Quote of the Day

"Buffett once told me there are three 'I's in every cycle. The 'innovator,' that's the first 'I.' After the innovator comes the 'imitator.' And after the imitator in the cycle comes the idiot." -Theodore Forstmann, quoting Warren Buffett

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King's men must put themselves together again - FT.com

Summary:
John Gapper explains why banks and insurance companies got addicted to complexity, through the practice of dicing up cashflows and risk. Origin of practice traces back to Black, Scholes and Merton, 1973. The appeal to financial institutions derives from four reasons: it skews the odds in favour of those who hold the technology; structured finance has been a huge money-spinner; complexity produced yield; and, most perilously, structured finance gave banks and others more chances to take on "tail risk." The future of finance and regulations now looks very uncertain. The crisis has exposed gaping holes in the US regulatory structure. The current system is outdated (devices in the 1930s). The biggest regulatory gap involves over-the-counter (OTC) derivatives. (Published: 19/09/08)

Notes:

• worst financial crisis in US markets since 1929
• the investment banks and insurers that caused the problem did so by taking mortgages and first packaging and repackaging them into bizarrely complex securities, and then topping them off with derivatives
• e.g. AIG had been writing credit default swaps (CDS)
• a form of derivative allowing one financial institution to pass the risk of a bond defaulting on to another
• sold them to banks wanting to protect themselves against defaults on collateralised debt obligations (CDOs), built from sub-prime mortgages
• when these CDS plunged in value because the market stopped trusting what they were worth, AIG came close to bankruptcy and was bailed out by the US Treasury
• dicing up of cashflows and risk
  
• has been a growing part of markets since Fischer Black, Myron Scholes and Robert Merton, three US academics, devised a way to value options in 1973
• over the ensuing three decades, banks and insurance companies got addicted to complexity
• four reasons
1. it skews the odds in favour of those who hold the technology
• rading in markets is essentially a zero sum game, in which you have an equal chance of winning or losing
• but: banks have been able to shift the odds by using computer models that others lack, to trade in volatility, for example
2. structured finance has been a huge money-spinner
• i.e. the practice of using the cashflows from stocks and bonds to create other securities
  
• every institution involved in creating and selling structured bonds, from banks to ratings agencies to insurance companies, gained a big fee every time such a bond was issued
3. complexity produced yield
• in an era of low interest rates, pension funds and insurance companies found it hard to earn much money from cash
• so any instrument that appeared safe but paid a higher interest rate than Treasury bonds, which mortgage-backed securities did, found ready buyers
• the problem was that these securities paid a higher yield than other triple A rated paper precisely because they were complex
• investors got paid more to hold them because they were so difficult to understand
4. structured finance gave banks and others more chances to take on "tail risk"
• this is an insurance-like trading strategy:
  
• one institution writes swaps or options that provide it with regular payments in exchange for taking another's risk of default
• in most cases, this produces profits, but occasionally it is disastrous
• was AIG's downfall
  
• huge uncertainty over the future of finance and of regulation
• risks of financial institutions devoting themselves to the underwriting and sale of complex securities have become abundantly clear
• complexity is a good way to make money, but it also causes bank runs
• crisis has exposed gaping holes in the US regulatory structure
• largely devised in the 1930s and is outdated
• the supervision of banks and investment banks is done by different bodies while insurers are regulated by US states
• biggest regulatory gap involves over-the-counter (OTC) derivatives
• the contracts traded among banks and insurance companies that lie at the heart of the financial crisis
• not regulated at all in the US since they were excluded by the federal government from Commodities Futures Trading Commission oversight eight years ago

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Quote of the Day

"Allowing investment banks to be leveraged to the tune of 30 to 1 is the equivalent of playing Russian roulette with five of the six chambers of the gun loaded. If one adds the off-balance-sheet liabilities to this leverage, you might as well fill the sixth chamber with a bullet and pull the trigger." - Michael Lewitt

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Why global capitalism needs global rules - FT.com

Summary:
Philip Stevens argues that once the financial storm has settled, politicians will need to consider what the crisis tells us about the nature of the world we live in. One thing it revealed is that governments have been left with responsibility without power. The grip of individual states on the levers of economic management decisively weakened, but the loss of control has not been matched by any corresponding diminution of responsibility. Tensions like this, resulting from globalization, are not restricted to just the economy. Voters want the ease of movement across national borders that comes with cheap travel, but they also want governments to control immigration and cross-border crime. They want to buy cheap electronics from China, but they blame politicians when global supply chains threaten job security at home. If the politicians want the liberal market system to work, they will have to make multilateralism work. We need global governance, and a set of credible international rules. (Published: 18/09/08)

