Saturday, November 26, 2011

Miss Lonely Hearts

From time to time, O Dearly Beloved, your Faithful Correspondent receives a letter in the electronic mailbag which he decides is worthy of more general airing in these pages than a simple direct reply.

Today’s specimen wends its way to the Volcano Lair from a junior investment banker of the distaff persuasion (let us call her “Tempted”). She solicits my advice on whether a workplace dalliance with a more senior colleague, one who is already in a committed relationship, would have a detrimental or indeed even positive effect on her professional advancement. She acknowledges being attracted to said individual, finding both his attentions pleasing and his person enticing.

As this situation is quite common in my industry—and, I imagine, many others—for reasons which I outline below, I thought it might be helpful to publish herewith a lightly edited version of the reply I sent Tempted earlier today.

Dear Tempted — Speaking purely from a professional perspective, which you seem to want me to do, screwing around with this guy sounds like a really bad idea. Some random thoughts:

  1. Sleeping with a woman does not raise a man’s professional opinion of her. Ever. Unless she is a prostitute.
  2. Sex, emotions, and relationships are messy. How would you keep this quiet at your firm? Office romances get out. You won’t be able to prevent it.
  3. You say he is smart and cute, and his attentions flatter your vanity. I expect you appeal to him at least in part because he is in a position of power and authority (or at least seniority) to you. This sounds like a lousy basis for a work relationship, or indeed any sort of relationship.
  4. If your firm employs more than 100 people, it will likely have explicit guidelines about intra-office romances, especially among people who work together. Check them out. You and your colleague might be violating workplace rules by proceeding.
  5. Sleeping with a more senior banker will earn you a reputation as someone who sleeps your way to the top. This is a really shitty reputation to have, whether among men or women, especially if it is not true.
  6. You will likely get the short end of any stick in this situation. He has a permanent job and an established reputation at your company. You don’t. If push comes to shove, you are the one who is likely to get the boot.
  7. Odds are most relationships at your age don’t last. Unless both of you are truly in love—and it sure doesn’t sound that way—it will not last. How will you be able to work together in the future? Never underestimate how knowing how someone looks naked or what embarrassing little quirks they have in bed can undermine a professional working relationship.
I recommend you extract yourself gently from any real engagement with this guy. Remind him of his girlfriend, tell him you’ve met someone special, tell him you’re worried how this will affect your chances at the firm, anything. You can flirt with him—mildly—but for heaven’s sake keep your clothes on. Unless you both fall madly in love—in which case one or both of you shouldn’t care about getting new jobs elsewhere, as you will likely have to do—this is a really bad idea.

I would offer you this same confidential advice if you worked for me and came to me in person. Good luck, and be careful.


* * *

Now, don’t get me wrong. I love sex. Sex is a wonderful thing, and one of the few unalloyed perks of being human, in my opinion. If I had my druthers, I wouldn’t give a rat’s ass whether all the healthy young girls and boys who work for me fucked each other like bunnies all the time they weren’t in the office. Why, I might even set up a mattress in the break room so they could sneak off for a little horizontal tango during lunch hour, just so they could work the nasty into their work schedules more efficiently.

And it is no surprise temptation is there. Throw together smart, attractive, ambitious, and energetic young men and women (or men and men, or women and women, for that matter)1 for 16 hours a day of high-pressure, high-stakes work seven days a week, 52 weeks a year. Make sure they develop an elite esprit de corps of shared suffering and accomplishment, compounded by societal envy and disapproval of what they do, and give them rare opportunities to blow off steam together in dark nightclubs and bars and the company of way too much alcohol. It’s a wonder every female investment banker under the age of 30 isn’t pregnant all the time.

But sex is messy. Sex is tangled up with all sorts of emotions, good and bad, and sex makes for a very awkward work environment. It is the rare couple who can conduct an affair at work that does not spill over into recriminations, drama, and undermining behavior, and that is just among their coworkers. In a work environment, sex fucks things up. As a boss, I won’t tolerate it. I just have too much goddamn work to do.

So keep it in your pants, boys. Keep your legs crossed, girls. At least with each other. Because if anything interferes with getting that big LBO pitch for Yahoo! done this weekend, I swear I will fucking geld you.

