Over the Counter

The bonus question

Mon, 09 Feb 2009 15:43:47 GMT

Is pandering to popular outrage about curbing bankers' pay really what the industry needs? Working in high finance is not a job for the faint-hearted and necessarily requires pecuniary rewards. As one banker pointed out to me over lunch last week, a failure to pay bonuses is the industry's equivalent of high treason.

The Markopolos Testimony

Thu, 05 Feb 2009 10:57:09 GMT

If that sounds like a Robert Ludlum novel, it's because, well, it sounds like a Robert Ludlum novel - complete with references to intelligence-trained Rangers (in this context a Ranger is a sort of American commando, rather than the last best hope for the safety of our pic-a-nic baskets). Markopolos even said he had spent the last eight years in fear for his life - I hope that he is comforting himself by remembering that the person who has most to worry about in that regard is probably the person who is accused of stealing several billion dollars belonging to a lot of very influential and presumably highly annoyed people, rather than the person who tried to get the SEC to stop it. He makes a lot of good points - not least, that a standard SEC inspection consists solely of walking into an empty conference room and inspecting the books provided by the company, rather than anything more probing like e.g. talking to employees. This may explain why its normal investigative technique for securities fraud over the last two decades has consisted of waiting for people to give themselves up. Anyway, Congress is wattling furiously and suggesting that the SEC ought to be shut down, and the rhetoric is reaching almost Australian Parliament levels of directness:

"You've told us nothing, and I believe that that is your intention. Your mission was to protect investors; what went wrong? One guy with a few friends and helpers discovered this thing nearly a decade ago. He led you to this pile of dung that this Bernie Madoff was and stuck your nose in it and you couldn't figure it out. You couldn't find your backside with two hands with the lights on. This is pathetic".

A new source of liquidity

Wed, 04 Feb 2009 12:27:03 GMT

"You follow the drugs, you get drug addicts and drug dealers. But you start to follow the money, and you don't know where it's going to take you." "In many instances, drug money is currently the only liquid investment capital... In the second half of 2008, liquidity was the banking system's main problem and hence liquid capital became an important factor," according to the UN's head of drug and criminal policy, Antonio Maria Costa (who has his own blog, including previous comments on the link between organised crime profits and the structured products business.) It would be fascinating to know what this is based on...

Duh diligence

Tue, 03 Feb 2009 17:41:42 GMT

Patrick Littaye, Mr. de La Villehuchet's partner, a co-founder of Access and the manager on the firm's Madoff relationship, says... his firm conducted thorough due diligence when selecting outsider fund managers. Candidates had to undergo a handwriting test with a graphologist and Access would often hire private investigators to check the background of executives. The relationship with Mr. Madoff, which for Mr. Littaye dated to the mid-1980s, wasn't subject to the same rigor, in part because of Mr. Madoff's reputation on Wall Street. "Of course we made an exception with Mr. Madoff," says Mr. Littaye. "I can't imagine asking him to pass a handwriting test."

So it's not even that they used graphology - a pseudoscience with the same intellectual basis as phrenology - in order to assess investment prospects. (Graphology is so famously nonsense that there are psychological studies done on why people keep believing it.) It's that they didn't even bother to use graphology when they thought someone was an nice guy. Their due diligence process was, essentially, "are you a decent chap? If not, do you at least write with the letters all sort of wiggly?" That alone should have been a warning sign. Even if there were other more orthodox due diligence processes in place - scrying, perhaps, or the invocation of Grande Ayizan, the voodoo spirit of commerce - using such patent nonsense as graphology should have warned people that not all was well at Access. Access apparently lost $1.5 billion of other peoples' money in the Madoff business.

Mr. Littaye says many people came to him over past decades dismissing Madoff as a scam, but he says he has no recollection of Mr. Markopolos sounding an alarm ahead of the December debacle.