Notes:

• once the storm abates the task for politicians will be to ask some bigger questions
• Putting aside the technicalities of collateralised debt obligations, capital ratios and the rest, what does the crisis tell us about the nature of the world in which we now live?
• growing tension between global integration and a shortage of credible international governance
• governments have been left with responsibility without power
• tensions as a result of globalization
  
• grip of individual states on the levers of economic management decisively weakened
• few political leaders outside the US were even vaguely aware of the degree to which their own banking systems were held hostage to the subprime loans made to American homeowners
• but: loss of control has not been matched by any corresponding diminution of responsibility
• voters still hold their own politicians to account for the insecurities that flow from interdependence
• blaming someone else offers insufficient answer to the homeowners trapped in negative equity or to depositors or creditors in a failing bank
• voters want the ease of movement across national borders that comes with cheap travel
• but they also want governments to control immigration and cross-border crime
• voters want to buy cheap electronics from China
• but they blame politicians when global supply chains threaten job security at home
• tensions are not susceptible to neat solutions
• but: all point in the same direction
• interdependence is no longer an abstract noun
• governments need to find ways to reclaim some of the sovereignty lost to globalisation
• means more global governance: credible international rules
• consequences of financial shocks
• capitalism will survive
• but: risk of a retreat to economic nationalism
• if the politicians want the liberal market system to work, they will have to make multilateralism work

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Word of the Day: The Pecora Commission

Commission established by the U.S. Senate to study the causes of the crash of 1929. The hearings lasted for two years (1932 - 1934) and resulted in the U.S. Congress passing the Glass-Steagall Act in 1933, which mandated a separation between commercial banks, which take deposits and extend loans, and investment banks, which underwrite, issue, and distribute stocks, bonds, and other securities.

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What Should Government Guarantee? - EconLog

Summary:
Arnold Kling says that financial markets are inherently unstable because they are based on trust and inherently lacking transparency. In fact, trust and reputation replace transparency in financial intermediation; if it were perfectly transparent, there would be no need for it, one could do its business oneself. Deposit insurance helps facilitate trust. It removes all motivation for the consumer to worry about the bank's risk management. It is, however, up to the insurer (FDIC) to worry. Any system can be gamed eventually, so it's a challenge for the regulators to stay one step ahead of the banks. Bear Stearns, Freddie and Fannie, Lehman, and AIG were not FDIC-insured banks, yet there creditors are being rescued. Ad hoc-ness of Fed and Treasury causing some resentment. Regulators should try to anticipate crises and prevent them. But almost by definition, the crises that do occur will be ones that they did not anticipate, and the responses will have to be somewhat ad hoc. (Published: 16/09/08)

Notes:

• financial markets are inherently unstable
• because financial intermediation inherently replaces transparency with trust
• if my bank were perfectly transparent, then I would know everything about its loans
• including the underlying risks of the real estate developers, small businesses, and individuals to whom it is lending money
• in that case, I would not need a bank,I could just make those loans myself.
• so if you assume perfect transparency, you assume away the need for financial intermediation
• you have to assume the opposite of perfect transparency, highly imperfect transparency
• with reputation and trust serving as substitutes

• deposit insurance helps facilitate trust
• private insurance pool might work, but people trust government-provided deposit insurance even more
• the consumer loses all motivation for worrying about the bank's risk management
• by contrast: the insurer has to worry a lot
• in the U.S., the FDIC has been getting better over the years, but you can never get complacent
• any system can be gamed eventually, so it's a challenge for the regulators to stay one step ahead of the banks
• Bear Stearns, Freddie and Fannie, Lehman, and AIG
• institutions that are not FDIC-insured banks
  
• question arises about whether some of their creditors ought to be protected by the government
• note: financial blow-up has not come from private hedge funds
• highly leveraged and unregulated business
• having some regulated, insured institutions, like the banks, is good
• we can or should not try to regulate everyone
• regulators should try to anticipate crises and prevent them
• but almost by definition, the crises that do occur will be ones that they did not anticipate, and the responses will have to be somewhat ad hoc

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Quote of the Day

“The rule is that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes it distinctive character to the aforementioned brevity of the financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.” - J.K. Galbraith, "A Short History of Financial Euphoria"

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The K-T Boundary - The Epicurean Dealmaker