Related reading:
She’s Got Legs (June 11, 2011)
Thank You for Smoking (August 6, 2010)
Fingernails that Shine Like Justice (May 21, 2007)

1 Hey, whatever floats your boat. I don’t care. I would simply observe that gay men and lesbians tend to be even scarcer in my industry than straight women.

© 2011 The Epicurean Dealmaker. All rights reserved.

Friday, November 25, 2011

The Cold Companionable Streams

The trees are in their autumn beauty,
The woodland paths are dry,
Under the October twilight the water
Mirrors a still sky;
Upon the brimming water among the stones
Are nine-and-fifty swans.

The nineteenth autumn has come upon me
Since I first made my count;
I saw, before I had well finished,
All suddenly mount
And scatter wheeling in great broken rings
Upon their clamorous wings.

I have looked upon those brilliant creatures,
And now my heart is sore.
All’s changed since I, hearing at twilight,
The first time on this shore,
The bell-beat of their wings above my head,
Trod with a lighter tread.

Unwearied still, lover by lover,
They paddle in the cold
Companionable streams or climb the air;
Their hearts have not grown old;
Passion or conquest, wander where they will,
Attend upon them still.

But now they drift on the still water,
Mysterious, beautiful;
Among what rushes will they build,
By what lake’s edge or pool
Delight men’s eyes when I awake some day
To find they have flown away?

— William Butler Yeats, “The Wild Swans at Coole”

Which is the more difficult duty: to leave too soon, or to stay behind, unable to follow? Stupid question, for each of us will assume both burdens soon enough, and likely much too soon.

Rest in peace, absent friends.

Live unwearied in love, joy, and passion, present ones.

© 2011 The Epicurean Dealmaker. All rights reserved.

Wednesday, November 23, 2011

Holiday Interlude

I’ve seen things you people wouldn’t believe. Attack ships on fire off the shoulder of Orion. I watched C-beams glitter in the dark near the Tannhauser gate. All those moments will be lost in time... like tears in rain...

— Blade Runner

The flesh surrenders itself, he thought. Eternity takes back its own. Our bodies stirred these waters briefly, danced with a certain intoxication before the love of life and self, dealt with a few strange ideas, then submitted to the instruments of Time. What can we say of this? I occurred. I am not... yet, I occurred.

— Frank Herbert, Dune Messiah

How can we endure? How can we ensure all our moments will not be lost, like tears in the rain? Does it help to share those moments with others, to pass the baton, as it were? Perhaps. It is pretty to think so.

Here is better advice: Occur well.

Happy Thanksgiving.

© 2011 The Epicurean Dealmaker. All rights reserved.

Saturday, November 19, 2011

Sovereign Triviality

Above all else, the mentat must be a generalist, not a specialist. It is wise to have decisions of great moment monitored by generalists. Experts and specialists lead you quickly into chaos. They are a source of useless nit-picking, the ferocious quibble over a comma. The mentat-generalist, on the other hand, should bring to decision-making a healthy common sense. He must not cut himself off from the broad sweep of what is happening in his universe. He must remain capable of saying: “There’s no real mystery about this at the moment. This is what we want now. It may prove wrong later, but we’ll correct that when we come to it.” The mentat-generalist must understand that anything which we can identify as our universe is merely a part of larger phenomena. But the expert looks backward; he looks into the narrow standards of his own specialty. The generalist looks outward; he looks for living principles, knowing full well that such principles change, that they develop. It is to the characteristics of change itself that the mentat-generalist must look. There can be no permanent catalogue of such change, no handbook or manual. You must look at it with as few preconceptions as possible, asking yourself: “Now what is this thing doing?”

— Frank Herbert, “The Mentat Handbook,” Children of Dune

While I do my best to suppress such realizations, Dear Readers, I have found it increasingly difficult to deny that we live in an age of Engineering and Science triumphalism. Signs abound for all to see, from technology’s relentless conquest and absorption of everyday human interaction, to the increasingly strident complaints that my own industry has hobbled the march of civilization by luring innocent youth away from test tubes and argon lasers and perverting them to the “socially useless” worship of Mammon. It is perhaps no stronger evidence that Science with a Capital S has consumed the heart of our common narrative that so many of the culturally and intellectually dispossessed have been fighting so fierce a rearguard action in denial of its most basic claims. Flat Earthers are never more strident or dangerous than when they feel their very relevance to society is threatened.