Guess he didn't see the writing on the wall. (sorry)

Hubris

Tue, 03 Feb 2009 13:53:18 GMT

This fascinating article looks at the background to the collapse of Washington Mutual. After a string of smooth acquisitions in the 1990s, chief exec Kerry Killinger got over-confident - he split off the mortgage branch into an autonomous, almost autarchic unit, became used to the Mahogany Row lifestyle which he had previously despised, and finally overreached with the Long Beach takeover and the subprime market which it brought. Killinger got the boot in September 2008; WaMu went under less than three weeks later. It's a simple story, which makes me instinctively suspicious. Also, the only named insider source is the former chief credit officer, Lee Lannoye. I've no reason to suppose that he's telling anything but the whole truth, but he retired in 1999, so he's been out of the loop for a decade. All the other sources are unnamed "executives" - many though not all of whom may just be Lannoye going non-attributable, and many of whom may have axes to grind. Read the whole thing, but grano salis.

Reefer Madness

Mon, 02 Feb 2009 09:41:57 GMT

Franz Müntefering, chairman of Germany's Social Democrats, hit out against bankers on Sunday..."Most of the bankers are competent and responsible, but there are also some beatniks, pyromaniacs and gangsters," he said in an interview with German newspaper Frankfurter Allgemeine Sonntagszeitung.

Beatniks?

The Bonus Army

Fri, 30 Jan 2009 17:15:16 GMT

Bonuses are down 44% this year, but that's from a previous figure which was a) almost unprecedentedly immense and b) justified with reference to booked profits which, it now turns out, were based on unrealistic valuations. The Wall Street numbers are $18 billion in bonuses and $35 billion in losses for last year. The Economist, among many others, is livid:

What will it take for bankers to show a little remorse?... signs of hubris abound. The most glaring is the sacking by Bank of America of John Thain, Merrill Lynch's former boss, after he rushed through generous bonus payments for his investment bankers despite disastrous losses, and the revelation that he spent $1.2m refurbishing his office. Citigroup, meanwhile, has cancelled an order for a $50m executive jet, though only after flying into flak from the media and the Treasury. And, as he fights off lawsuits from angry investors, Dick Fuld, one-time leader of the now defunct Lehman Brothers, has sold his three-acre Florida estate for a princely $100 -- to his wife...

As well as all the other causes mentioned (entitlement, unaccountability, looting) it's basically a problem of asymmetry - absent clawback rules, which haven't come in yet, or paying your people in toxic waste, there's no way of making compensation perfectly correlated with company performance. The FT's Philip Stephens comments "I cannot think of a more popular policy than shooting the bankers and nationalising the banks" but summary execution would almost certainly be blocked by the European Court of Human Rights (UNACCOUNTABLE EUROPEAN REGULATOR SAVES CITY BANKERS) and even the stocks, last used on the perpetrators of a pump and dump scam involving a man disguised as a Polish hussar, have fallen out of use. A bit of weekend reading: Why do people die in earthquakes? A discussion (42 pp pdf) of preventative spending with this interesting aside:

There is absolutely no overlap between the top twenty most costly insured disasters worldwide 1970-2005 and the top twenty worst catastrophes in terms of lives lost. All of the most costly events in terms of property damage hit wealthy countries (where the density of economic activity is higher), all of the most deadly hit developing countries. In addition, eighteen out of twenty of the most costly were hurricanes, typhoons and storms, eleven out of twenty of the most deadly were earthquakes. Why is this? Earthquake deaths in particular can be prevented by engineering approaches that are widely applied in wealthy countries but rare in the developing world. It is more difficult to comprehensively prevent flood and wind damage using similar approaches.

And this, on model risk when predicting very rare catastrophic events. (18 pp pdf)

A flattering suggestion

Thu, 29 Jan 2009 17:58:45 GMT

From the NY Times Dealbook blog comes this suggestion, by due diligence expert Randy Shain:

Some investors may be surprised to learn that the Securities and Exchange Commission has a unit charged with outwitting those who would defraud Wall Street investors. That unit's record has, with only mild exaggeration, mirrored that of the N.F.L.'s Detroit Lions, who finished the season winless... Instead of entrusting the S.E.C.'s investigative work to lawyers who dream of working on Wall Street, mix things up by hiring the best of our nation's out-of-work financial and investigative journalists.