Summary:
Epicurean Dealmaker elaborates on John Gapper's FT comment about how the investment banking industry got to this stage. The problematic component of i-banking is the capital markets business. Maintaining a credible and effective capital markets operation has always been an expensive proposition, compared to the advisory side of the business. When fixed commissions were eliminated, the huge capital markets business of a typical investment bank could no longer support itself financially. Started using a much larger amount of money trading for their own account, on a proprietary basis. As a result of US's ballooning trade deficit, and low interest rates under Greenspan, capital markets operations became the dominant business line of all major investment banks over the past couple of decades. Compensation systems at investment banks could not deal with this development. Imbalances built up, risk and return became misaligned. But capital markets business has always been an integral part of an investment bank's advisory business. No better definition of market-based advice, and no better example of the type of added value an integrated investment bank can bring to its client. Pure advisory boutiques cannot deliver this sort of advice, because they do not have the capital markets arms to deliver it. Catch-22. capital markets capabilities cannot pay for themselves without proprietary trading operations. (Published: 16/09/08)

Notes:

• how did the investment banking industry get itself into this pickle, and where does it go from here?
• John Gapper, "May Day": the elimination of fixed commissions for stock trades in 1975
• launched the industry onto the path of relentless growth in capital, people and profits
• capital markets business
• securities sales and trading activities
• has always been a key component of the investment banking model
• but: maintaining a credible and effective capital markets operation has always been an expensive proposition
• requires a lot of people, information technology, dedicated real estate, and other doodads that cost a lot of money to install and a lot of money to maintain
• unlike the advisory side of the business
• your typical M&A banker requires very little in the way of infrastructure
• May Day: when fixed commissions were eliminated, the huge capital markets business of a typical investment bank could no longer support itself financially
• banks needed to find another use for all that investment in infrastructure
• Salomon Brothers:
  
• first to make the transition from using relatively small amounts of in-house capital to support underwriting and market-making activities to using a much larger amount of money trading for their own account, on a proprietary basis
• because they were "in the flow" and saw the securities markets from the privileged position of market makers, "prop desks" at investment banks started making money hand over fist
• i.e. they started acting like hedge funds
• ballooning federal deficits of the Reagan years
  
• resulted in huge trading volumes in fixed income securities and related derivatives
• led to an explosion in equity trading
• accompanied the internet boom
• Alan Greenspan
  
• plying the financial markets with liquidity "like a whorehouse madam plies shore-leave sailors with booze"
• result: capital markets operations became the dominant business line of all major investment banks over the past couple of decades
• trouble in paradise
• problems caused by trying to incorporate a volatile principal-oriented business like proprietary trading into an organization that was otherwise focused on agency business like M&A advisory, capital raising, and underwriting
• when the prop traders made a bundle betting for the firm, they brought home annual bonuses that struck even the highly overcompensated bankers in M&A and corporate finance as nothing short of obscene
  
• when their trades blew up in their faces everybody else at the firm suffered big cuts in compensation regardless of how good their individual years had been
• compensation systems at investment banks could not deal with this development
• proprietary traders, CDO structurers, and derivatives specialists began taking and holding positions with longer and longer risk tails
• but still got measured and paid based on systems designed to measure the annual production of a banker conducting traditional agency business, like M&A or equity underwriting
• imbalances built up, risk and return became misaligned, "and various pieces of shit began hitting various fans"
• paying traders, corporate financiers, and M&A advisors with long-vesting restricted stock did create some sort of alignment with the firm's and shareholders' interests
• but: it was too blunt an instrument to contain and control the stresses building up in the new hybrid hedge fund-investment banking model
• why didn't the investment banks abandon the securities sales and trading business when it became unprofitable after May 1975? Three reasons:
1. commissions did not vanish in one fell swoop after May 1, 1975
• competition was introduced, and commissions shrank gradually over a number of years
• investment banks did not necessarily see the writing on the wall for quite some time
• by the time they realized that pure agency capital markets was now and forever a loss leader business, it was in many respects too late to change
2. capital markets businesses were always large
• controlling roughly half the resources of a typical investment bank and sometimes more
• very difficult to kill a business line with so much human, psychological, and political capital committed to it
• plus sharp-elbowed leaders who are committed to fight for it
3. most importantly: the capital markets business has always been an integral part of an investment bank's advisory business
• obvious for corporate finance activities like selling bonds to raise capital for a railroad or underwriting an initial public stock offering for a technology company
• raising capital for corporate clients has always been an extremely important business line for investment banks
• was really the only business investment banks conducted for many years after their separation from commercial banks in the 1930s after Glass-Steagall
• until the emergence of a new business in the late 1970s which came to be known as mergers and acquisitions advisory
• "client bankers" to Ford Motor Company, CSX Corporation, and Netscape did and do rely heavily on their buddies on the capital markets desk to gauge investor demand, structure attractive security offerings, and help sell their clients' securities to new investors
• M&A bankers rely heavily and often on their capital markets colleagues, too
• in the case of corporate clients, there is all sorts of useful intelligence an M&A banker can glean from his capital markets partners
• bears directly on the approach, feasibility, and potential price of doing a deal
• publicly traded corporations want to know how the markets will react to the announcement of a transaction
• CEOs want to know who are the top 20 critical investors they should talk to to explain the rationale for selling a division or buying their biggest competitor
• there is no better definition of market-based advice, and no better example of the type of added value an integrated investment bank can bring to its client
• pure advisory boutiques cannot deliver this sort of advice, because they do not have the capital markets arms to deliver it
• capital markets operations of any consequence are too expensive to support solely with the revenues a successful M&A practice brings in
• Catch-22:
• advisory practices cannot compete with fully integrated investment banks in all situations without capital markets capabilities
• but: capital markets capabilities cannot pay for themselves without proprietary trading operations
  