Within the mainstream conversation, however, there seems to be a general consensus that as a country we neither possess nor produce enough scientists and engineers to meet our current and projected challenges, so many of which are asserted to be scientific or technical in nature. Climate change, pollution, adequate energy, population pressures, poverty—all these and more are asserted to be in some form or fashion reducible to technical problems. Problems which, many seem to assume, can be solved if we simply graduate more scientists and engineers to fix them (and make sure they don’t go to Wall Street). Let us birth more Steve Jobs and Mark Zuckerbergs, the argument goes, and all will be well.

Accompanying this narrative, of course, is a general wailing and gnashing of teeth that we devote too many resources within higher education to the teaching of the liberal arts and humanities, resources which could be better allocated to training the technicians, engineers, and scientists we really need. Now, as a fierce devotee of the liberal arts and humanities in my own right—and, in full disclosure, a graduate with a degree in a traditional “soft” social science—I am understandably partial to arguments which refute such heresy. Sadly, the few examples I have seen so far1 have done little to press what I consider the strongest arguments in favor of maintaining broad and robust humanities programs in higher education.

The weakest are of a kind: arguing the instrumentalist case that liberal arts disciplines can be functionally useful to society, either in their own right or as producers of the junior partners—translators, communicators, panegyrists, and apologists—for the scientists and engineers who do the “real” work. But this will not do. That way lies intellectual stepchildren like “Applied Philosophy” and “Science Journalism,” fine professions no doubt, but hardly compelling enough societal amanuenses to justify $200,000 bachelor degrees and ongoing taxpayer subsidies.

Writing in The Economist, Will Wilkinson supplies stronger arguments. He points out that college, for most, is now a major consumption good, which students exploit because they can. He flips Alex Tabarrok’s argument of education in the service of economic growth on its head:

What is economic growth for, anyway? It’s for expanding our choices and making life better. Is it really so surprising that, as we grow wealthier as a society, more and more of our young people, when the amazing resources of the modern university are put at their disposal, choose to use them learning something satisfying and enriching and not for anything except cherishing the rest of their lives? Is it really so surprising that taxpayers are not in revolt over the existence of poetry professors?

He also makes the more germane instrumentalist point that, as Western society gets richer, we expend more and more leisure time consuming the products of artists, writers, and other creative folk. Who else but Film Studies and Comparative Literature majors will produce these entertainments, anyway? Physicists? Mechanical Engineers? Please.

* * *

But all these counterattacks miss the three most important reasons I believe broadly available liberal arts education will remain critical to our society and polity for the indefinite future. First, there is the point which Frank Herbert makes so artistically and metaphorically in my epigraph above. As the body of scientific and technical knowledge swells exponentially, scientists and engineers by definition simply must become narrowly focused specialists. You cannot be effective as a scientist or engineer nowadays if your knowledge spans too broad a field. Our collective scientific knowledge is simply too deep. But this introduces the dilemma of the expert, who literally cannot see the forest for the trees or, more aptly, for the respirative pores on the bottom of leaf #6,972 on branch #473 of tree #1,204. Who will aggregate and balance the competing viewpoints, suggestions, and research programs of all these specialists in highly complex microdomains? Who else but someone who has been rigorously educated in the general discipline of how to think, of how to evaluate competing claims and conflicting evidence under conditions of extreme uncertainty? Who has been taught not only how to analyze and synthesize disparate, incompatible, and even conflicting data but also how to judge?2

The second point to realize is that the usual suspect scientific and technical conundrums which the techdysiasts would have us address are defined and constrained far more by their social and political dimensions than by the hard science issues at their core. Fixing climate change, poverty, or even global financial regulation is not merely a problem of finding the correct solution to a thorny technical problem. These big issues are big because they entail questions of philosophy, ideology, justice, the proper form of society, and even culture. The underlying science is almost trivial compared to the value questions at stake.3 Here, again, we find that the study of liberal arts and humanities prepares a student far better to come to grips with the thorny issues at hand than, say, one prerequisite bioethics course for a pre-med major. Do we really want to turn the keys to our global future over to a bunch of narrowly-educated, really smart, culturally and historically naive technocrats? I sure don’t. Give me someone who has read Herodotus, analyzed Shakespeare, or argued over Rawls instead.

