Tuesday, April 27, 2010

Fiddling While America Burned?

Goldman Sachs is a trading company. It was set up to be a trading company and it remains a trading company. It goes long and short to make money, takes risks and mostly manages them pretty well. When the sub-prime damages began to be tallied in 2008, GS came out OK because it had shorted the market. Bravo, everyone said. Clever boys!
Then Washington finally got around to digging into the whole mess, and lit upon GS like a duck on a Junebug. Cries of "trading against The American People" rang throughout the country. Outrage ensued. Butts were hauled in front of a senate panel yesterday to explain why they were net short the mortgage market.
For several grueling hours in front of the panel, the poor mugs from Goldman Sachs' mortgage-backed market making desk tried in vain to explain how markets work. Although it was clear that Goldman Sachs' lawyers briefed their clients well, they were no match for the irate - if often ill informed - questioners. In the end, they had to answer some of the questions. (And Fabulous Fab, cool as 'le concombre', was the most forthright.)
But, as my Mum always told me, when someone criticizes you maybe they should take a look in the mirror. The senate is bashing a trading company (turned investment bank) for packaging, selling and buying instruments that the government itself allowed - even encouraged - to exist. There were no regulators screaming about sub-prime mortgages until it was too late. "Free markets" was the term bandied about with absolute certainty during the years after Glass-Steagall's demise. 
After the dot com bubble burst, the government was thrilled to have a new bubble to take people's mind off it. The housing market. The similarities are remarkable. When I started writing about dealing room technology in 1999, there were over 1,200 companies in London that were on my 'talk to' list. After the dot com bubble burst, there were about 12. Before the bubble burst, I remember hearing people say it would never end. That technology stocks would go up and up forever. They didn't, of course.
When I moved to the US in 2003, it was clear to me that the housing market was overheated. But everyone kept saying it would never go down. Look at all the Baby Boomers that have to buy retirement property or second homes, they said. Even the most sophisticated investors believed it, clearly. Five years later, the market collapsed. And the traders that were taking advantage of people's naiveté were both buying and selling instruments based on the very mortgages the government had encouraged.
GS happened to be net short at the time. Whether by design or by accident, GS was not fiddling while America burned. It was simply trading. Today Goldman Sachs must be wondering whatever possessed it to get into investment banking. And to go public with an IPO. I would be absolutely astonished if the powers-that-be at Goldman Sachs were not currently investigating the quickest path back to partnership.

Sunday, April 25, 2010

Regulating OTC derivatives will take more than clearing

I tend to be a pro-regulation kind of person. I agreed with President Obama when he said last week that a free market was not supposed to mean free license to take whatever you can get, however you can get it. (Clearly he has not met many traders.)
But the recent hue and cry over OTC derivatives regulation is beginning to annoy me. It appears to be a battle between clearing houses, which stand to gain a LOT if the bulk of derivs have to be cleared, and derivatives traders, which stand to have to PAY a lot (and maybe stop inventing stuff that can't be cleared).
I do believe that OTC derivatives need regulating, and not just because they have attracted a lot of unwanted attention recently. Credit default swaps were one of the culprits often blamed for the credit crisis and for bringing Greece to its knees. And CDOs made the mainstream press (for probably the first time) after one of Goldman Sachs' CDOs was fingered by the SEC last week.
Warren Buffett was right to call them "financial weapons of mass destruction"  seven years ago. Not because of the instruments themselves, but because of their enormous growth rate and lack of transparency. CDS took off at light speed: when the International Swaps and Derivatives Association began surveying volumes in 2001, CDS volumes were $631.5 billion. At the end of 2007, 8 months before the credit crisis exploded, they had reached an unbelievable $62 trillion. (Can that really be 9,999% growth? Geeks, please help.)
Processing them was a tedious and mostly manual effort, and was falling so far behind that if anyone defaulted it sometimes took months to figure out who was owed what. But, while a heroic effort by ISDA and an industry working group automated the processing as best they could, the risk associated with CDS and other OTC derivatives was soaring.
Think about it. In the late 1990s/early 2000s traders were still using Black Scholes models and (mainly) individual spreadsheets to calculate their positions. Risk management was a back-of-the-envelope process for the most part, or was partially manual with clerks entering trades into one of the new-to-market risk solutions.
When the enterprise software boom took hold pre- Y2K, major investment banks had to migrate thousands upon thousands of these spreadsheets onto internal platforms. Risk management systems were asset class related therefore risk was managed in silo fashion, with little cross pollination. In the meantime, banks, traders and quants were breeding new instruments like flies. Risk was bubbling furiously under the surface and no one knew it.
Technology is catching up with OTC derivatives, but simply throwing clearing at them will not solve the problems. Complex instruments need to be automated and risk systems must make the downside more transparent, using strenuous stress testing under doomsday/Black Swan scenarios. Capital requirements should go hand-in-hand with the stress testing, i.e. if the worst should happen there is enough money in the bank to pay the bill.
Mandating that OTC derivatives go through the clearing process is a step toward transparency, true. But I worry that the clearing houses themselves are biting off more than they can chew. How many can handle trades that have the potential to double each year in volume?
Also, I know the beast (trading firms), and they will figure out ways to get around it.