He goes on to point out the advantages: journalists, unlike lawyers, won't be planning to use the SEC as a springboard into a job in Wall Street and so have less incentive to be nice; they've got the investigative skills that lawyers lack; and they're a lot cheaper. I think it's a good idea. Well, I would. It's nice to be told that one's colleagues are the only people who can save civilisation. But it makes objective sense; for example, take Enron. The wheels didn't come off Enron because of a rating agency report or an SEC investigation - the first doubt was cast by Bethany McLean's Fortune article "Is Enron Overpriced?" And read this account of the Bayou fraud to see how easily it was discovered with a bit of basic research. Shain points out that investigative journalists would also be better at cultivating insider sources - such as the insiders who discovered the WorldCom fraud. They might, he adds, also be less deferential - and be more keen to follow the money wherever it leads.

The Risk Awards 2009

Thu, 29 Jan 2009 14:31:21 GMT

The Risk Awards 2009 were presented yesterday evening in a ceremony at London's Jumeirah Carlton Hotel - photos and video will be up on www.risk.net soon. The 2009 awards featured four firsts - the first Islamic derivatives house award, won by Deutsche Bank; the first derivatives law firm award, which went to Allen & Overy; the first hedge fund derivatives award, which also went to Deutsche Bank; and the first appearance at a Risk event of a live choir, singing songs specially rewritten for the industry. (How easy is it to find a rhyme for "Algorithmics"? Not easy.) House of the year went to JP Morgan, and the lifetime achievement award to Cornell's Robert Jarrow. For the full list of winners, as published in the January issue of Risk, see here.

Just rewards

Wed, 28 Jan 2009 11:12:35 GMT

Paul Krugman finds an extraordinary article from the depths of the pre-crash past (July 2007; beautifully timed for the crest of the wave).

The tributes to Sanford I. Weill line the walls of the carpeted hallway that leads to his skyscraper office, with its panoramic view of Central Park. A dozen framed magazine covers, their colors as vivid as an Andy Warhol painting, are the most arresting. Each heralds Mr. Weill's genius in assembling Citigroup into the most powerful financial institution since the House of Morgan a century ago... Mr. Weill's vision was to create a financial institution in the style of those that flourished in the last Gilded Age. Although insurance is gone, Citigroup still houses commercial and investment banking and stock brokerage.
[Glass-Steagal was revoked] partly to accommodate the newly formed Citigroup, whose heft was necessary, Mr. Weill said, if the United States was to be a powerhouse in global financial markets.
''The whole world is moving to the American model of free enterprise and capital markets,'' Mr. Weill said, arguing that Wall Street cannot be a big player in China or India without giants like Citigroup.

The comparison with the Gilded Age is interesting in two ways. The Gilded Age, like the Credit Age, ended with a financial crash, the Panic of 1893 (which included a mortgage crash). But it also left lasting benefits - the steel and railroad barons built the industrial base which made the US into the world's largest economy, and which was to be drawn on half a century later to underpin Allied victory in the Second World War. The upside this time around is rather more difficult to see. Sticking with this theme, Timothy Geithner apparently walked into the office on his first day in the job, picked up the phone and told Citi to cancel the jet order, now. And John Thain has been subpoenaed over the bonuses business. (The FT is now referring to Ken Lewis as "embattled"; always a bad sign.)

Rollover week

Tue, 27 Jan 2009 11:27:05 GMT

$230 billion of US commercial paper held by the Fed is due to mature this week - what are the options for the borrowers? Revolver conditions are tightening up, as we wrote earlier this month, but the conventional CP market seems to be recovering. Now we find out whether there is a credit recovery after all.