Lastly, there is the larger issue that, for all their power and demonstrable success, science and technology simply do not, cannot, will not address a host of questions and problems which are natural to the human condition. Here is Richard Feynman:

The next reason that you might think you do not understand what I am telling you is, while I am describing to you how Nature works, you won’t understand why Nature works that way. But you see, nobody understands that. I can’t explain why Nature behaves in this peculiar way.4

But this is simply not good enough. It may be futile, unscientific, even a cognitive mistake to ask big questions about the nature of reality (the “whys”), the proper form of relations to other human beings in society, our rights and duties to ourselves and others, and the very reasons for belief in our own knowledge (including, of course, science itself), but it is natural and ineluctable. Science will never address these questions. It doesn’t have the tools. Art, social science, literature, cultural studies, history, psychology, and soft sciences like economics do. For this reason alone we cannot, must not, will not abandon them.

To do so would be to forswear the very nature of what it means to be human.

The verifiability, the falsifiability of the sciences, their triumphant progress from hypothesis to application, constitute the prestige and the increasing domination they exercise in our culture. But in another sense, these also make up their sovereign triviality. Science cannot give an answer to the quintessential questions which possess or ought to possess the human spirit. Wittgenstein noted that point insistently. It can only deny their legitimacy. To inquire about the nanosecond prior to the Big Bang is, we are didactically assured, an absurdity. Yet we are so created that we do inquire, and may find St. Augustine’s conjecture far more persuasive than that of string-theory.5

* * *

I suspect Harvard’s Philosophy Department will be able to order that new laser printer next year, after all.

Related reading:
Alex Tabarrok, College has been oversold (Marginal Revolution, November 2, 2011)
First, Let’s Shoot All the Philosophers (April 22 2011)
Mary Crane and Thomas Chiles, Why the Liberal Arts Need the Sciences (and Vice Versa) (The Chronicle, November 13, 2011)
Why we subsidise arts majors (The Economist, November 3, 2011)
Eugene Wigner, “The Unreasonable Effectiveness of Mathematics in the Natural Sciences” (February 1960; accessed November 19, 2011)

1 A sample which I freely acknowledge, for the benefit of my more scientifically inclined friends, to be neither comprehensive nor statistically significant.
2 I speak, naturally, of the best of liberal arts education. Expecting a specialist in 15th Century Catalan poetry to be able to make such judgments is heroic, at the least (but perhaps not impossible, even then). But there are many disciplines under the rubric of the humanities which teach such skills. I do not wish to oversell this point, but it is clear—at least to me—that in an age of increasing specialization, someone should be paying attention to the forest.
3 If only, we presume, because it may admit of a clear solution we all agree to. Questions of value do not.
4 Richard P. Feynman, QED: The Strange Theory of Light and Matter, Princeton, New Jersey, 1985, p. 10.
5 George Steiner, “Ten (Possible) Reasons for the Sadness of Thought”, Salmagundi, Nos. 146, Spring 2005, pp. 3–32.

© 2011 The Epicurean Dealmaker. All rights reserved.

Sunday, November 6, 2011

Known Unknowns

[Edward Ferrars and Elinor Dashwood are baiting Margaret Dashwood, who is hiding]

Edward: “Oh... Miss Dashwood. Forgive me. Do you by any chance have such a thing as a reliable atlas?”
Elinor: “I believe so.”
Edward: “Excellent. I wish to check the position of the Nile. My sister tells me it is in South America.”
Margaret: [out of sight; laughs]
Elinor: “Oh. No. No, um... she’s quite wrong. Um... for I believe it is in Belgium.”
Edward: “Belgium? Surely not. I... I think you must be thinking of the Volga.”
Margaret: [still out of sight; appalled] “The Volga?!”
Elinor: “Of course, the Volga. Which, as you know, starts in...”
Edward: “Vladivostock, and ends in...”
Elinor: “Wimbledon.”
Edward: “Precisely. Where the coffee beans come from.”
Margaret: [revealing herself] “Ah! The source of the Nile is in Abyssinia!”
Edward: “Is it? How interesting.”

— Sense and Sensibility

It is a heartening feature of the internet that one can often determine the truth about a subject by asking for the input and advice of experts, who upon application will usually contribute their knowledge freely. In my experience, it is an even more effective method to adopt a strong and firmly argued position upon a topic you know very little about. This will flush out even more experts, who will dismantle your faulty reasoning and expose your flimsy command of the facts with fierce glee or kind patience, depending on how charitably they view your ignorance and presumption.