Friday, April 16, 2010

Timing is Everything

As the storm clouds gathered over Washington, D.C. in the run up to the battle over financial regulatory reform, a little ray of sunshine peeked out and shone on President Obama and his band of reformers. The SEC nailed the Big Kahuna, the Vampire Squid, the biggest swinging Mickey of them all for fraud - Goldman Sachs.

The beauty in this is in the timing of the announcement - a ringing endorsement for regulation and oversight on the virtual eve of the battle to get the reform bill through Congress. It is difficult to tell your constituents that you are voting against financial reform when they can read in the papers that yet another bank was involved with fraud. It also dovetails nicely with the SEC's quest for additional funding.

The charge against Goldman is, of course, serious. A GS vice president (a Frenchman - perhaps channelling Jerome Kerviel?) structured a sub-prime portfolio on hedge fund giant Paulson & Co's advice, which Paulson then promptly shorted against. The bottom line is, however, not so serious. GS will get slapped with a fine and might have to make some of the investors whole, but that is chicken feed for the bank. (If it remains a civil crime that is. If the Department of Justice gets involved, it might open a different can of worms.)

Paulson comes out of it looking less like the genius that predicted (and cashed in on) the financial crisis and more like a criminal mastermind who found a willing patsy. The hedge fund shows the world exactly how far some of them will go to make the returns their wealthy clients demand. (Which reinforces the regulation of hedge funds too.)

Goldman's Fabrice Tourre (who called himself "Fab" in an email) comes out looking like a sap. I wonder how much Goldman could have been paying him if he was that motivated to break the law. I guess keeping up with the Joneses in Tribeca is a seriously expensive endeavor.

Nabbing Goldman Sachs is a shot across the bow to those Congressmen who thought the regulations we had worked "jus' fahhhn." They did not. But Congressmen are under almost unprecedented pressure from Wall Street lobbyists. There are reportedly four financial industry lobbyists for each politician in the house and the senate. Larry Summers said in an interview that the lobbyists were spending on average $1 million per Congressman.

The crux of the matter is capitalization. Capital requirements have to be raised in order for Wall Street to be able to bail itself out next time. The trouble is, Wall Street does not want to waste good trading money by keeping it in the bank (especially if they pay themselves the same crappy savings rates the banks pay us).

So those Congressmen on the Wall Street side might have to step into the middle of the road before the upcoming vote. Their constituents may be able to see the picture a little bit more clearly now. The government gave Wall Street a bucket load of money, which was spun into golden bonuses. For Wall Street. And all the while it was smiling and nodding and "Three Bags Full"-ing, and continuing to rip the faces off investors.

Critics of the financial reform bill are already screaming that you can't legislate against fraud. That may well be. But you CAN find the fraudsters and nail them as long as the regulators have the authority and the tools to do so.  The SEC is doing better all the time, but it remains seriously underfunded. It has a big hill to climb and one showcase conviction is not enough. 

Friday, April 9, 2010

It Was Like That When I Got Here

The headlines in the financial press lately sound like a litany of Homer Simpson's three little sentences that will get you through life:

Number 1: Cover for me. (Citigroup to - allegedly - Oliver Wyman for recommending it enter into structured finance).
Number 2: Oh, good idea, Boss! (Alan Greenspan on how Congress would not have let him put the brakes on the housing bubble.) 
Number 3: It was like that when I got here. (Robert Rubin testifying to Congress about his time at Citigroup. )
I'd like to add my own little sentence to Homer's:
Number 4: "Everyone does it." (Repo 105.)