Staying with the compensation issue

Mon, 26 Jan 2009 17:53:28 GMT

There is enough blame to go around at BoA/Merrill - John Thain has agreed to pay for his own credenza, according to a memo leaked to the FT. (Apparently it's a sideboard. I did not know that.) Bank of America knew all about the bonus payments in advance, he goes on (see here - the bonuses in question have attracted unwelcome attention). And a rather plaintive remark from Bill McNamee, who runs Citi's fleet of executive jets - to which a new Falcon 7X has just been added. The NY Post asked him for a comment, to which he replied "Why should I help you when what you write will be used to the detriment of our company?" Well, yes; when your bank is splitting into two after record writedowns and record government bailouts, and you decide that you will despite this go ahead with that $50 million corporate jet purchase, there probably isn't any positive spin you can put on it.

I don't even know what a credenza is

Fri, 23 Jan 2009 18:36:38 GMT

But John Thain paid $68,000 for one to put in his office. Also:

$87,000 for an area rug in Thain's conference room and another area rug for $44,000; a "mahogany pedestal table" for $25,000... a sofa for $15,000; four pairs of curtains for $28,000; a pair of guest chairs for $87,000; a "George IV Desk" for $18,000; six wall sconces for $2,700; six chairs in his private dining room for $37,000; a mirror in his private dining room for $5,000; a chandelier in the private dining room for $13,000; fabric for a "Roman Shade" for $11,000; a "custom coffee table" for $16,000; something called a "commode on legs" for $35,000; a "Regency Chairs" for $24,000; "40 yards of fabric for wall panels," for $5,000 and a "parchment waste can" for $1,400.

Political blogger Kevin Drum boggles slightly and asks the right question: "Who leaked this? Most probable answer: BofA chief Ken Lewis, the guy who fired Thain, in an effort to keep attention focused on his scapegoat of the hour,,,"

The end of prop trading

Thu, 22 Jan 2009 11:27:07 GMT

For three reasons, I believe that the prop trading desks will be much smaller or non-existent at most banks in a year's time: First, many banks (like Deutsche for example) have suffered heavy losses from prop trading gone wrong. Second, there's regulatory pressure, for example in this G-30 paper - which suggests that cornerstone banks shouldn't be allowed to have prop trading desks, because of the danger of a collapse caused by prop trading losses. Third, we're already seeing the start of the wind-down - people like Boaz Weinstein leaving banks for hedge funds, and other banks like JP Morgan shutting entire prop units. This is unquestionably a good thing. Banks need to stick to banking and avoid getting into the shoal water of fiduciary irresponsibility. You're taking risks with your customers' and shareholders' money that they maybe didn't sign up to take - many banks are a bit vague about the exact volumes and exposures attached to the prop trading desk. There's temptation for insider dealing and front-running - see this article from 2007. There's also a lack of oversight. Senior management can't devote all their time to the prop trading business, given all the other business lines they're running as well - M&A, capital markets products, broking, retail, wealth management - another complex and risky business is the last thing they need. Running an in-house hedge fund with your customers' money is not only not your core business, it will have two deleterious effects: first, it'll expose you to market volatility; second, more perniciously, it'll distort your management. In the good times, when the prop trading desks are producing excellent profits for the bank, their heads will be promoted and could end up running entire divisions, or even the bank itself. What happens when you put a hedge fund manager in charge of a major bank? Citi happens.

More good news?

Fri, 16 Jan 2009 16:18:12 GMT

There is some - despite what's happened to Bank of America, Merrill Lynch and Citi. The Ted spread is continuing to fall - it dipped below 1% today (now back up at 103bp) and is generally back down at the sort of levels last seen before Lehman Brothers went under. (So it should be - with the amount of support, insurance and just plain hard cash being put into the interbank market these days.) And Alea notes that repo fails are way down - the planned fines may not be necessary after all.

Calling the recovery

Thu, 15 Jan 2009 16:22:17 GMT

This, from the WSJ, notes signs of recovery in the US corporate credit market:

...it is looking certain at least that the credit markets are more open than they have been for at least a year and investor appetite is allowing for multibillion-dollar deals. Last week, companies raised $152.6 billion by selling debt to investors. That is the highest volume since the first full week of 2008, when volume was $176.3 billion, according to Thomson Reuters data. It is a sign that investor nervousness has dispelled considerably since the near-total shutdown of the summer and fall...