• we seem to be stuck with the integrated i-bank model, whether we like it or not

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Roubini Misses the Boat on Regulation - Mish's blog

Summary:
Mike Shedlock argues that the cause of the financial crisis is not lack of regulation, as argued by by Roubini et al., but government intervention in free markets and fractional reserve banking. Government promoted an ownership society mentality and established HUD, FHA, Fannie, Freddie, and hundreds of affordable housing programs. But government promotion of housing put an artificial bid on housing that a free market never would have, raising the price of housing. In addition, the simple reason Moody's, Fitch, and the S&P do such a miserably poor job is government sponsorship. If Moody's, Fitch, and the S&P had to survive based on how good their ratings were instead of a model where the SEC says they have to rate everything, the problem with rating agencies would be cleared up overnight. The Fed is part of the problem too. The creation of the Fed was a blatant intrusion on the free market in the first place, but the Greenspan Fed's allowance of sweeps was economically equivalent to reducing the reserve-requirement ratio to zero for banks with sweep programs. Ultimately, the problems can be blamed on fractional reserve lending and the ability to create money (credit really) at will by borrowing it into existence. (Published: 10/09/08)

Notes:

• Roubini correct about US becoming United Socialist State Republic of America
• but: wrong about what went wrong and who is to blame
• e.g. the "fanatically and ideologically zealot free-market laissez-fair administration"
• e.g. "ideologue regulators who literally held a chain saw at a public event to smash unnecessary regulations"
• true cause: government meddling in the free markets
  
• there does not need to be regulation of Fannie Mae or Freddie Mac because neither should have existed in the first place
• it was government meddling in the free markets that created Fannie and Freddie
• government meddling in the free market will always blow up
• no matter how many government regulators one threw at Fannie or Freddie, both were going to blow up sooner or later
• ownership society mentality
• the HUD, FHA, Fannie, Freddie, and hundreds of affordable housing programs all came out of "ownership society" type thinking
• sponsorship of such entities creates a problem that regulators can never get right
• the bureaucratic mission inevitably takes on a life of its own
• government promotion of housing put an artificial bid on housing that a free market never would have
• that artificial bid had the exact opposite effect of what was intended
• every government sponsored affordable housing program raised the price of housing
• regulation could not fix that basic flaw and eventually the model blew up with ever increasing efforts to keep the ponzi scheme operative
• Ponzi schemes always blow up as soon as but not before the pool of greater fools runs out
• solution to all the above problems is simple
• eliminate government sponsorship of housing
• i.e. abolish the FHA, the HUD, Fannie Mae, Freddie Mac, Ginnie Mae, and every silly program on the books to create affordable housing
• government sponsorship of rating agencies
• many blame lack of regulation for the incredible fiasco at the rating agencies
• the simple reason Moody's, Fitch, and the S&P do such a miserably poor job is government sponsorship
• solution is easy: End government (SEC) sponsorship of the big three
• far past Time To Break Up The Credit Rating Cartel
• if Moody's, Fitch, and the S&P had to survive based on how good their ratings were instead of a model where the SEC says they have to rate everything, the problem with rating agencies would be cleared up overnight
• no amount of regulation can possibly cure flaws that arise out of government sponsorship
• Fed is the problem
• creation of the Fed was a blatant intrusion on the free market
• Greenspan Fed, ever wanting to "help" banks make more profits, instituted a policy of sweeps
• note on sweeps
• retail deposit sweep programs increase bank earnings by reducing the amount of noninterest bearing deposits that banks hold at Federal Reserve banks
• a bank's transaction deposits beyond approximately the first $50 million are subject to a 10 percent reserve requirement ratio, which is satisfied by holding vault cash or noninterest-bearing deposits at Federal Reserve banks
• in contrast, savings deposits are subject to a zero percent ratio.
• retail deposit sweep programs take advantage of this difference by "sweeping" transaction deposits into savings deposits
• that is, relabeling transaction deposits as savings deposits for reserve-requirement purposes.
• this is economically equivalent to reducing the reserve-requirement ratio to zero for banks with sweep programs
• effectively, the end of binding statutory reserve requirements
  