My recent post on the current state of counterparty credit risk in the global financial system has already elicited two excellent reponses, and I am reliably assured that more are coming. The first of these was submitted to me by email, by a mysterious personage (let us call him or her “X”) who appears to be even more skittish about his or her real identity than Yours Truly, which is saying something. X’s first messages to me assumed a higher level of knowledge on my part than I possess, and X declined to let me disseminate his or her thoughts for reasons of security. Fortunately, after X read my babbling here and discovered exactly how ignorant I am about the day-to-day finance and operations of large trading banks, he or she took pity on me and sent new material fit for publication.

I now quote M/Mme/Mlle X at length, for your education as well:

Let’s look at the example of Bank A hedging some exposure by trading with Bank B. Let’s say

(1) Bank A has bought $100mm of CDS from Bank B,
(2) The CDS is currently worth 65 points (i.e. the $100mm notional contract is worth $65mm),
(3) Bank B has posted $60mm of collateral to Bank A.

What is Bank A’s direct exposure to Bank B? I would argue that the correct number is $5mm. If Bank B were to default and have 0 recovery, Bank A would post an immediate loss of $5mm, since Bank A already has the $60mm in collateral.

The point is that direct counterparty risk only exists on the uncollateralized portion of any exposure. One term for this is “gap risk.” This is relevant because in your example, Bank A would not try to hedge out its exposure to Bank B by buying protection on Bank B from Bank C. Almost all of Bank A’s exposure to Bank B is already covered by collateral. As for the remaining part, generally the amount of uncollateralized exposure that Bank A has to Bank B is not correlated to Bank B’s credit rating, especially if there are a large number of trades in multiple asset classes between the two banks. Bank A can’t know a priori what the uncollateralized amount will be if Bank B defaults; it’s just as likely that the CDS in the above example has moved from 60 points to 55 points and Bank A actually owes Bank B collateral. Also note that since this is essentially portfolio risk, doubling the number of trades with Bank B doesn’t actually double the exposure, especially if (as is common) many of the new trades are offsetting in risk. There’s no gross buildup of residual risk; this just boils down to net risk against the counterparty.

Why was AIG different? The above is a fairly accurate stylized approximation of what happens for relatively liquid CDS (which do increasingly go through central clearinghouses anyway). Something like a corporate or sovereign CDS is a distinct product that trades and has an observable market price. In the AIG case, most of AIG’s CDS exposure came from much more bespoke deals on structured products. A typical AIG CDS contract might be on some particular complex mortgage product, for which the only CDS trade was the one in which AIG wrote the protection. It has no observable market price and has to be priced using model assumptions on the underlying. This contrasts with e.g. sovereign CDS, where a price can be observed in the market and multiple trades happen on the same CDS; i.e. where there does in fact exist an observable market price.

Why is this relevant? In the above example, we assume that banks A and B agree on the contract’s valuation. If instead Bank A believes the contract is worth $65mm but Bank B only believes the contract is worth $30mm and has only posted that much collateral, then Bank A has $35mm of exposure to Bank B, which it will need to hedge accordingly. But the point is that this is a valuation issue; if the two banks actually agreed on the value of the contract, but Bank B simply refused to post collateral, then Bank B would be defaulting outright on its obligations, and would have its positions closed out accordingly, rather than have the counterparty risk just continue to exist.

The above discusses direct counterparty exposure in the sense of “losing money if my counterparty defaults.” There is of course further risk; if Bank B defaults, Bank A is left with that $100mm of risk that it previously didn’t have. But the risk here is actually a function of Bank B’s net exposure, not Bank A’s gross exposure. If, for example, Bank B had an offsetting contract for $90mm notional with Bank C, then after a default by Bank B, you would expect that Bank A and Bank C would offset their newly acquired risk against each other, such that e.g. Bank A only ends up with a $10mm change in risk, and Bank C ends up with no change in risk. This is pretty much what happened after Lehman defaulted. In fact there was a special trading session arranged for just that purpose, though most of the risk rebalancing actually happened in normal trading after the default.