Don't say this if you're a UK politician, of course - you'll get ridiculed and accused of being insensitive, thanks to a deliberate confusion between the credit crisis and the ensuing recession. But it's worth pondering: what does a post-recovery economy look like? Early 2007? No, that's an unsustainable bubble inflated by too much leverage, surely. A stable economy's going to have significantly tighter credit than was the case two years ago - maybe this right now is as good as it should get?

"Looks like we got ourselves a fugitive"

Wed, 14 Jan 2009 15:30:33 GMT

The head of UBS' global wealth management division, Raoul Weil, is now officially a fugitive from justice. (Background here). Bernie Madoff, on the other hand, is still in the US, and reportedly negotiating for a settlement. What's he got to offer prosecutors? Ritholz is hearing rumours. The full list of Madoff losses here. The SEC fails to inspire confidence. The view on Madoff through that invaluable diagnostic tool, the retrospectoscope, here.

The financial crimewave

Mon, 12 Jan 2009 15:01:33 GMT

Are we riding a wave of financial crime - and if so, why? It's not just Madoff - there have been a few others over the last few years, such as Paamco, and the subprime crisis was partly a wave of mortgage fraud. This article raises an interesting possibility - that dodgy dealings in the US rose because the FBI's attention had been diverted to counterterrorism. (Which sounds familiar.) Stephen Dubner (author of Freakonomics) and security guru Bruce Schneier tend to agree.

Tarp seen as a hedge fund

Thu, 08 Jan 2009 16:16:48 GMT

Nasdaq OMX has launched an index to track the performance of bailed-out companies.

The index, comprising companies that have received at least $1 billion from the Troubled Asset Relief Program (TARP) and other government aid plans, is called the Nasdaq OMX Government Relief Index.
The index is dominated by financial institutions such as Bank of America Corp, JPMorgan Chase & Co, Citigroup Inc and Wells Fargo & Co, but also includes American International Group Inc and General Motors Corp.
All the companies are equally weighted in the index. New components will be added as more firms receive more and more government funds, John Jacobs, executive vice president of Nasdaq OMX, told Reuters.
"With a huge expenditure of taxpayer money, we should have some measures out there to measure the effectiveness of it, so we can see five years from now, or every month ... in between, how effective was the bailout," he said.

But surely this is completely missing the point of the bailout? The objective wasn't to make a decent return for the US government by investing in troubled banks - the objective was to prop up banks whose failure would have horrendous consequences for the entire financial system and the wider economy. If anything, a proper index to track the success of the bailout would be, well, the S&P 500. Of course, at the rate the money's being doled out, the bailout index will pretty soon include every company in the S&P 500 anyway. The bailout's running through the money fast - we cover how fast in Risk News today.

Derivatives and democracy

Wed, 07 Jan 2009 17:30:03 GMT

(by Matthew Crabbe)

The FT ran a full page feature by John Plender this week on the future of financial innovation, post the financial crisis. Plender cites Robert Shiller’s claim that much of the recent damage could have been avoided if finance had been democratised and innovation used to manage individual homeowners’ house price risks, for example. The democratisation of finance with new derivative hedging instruments is a fascinating idea. But how exactly would it happen in practice? Has it become more or less likely? Should we care? I'm reminded of one of the most lucid and interesting discussions of the potential of financial derivatives: the lecture Robert Merton delivered on being awarded the Nobel Prize for economics (shared with Myron Scholes) back in 1997. The full text of the lecture is here, and the following extract addresses the key challenge of just how it might become economic (this is 11 years ago, remember!) for banks to design and market derivative products that truly help individuals bundle and manage their life-cycle risks:

The creation of such customised financial instruments will be made economically feasible by the derivative-security pricing technology that permits the construction of custom products at assembly-line levels of cost. Paradoxically, making the products more user-friendly and simpler to understand for customers will create considerably more complexity for the producers of those products. Hence, financial-engineering creativity and the technological and transactional bases to implement that creativity reliably and cost-effectively are likely to become a central competitive element in the industry. The resulting complexity will require more elaborate and highly quantitative risk-management systems within financial service firms and a parallel need for more sophisticated approaches to government oversight. Neither of these can be achieved without greater reliance on mathematical financial modelling, which in turn will be feasible only with continued improvements in the sophistication and accuracy of financial models.

