldn't be able to tell whether you were full of shit or not, so you just need to sound smart. Still, for the sake of intellectual honesty, you might as well deliver a half decent answer.
"A derivative is a fancy bet," you'll begin. "In fact, a derivative can be a bet on pretty much anything. You can trade a derivative on a stock, a bond, a commodity, and even your Prada purse if you want. What matters is that the value of your trade is derived from an underlying asset."
"Huh? You really are a shitty explainer."
"Sorry, let me give an example. It's probably easiest to do it with stocks. You have any stocks you like?"
"Yeah, Saks. I work there, and they gave me some stock. But I'd rather have shoes."
"Okay, suppose you own 1 share of Saks stock, and it's worth $10. Suppose further that you think the fall collection has a lot of promise and the stock will go up to $15 in the near future. Now, you could just buy another share, but you may not have $10 to spend. So, instead, you could contract with another party for the option to buy a share at a certain strike price -- let's say $15. This call option, a type of derivative, would work in the following way: if Saks rises to $16, you will profit because you have the right to buy the stock at $15 and can then immediately sell it for $16; however, if Saks never reaches $15 before your option expires, your contract will be worthless -- you wouldn't want to buy a share for $15 when the stock is trading below that. Am I going too fast?"
"No, this kind of makes sense. So, you're saying that with an option, I could get the right to buy a stock at a certain price, and if the stock ends up above that price, I will make money; otherwise, I won't."
"Yeah, you have the hang of it."
"That seems cool. Why doesn't everybody just do that?"
"Well, it's risky. Suppose the option to buy the Saks stock for $15 is trading at $2. $2 is a lot less than $10, the price of the stock now, but it can end up being a bigger outlay than you think. See, when you trade a stock, you don't generally have to worry about losing all of your money. Yeah, the thing may go up or down 5 or 10% over a few months, but unless the company goes bankrupt (not out of the question for Saks), your stock won't plunge to 0. With options, it's different. If Saks doesn't end up above $15, when your option expires, what you paid $2 for will in fact be worth 0. So, there's a very real chance that you could lose 100% of your money. See, with options, percentage gains and losses can be magnified."
"Oh, I get it. Kind of like shopping at one of those discount outlets. You could end up with a really great pair of Jimmy Choos but run the real risk of picking up fake heels instead."
"I guess you could say that. The financial term is 'leverage.' Like a bargain shopper, you don't put down a lot of cash for something that may make you very happy yet could produce more pain than a botched pedicure."
"I see. Thanks. I think that's enough for one night."
"Yeah, I'm getting kind of tired myself." Then, you'll look into her eyes and make the move. "Any plans for the rest of the night?"
"Heading over to my boyfriend's place actually. Thanks for all the info, though."
Thursday, October 8, 2009
My Ex
"I'm an ex-derivatives trader." That's how I introduce myself to colleagues these days. I haven't fully decided whether my past should be a source of pride or shame. On most days, I think the latter and usually deliver my opening line with the contrition of an AA member. Of course, my tone doesn't matter much to the people listening. None of them know what a derivative is and few care to find out. So, the conversations tend to be brief and a bit awkward -- kind of like my career on Wall Street.
If I do make it to a second introductory sentence, I hasten to add, "I voluntarily left Wall Street," with an emphasis on the "voluntarily" part. My career was short and no doubt painful, yet I left the trading floor on my own accord. In fact, after two years, I'd amassed a great deal of responsibility, probably too much. Scarcely above the legal drinking age, I somehow found myself trading two of the most esoteric derivatives books at one of the largest banks in the world. I like to think I'm a smart guy (and certainly nobody has accused me of thinking otherwise), but I'll be honest -- most of the time, I had no fucking clue what was going on. And neither did anybody else.
See, that's the really funny thing about Wall Street. If it seems inscrutable from the outside, it's downright cryptic from the inside. It wasn't until I actually arrived on the trading floor that I realized just how opaque the engines of the financial sector really were. I'm talking about derivatives particularly, which fueled the banking industry before the credit crunch and will likely reassert their dominance when Alan Greenspan or some other luminary says the crisis has ended.
Because derivatives are so important, I've decided to devote a blog to them. Yes, I'm aware that most of Wall Street doesn't understand these curious creatures and that most of the world beyond Wall Street doesn't give a shit about them. Still, I'm hoping a few people might care. What can I say? I guess I'm hung up on my ex.
If I do make it to a second introductory sentence, I hasten to add, "I voluntarily left Wall Street," with an emphasis on the "voluntarily" part. My career was short and no doubt painful, yet I left the trading floor on my own accord. In fact, after two years, I'd amassed a great deal of responsibility, probably too much. Scarcely above the legal drinking age, I somehow found myself trading two of the most esoteric derivatives books at one of the largest banks in the world. I like to think I'm a smart guy (and certainly nobody has accused me of thinking otherwise), but I'll be honest -- most of the time, I had no fucking clue what was going on. And neither did anybody else.
See, that's the really funny thing about Wall Street. If it seems inscrutable from the outside, it's downright cryptic from the inside. It wasn't until I actually arrived on the trading floor that I realized just how opaque the engines of the financial sector really were. I'm talking about derivatives particularly, which fueled the banking industry before the credit crunch and will likely reassert their dominance when Alan Greenspan or some other luminary says the crisis has ended.
Because derivatives are so important, I've decided to devote a blog to them. Yes, I'm aware that most of Wall Street doesn't understand these curious creatures and that most of the world beyond Wall Street doesn't give a shit about them. Still, I'm hoping a few people might care. What can I say? I guess I'm hung up on my ex.
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