I believe points (2) and (3) in your blog post boil down to concerns regarding net risk. I agree that large concentrations of net exposure would be a cause for concern, more so in illiquid positions but even to some extent in liquid ones. One way to get more comfortable with this in CDS space is just to look at the DTCC net notional numbers. By definition no entity’s net position can exceed the total net position. This ends up giving you a cap on how bad things can be; of course not ideal, but maybe less bad than you would initially think.

* *
One more thing—and you can share this too as long as it’s not attributed.

The “margin call contagion” scenario you propose is not representative of how banks operate. Just about everything in a bank’s portfolio will already be contributing to its funding. Bonds will be repoed out (i.e. for cash equal to the bond’s value, less a haircut), stock will be lent out, and collateral posted on derivative contracts will be rehypothecated.

It’s possible that e.g. repo haircuts will exceed the bid-offer on some instruments and selling a security might give me slightly more cash than repoing it, but the extra amount is small. In general the notion of “liquidating a valuable position for cash” doesn’t make sense for a bank. Of course this may be different for a buy-side firm, but it doesn’t make sense for a bank to sell a security for liquidity purposes when it’s already used to secure some cash. This is also less true for illiquid things that can’t be financed; it is however true for any collateralized derivative position due to rehypothecation.

Alles klar?

* * *

So, at the risk of having my mysterious interlocutor correct me once again, I will take the liberty of drawing a few conclusions.

First, I think X has substantially diminished my fears about investment banks being piles of counterparty credit kindling just one counterparty default away from causing massive systemic conflagration. The daily zero-limit, two-way settlement of collateral calls between large investment banks (now current practice among most large market participants, according to this BIS study) means that, except in very fast moving markets, one should expect that changes in net margin requirements triggered by changes in the value of underlying investment contracts should be reasonably well-reflected in the risk books of most major banks. Second, the fact that big trading banks settle margin exposure on a net portfolio basis—which, Harry Markowitz assures me, should net out to less than the simple addition of each individual exposure across large, multi-market and multi-instrument portfolios—gives me some comfort that whatever residual risks accumulate on bank balance sheets should not be extreme. Third, X’s assurance that investment banks prefer to use asset positions to fund their operations rather than sell them for cash in a market meltdown leads me to discount the risk of cross-market contagion and “death spirals” triggered by collapses in unrelated markets. All these points directly address the second concern I cited in my previous post.

However, if my concerns about the risk of market collapse inherent in the structure and operations of large trading banks have been partially assuaged, I remain less confident about systemic risk in general. In particular, I worry more about investment banks’ exposure to substantial net risks created by large hedge funds, other originating banks (e.g., Dexia), and non-bank participants (e.g., AIG Financial Products). If one is to believe X, this is where the major risks are created and packaged. If Bank A trades with Hedge Fund 1, which cannot meet its financial obligations and has no counterparty assets of its own to net against A, Bank A could still be seriously fucked if Hedge Fund 1 defaults. Especially if Hedge Fund 1’s default coincides, as it well might, with a substantial gapping out of risk exposure on the underlying trade with Bank A.

Assume, as I would certainly hope we can in today’s markets, that most investment banks aspire to pretty close to zero-net present value risk books across the firm. (This is the fundamental philosophical tenet of the Volcker Rule.) Then risks to the system will be created not by the banks at the center of the markets, but rather by the risk-takers (investors, hedge funds, etc.) at the edges. And, should you need reminding, risk-takers don’t hedge all their risks to zero. Duh.

I also worry that investment banks remain seriously exposed in illiquid, hard-to-value markets now and in the future. X him- or herself hints strongly that the nifty daisy chain of traditional bank risk mitigation can get dangerously frayed under such circumstances. Sovereign CDSs may be relatively transparent, given the monitoring and data publication of the DTCC, but this is not true in every market. In particular, I worry that the next dangerous net risk exposure will be created in one of those opaque, highly-illiquid, obscenely profitable new markets which Wall Street is so fond of creating. And if there is no central repositary of trade data in a particular security or derivative market, no standardization and reporting of net and gross positions, what is to prevent the rise of yet another bunch of idiots like AIGFP to create a huge net risk position of which their multiple, competing investment bank counterparties remain blissfully unaware?