Merton went on in his lecture to make it clear that it would be a mistake for financial engineers to depend too much on the accuracy of those models. It could be argued that the events of the past year have highlighted a more fundamental problem with the golden scenario he painted. Perhaps too small a number of large banks ended up with the technology required to manufacture and trade complex, derivatives-based, financial products. They made massive investments in the software and the brain-power required to grow their market share, but also ended up with dangerously illiquid assets, partly because the very size of those investments in software and brain power also became barriers to entry to new players. In his FT article, Plender concludes that “the backlash to today’s financial crisis will inevitably provide tasks for the next generation of regulatory arbitrageurs”. Which means innovation is far from dead. However, it’s hard to see how a more “democratic” financial marketplace will become possible unless regulators, governments and the derivatives industry itself actively work together to encourage a broader range of financial firms to trade complex financial instruments, where those instruments are deemed useful and fit for purpose. And that’s not exactly compatible with a backlash of regulation. (AC adds: it's also worth remarking that it will be uphill work at the moment trying to convince banks that the next big business opportunity will involve constructing incredibly complex and necessarily illiquid - because customised rather than standardised - derivatives based on the residential property market!)

More on Madoff

Tue, 06 Jan 2009 10:10:10 GMT

We'll have a full account of yesterday's Congressional hearings, plus analysis, later on today. In the meantime, a few thoughts: The oldest con in history is "you're part of the con" (see, for example, The Sting) - and there were early suspicions that Madoff's reported returns weren't due to a Ponzi scheme but to front-running through his brokerage arm. How many of his investors shared these suspicions and decided to ignore them because there was money to be made? Madoff was investigated by both Finra and the SEC - did they communicate fully? How much better would a streamlined regulatory system have done? Can the SEC survive this sort of incredibly public failure?

A Christmas story

Fri, 19 Dec 2008 09:17:27 GMT

If you're good, everyone knows, you get presents at Christmas. If you're bad (and Swiss) you get toxic waste.

Swiss bank Credit Suisse will link payouts for its top investment bankers to illiquid assets in an innovative new bonus system that may set an example for others in the industry. The new system will cut the bank's risk exposure by linking bonus payouts for 2,000 investment bankers to some $5 billion in illiquid and often opaque assets, which have tumbled in value and been blamed for deepening the credit crisis....

Words cannot describe how impressed I am by this. I hope it catches on. No wonder so many bank executives have been so happy to waive their bonuses...

Madoff

Thu, 18 Dec 2008 16:01:09 GMT

...possibly the greatest crime in history by a clear two orders of magnitude. To put it in terms that the previous record holder, the 17th century pirate Long Ben Every, would understand - $50 billion at current prices would get you 1500 tons of gold bullion. We'll have analysis of the implications tomorrow - in the meantime...

A few quick links

Tue, 16 Dec 2008 09:30:10 GMT

Brad Setser looks at the sovereign loss funds... a worthwhile reminder of just how much of global finance is still completely opaque (SWFs and the oil industry, for two.) The mystery of Ecuador's idiotic default Apparently, the Tarp's restrictions on executive pay have been carefully removed. "Congress wanted to guarantee that the $700 billion financial bailout would limit the eye-popping pay of Wall Street executives, so lawmakers included a mechanism for reviewing executive compensation and penalizing firms that break the rules. But at the last minute, the Bush administration insisted on a one-sentence change to the provision, congressional aides said..." Read the whole thing - it's a very neat piece of manoeuvering.

Better...

Tue, 09 Dec 2008 17:30:04 GMT

Morgan Stanley and Merrill chiefs forgo bonuses And should the CDS markets be shut down? John Dizard thinks so. They aren't bad in themselves, but, like automatic weapons, they allow the foolish to amplify their folly very effectively...