• every penny has been swept out and lent out (10 times over) thanks to the Greenspan Fed and fractional reserve lending
• what cannot be paid back will be defaulted on
• securitization problems
• in a free market with a sound currency, the originate to securitize model, aided and abetted by the rating agencies, would never have occurred in the first place
• None of the problems can be blamed on "free-market laissez-faire policies"
• every one of them can be blamed on fractional reserve lending and the ability to create money (credit really) at will by borrowing it into existence

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After 73 years: the last gasp of the broker-dealer - FT.com

Summary:
According to John Gapper, recent events mark the end of 73 years of full-service investment banking, i.e. buying and selling shares and bonds for customers as well as advising companies and trading with its own capital. In order to generate the revenues needed to match larger institutions, banks such as Lehman scurried into risk-taking that eventually sunk them. Two milestones in the history of IBs: 1933 Glass-Steagall Act (enforced the separation of banks and investment banks) and May 1 1975 (fixed commissions for trading securities were abolished) Despite the latter setting off a squeeze on broking revenues, IBs prospered for the next 30 years, mainly through gambling with their own (and later others') capital. But the gambles were potentially life-threatening: IBs did not have sufficient capital to cope with a severe setback in the housing market or markets generally. According to Gapper, there are two options for Goldman and Morgan Stanley: sell out to a large commercial bank with a big capital and deposit base, or scale back heavily, or abandon, their broker-dealer arms and become more like big hedge funds or private equity funds. (Published: 15/09/08)

Notes:

• Goldman Sachs and Morgan Stanley last hold-outs among Wall Street's independent investment banks
• future also in doubt
• full-service investment bank is doomed
• i.e. buying and selling shares and bonds for customers as well as advising companies and trading with its own capital
• in order to generate the revenues needed to match larger institutions, banks such as Lehman scurried into risk-taking that eventually sunk them.
  
• investment banks in future will be smaller, specialist institutions
• like the merchants of old
• history
  
• 1933 Glass-Steagall Act
• enforced the separation of banks and investment banks
• e.g. Morgan Stanley founded in 1935
  
• May 1 1975
• fixed commissions for trading securities were abolished
• set off a squeeze on broking revenues
• abolition of the system that has enriched them in good times and pulled many of them through during long periods of market slack,
• investment banks had relied on these commissions during the financial doldrums following the 1973 oil crisis.
• following 1975, investment banks went on to enjoy 30 years of prosperity
• grew rapidly, taking on thousands of employees and expanding around the world
• but: under the surface they were ratcheting up their risk-taking
• was increasingly hard to sustain themselves by selling securities
• the traditional core of their business -
  
• because commissions had shrunk to fractions of a percentage point per trade
• so they were forced to look elsewhere for their profits
• started to gamble more with their own (and later others') capital
• Salomon Brothers pioneered the idea of having a proprietary trading desk that bet its own money on movements in markets
  
• at the same time as the bank bought and sold securities on behalf of its customers
• banks insisted that their safeguards to stop inside information from their customers leaking to their proprietary traders were strong
• but there was no doubt that being "in the flow" gave investment banks' trading desks an edge
• also expanded into the underwriting and selling of complex financial securities
  
• e.g collateralised debt obligations
• were aided by the Federal Reserve's decision to cut US interest rates sharply after September 11 2001
• set off a boom in housing and in mortgage-related securities
• catch: investment banks were taking what turned out to be life-threatening gambles
• did not have sufficient capital to cope with a severe setback in the housing market or markets generally
• when it occurred, three (so far) of the five biggest banks ended up short of capital and confidence
• a bank can be highly skilled in risk management and trading, as Goldman has proved
• but: a single big mistake may spark a fatal spiral
• two options for Goldman and Morgan Stanley
• sell out to a large commercial bank with a big capital and deposit base
• e.g. Merril
• could provide them with sufficient backing for their capital markets divisions, which can be revenue and profit powerhouses in good times.
• scale back heavily, or abandon, their broker-dealer arms and become more like big hedge funds or private equity funds
• would involve a switch from sell side to buy side, where most money is now made
• in exchange for becoming much smaller, they might retain their high margins

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