Last, I retain a nagging worry about the sheer complexity of the balance sheets, risk books, and insanely complicated credit and financing plumbing upon which modern day investment banks rely. Long-time Readers will know I am no fan of complexity, because it introduces fragility and vulnerability into any system. X and his peers may have designed a beautifully functional risk transmission system for their employers, but what happens if one of the pipes clogs or breaks, due to human error or unforseen complications? (How likely are those, I ask you? Yeah.) I have every faith that the clever gnomes of Wall Street can figure almost anything out, if you give them enough time. The problem is, that when the shit hits the fan at an investment bank, your clients are sucking funds out at a blistering pace, and the ratings agencies and your shareholders are in a desperate race to write you off forever, you have almost no time at all.

© 2011 The Epicurean Dealmaker. All rights reserved.

Saturday, November 5, 2011

Methinks Thou Dost Protest Too Much

Any sufficiently advanced technology is indistinguishable from magic.

— Arthur C. Clarke

Attentive Readers will realize that I have used my durable and insightful epigraph before, specifically in a post which defended my industry against accusations of malfeasance arising from the common tendency of merchants in any economy reliant upon buying and selling to conceal the true costs and profits embedded in their activities. It was my contention then and is now that no law, human or otherwise, compels a vendor to offer buyers of its wares the “best price”—whatever that may be—or, indeed, prevents it from doing what profit-maximizing enterprises are commonly presumed to do: maximize profits. As long as said vendor is not selling faulty merchandise to inappropriate customers in a fraudulent manner, we should not expect to know nor require it to reveal all of its secrets.

This, however, is not that post.

For those of you with half a brain will (or should) realize that my idyllic little précis of laissez-faire capitalism skips lightly over two critical assumptions: that 1) all this happy buying and selling take place in reasonably competitive markets, where other vendors compete to offer the same good or reasonable substitutes therefor, and 2) the manufacture and sale of these goods does not impose intolerably noxious externalities on the society in which they are sold. The first of these can be seen as simply a special case of the latter, in which the externality which society should naturally seek to limit is economic rent-seeking in all its forms: monopoly, oligopoly, producer or factor cartels, preferential government regulation, etc. Of course, this tends to assume that the economy should be servant to society, rather than vice versa, which belief seems unhappily out of fashion nowadays.1 Go ahead, call me a dreamer.2

A cynic might say that politics is nothing more than a neverending argument over the size and distribution of economic rents in society. But let us set that question aside for now. Instead, I would like to focus on other kinds of externalities: those corrosive and destructive injuries to society which are generated as ineluctable byproducts of the activity of certain unsavory economic actors, like arms dealers, child pornographers, and television reality show producers.

And investment banks.

* * *
First, some history.

One of the principal functions of investment banks is the distribution of economic risk in society, from those who wish to sell it (and its associated productive return) to those who wish to buy. In the past, investment banks generally worked pretty well as conduits for risk, passing it from natural seller to natural buyer pretty effectively while skimming a small percentage off the top as recompense for their services. On the wholesale securities side of the house, they acted as large, temporary warehouses, buying and selling securities and derivatives on behalf of clients and maintaining minimal stocks in inventory to satisfy unforseen demand. It was a model which required little equity capital to support it, so investment banks levered up with short-term financing of their short-term assets and earned a nice return on the shareholder or partner equity they employed. Operating with so little equity entailed substantial risk, as a simple mistake or unexpected market shock could send the entire house of cards tumbling down. But because they tended to deal in liquid, easily marketed instruments, failed investment banks could be liquidated with relatively little disruption to their counterparties or the financial markets. Of course, the shareholders or equity partners got wiped out, but that was understood as part of the game. Live by the sword, die by the sword.

But then came the Great Moderation, and the industry changed. Investment banks merged and converted into universal banks, with commercial lending, mortgage businesses, and retail depositors, and they began swelling like mutant ticks on a hemophiliac dog. They began to warehouse more and more securities and derivatives to accommodate increased trading volumes on the market-making side. They began to warehouse more and more financial instruments for their own proprietary trading efforts. And they began to manufacture securities and derivatives, like mortgage-backed securities, credit default swaps, and other “structured products,” to meet investors’ insatiable demand for adequate returns in a seemingly riskless world. But as their balance sheets ballooned, these banks stuck with the tried and true risk management philosophy they had developed over decades as pure investment banks: mark your assets to market in real time, get out of losing positions early, and never hold risky assets in inventory without hedging them. Unfortunately, this is a strategy which depends at its core on operating in liquid, transparent markets, where prices are well known, trading volumes are robust, and hedging instruments are effective and liquid themselves. It also depends on a key principle which every trader knows: it doesn’t matter whether the markets are liquid or not if your position has become so large that you effectively are the market.