Citi entered into collateralized debt obligations for the same reason every other bank did - because everyone was making money on them. So what if a consultancy produced a study that showed that CDOs were as harmless as fluffy clouds and could make a shed-load of money? Shouldn't the bank have done a little due diligence before jumping in? Blaming (allegedly) Oliver Wyman is shooting the messenger.

Alan Greenspan - had he read the foreign press - should have known full well that the US government was creating a housing bubble to replace the burst dot-com bubble. Money had to go out of consumers' pockets one way or another in order to support the economy. Buying and fixing up houses is one very efficient way to spend a lot of money. He is right not to allow Congress to throw him under the bus, but he should have been a lot tougher with them at the time. If indeed he suspected there was an issue.

Robert Rubin, became a 'senior advisor' at Citi after he had systematically dismantled Glass-Steagall, which gave Citi and others the chance to dabble in investment banking (read: trading). After receiving over $125 million in total over 8 years to 'advise' Citi, he told Congress that he was not responsible for looking at Citi's activities with any real 'granularity'.  Eek. What exactly was he looking at then? (He could also be compared to Sergeant Schultz in Hogan's Heroes: "I know nothing! Nothing!" )

The Wall Street Journal on April 8th reported that most of the major investment banks had masked their debt levels, hence risk exposure, by using repos. Shock, horror in the financial press. How could this have happened without us knowing? Hellooooo. End-of-year balancing is rife for trading companies, whether they use repos or stuff things off-balance-sheet or roll positions forward. One way or another they will boost the coffers for bonus calculation. (Haven't they ever met a trader?)

Whatever happened to accountability?

BTW, Goldman Sachs is channelling Lisa Simpson instead of Homer. Accused of 'betting against its own clients' it stood firm in its annual report by defending what it did as normal trading practices and hedging. Which is true. But a few clients might have stepped in the way when they shouldn't have and got burnt.
As Lisa said: "You can't create a monster, then whine when it stomps on a few buildings."

Thursday, April 1, 2010

Parlez Vous la Regulation?

You know you are doing something very wrong in the global financial arena when the French have to tell you how to fix it.  France is not exactly a powerhouse in financial markets, despite its attempt to lure investment banks and funds from London to La Defense.  Yet the vertically-challenged Nicolas Sarkozy came to Washington this week and let it be known that the United States is not doing its part to reform regulation. Hinting strongly that Washington cannot run the world on its own, he urged the Obama administration to work closely with France and the G20 in regulation reform.

Meanwhile a senator from that Mecca of financial markets - Tennessee - has thrown his toys out of the pram and is threatening to jeopardize reform.  According to the Wall Street Journal, Republican Senator Bob Corker said Tuesday he "absolutely cannot support" a bill written by Senate Democrats to overhaul financial regulations unless changes are made. (He is clearly not a "corker" in the English slang sense - i.e. an excellent and outstanding thing or person.)

I wonder if Senator Corker ever reads the financial press. If so, he might have come across reports yesterday on the real cost of the financial crisis. Speaking at the Institute of Regulation & Risk, North Asia (IRRNA), in Hong Kong this week, Andrew Haldane - the succinctly titled executive director for financial stability at the Bank of England - called the banking industry a 'pollutant' where systemic risk is the byproduct.

Them's fightin' words to U.S Republicans, seemingly bent on supporting the banks in their quest to dominate the world - unfettered by rules and regulations. This shot across the bow was accompanied by a breakdown of the actual cost of the crisis, or "the $100 billion dollar question."  

According to Haldane, the approximate outright cost to the US government (and taxpayers) of the financial crisis was about $100 billion. So far, so what? This is less than 1% of GDP.  The kicker here is that, as a result of the crisis, world output in 2009 "is expected to have been around 6.5% lower than its counterfactual path in the absence of crisis," said Haldane. To the tune of output losses of $4 trillion in the US alone. Moreover, he said that some of these GDP losses are expected to persist and may even be permanent. If this is the case then the $4 trillion will be an understatement.

Doing nothing is not an option - $4 trillion is not chicken feed and if it were to happen again I fear financial Armageddon..... Republican naysayers will have to pitch in with concrete ideas that support financial markets reform. Otherwise the French and the rest of the G20 will make the US government look weak. Like it is enslaved by its banking giants.