In addition, investment banks began to take on more and more counterparty risk as they waded deeper and deeper into such activities as leveraged lending, prime brokerage (lending and clearing for hedge fund clients), and derivatives and other structured products. And this was not the simple counterparty trading risk of old, where your primary worry was whether the party you traded with would deliver a security. It was counterparty credit risk, incurred as part of a trade in which your ultimate profit depended on your counterparty’s ability to satisfy its financial obligations, like repaying a loan, delivering an unencumbered security, or paying off a derivative. And let’s face it: investment banks have historically been lousy at credit analysis. Oh, sure, they’re fine when it’s short-term, secured lending, like a margin loan collateralized by liquid, easily-marketable securities with transparent market values. But lending money (or, what is the same thing, contracting for delivery of future economic value under certain circumstances) to counterparties subject to multiple financial risks and multiple financial obligations over a longer period of time? Not so much. And this is a big problem, because it seems that investment banks as a group have become their own biggest credit counterparties in many markets, particularly derivatives.

* * *

The problem is neatly illustrated by a recent Bloomberg article on the European sovereign credit default swap market:

Five banks—JPMorgan, Morgan Stanley, Goldman Sachs, Bank of America Corp. (BAC) and Citigroup Inc. (C)—write 97 percent of all credit-default swaps in the U.S., according to the Office of the Comptroller of the Currency. The five firms had total net exposure of $45 billion to the debt of Greece, Portugal, Ireland, Spain and Italy, according to disclosures the companies made at the end of the third quarter. Spokesmen for the five banks declined to comment for this story.

While the lenders say in their public disclosures they have so-called master netting agreements with counterparties on the CDS they buy and sell, they don’t identify those counterparties. About 74 percent of CDS trading takes place among 20 dealer- banks worldwide, including the five U.S. lenders, according to data from Depository Trust & Clearing Corp., which runs a central registry for over-the-counter derivatives.

Gross exposures are many multiples higher, of course, but the banks like to advertise their net exposures instead. The problem is that net exposures are not the clean, unassuming things a layperson might think they are. Take the following scenario: Bank A sells a $100 million credit default swap on Underlying Company or Country X to Hedge Fund 1. Then, in order to hedge itself, it buys an identical $100 million CDS on X from Bank B. Bank A has completely eliminated its exposure to X and can sail off into the sunset, happily counting the money it made in spread between the two transactions, right? Wrong. Bank A has not eliminated its risk exposure at all, it has merely introduced a credit risk exposure to Bank B, which is now on the hook to pay off the CDS if X craters. But what if B craters? Bank A is still on the hook, and now it is completely naked short a $100 million CDS. Now Bank A could try to protect itself against Bank B’s default by buying a CDS on Bank B from Bank C or Hedge Fund 2, but I think you must begin to see that that merely introduces a credit exposure to Bank C or Fund 2. Of course in real life all these counterparties try to ameliorate this exposure by requiring frequently refreshed margin collateral on these trades, with the objective that any party’s true risk exposure at any point in time is simply the difference between the value of the collateral held (usually cash) and the net cost to replace the instrument in question.

The challenge to global financial stability posed by investment banks conducting these activities is threefold, in my humble opinion. First, the daisy chain of trades illustrated above clearly demonstrates that investment banks never completely eliminate the residual risk involved in buying and selling investment contracts like CDSs and other derivatives. There will always be some risk attendant on any transaction which has not been completely immunized (like, e.g., Bank A buying an offsetting CDS from Hedge Fund 1, which would have the effect of cancelling the original trade), whether this is direct credit exposure to your counterparty or basis risk introduced by trying to hedge counterparty credit risk indirectly, like via short-selling its stock. Each such trade adds residual risk to the bank’s balance sheet and, given the tremendous aggregate volume of gross derivative trades investment banks do, these residual risks can accumulate to a very large and scary extent.

Second, because most big banks have overall margin agreements (Credit Support Annexes) in place with each other that aggregate offsetting daily margin requirements across all trades outstanding between the firms, the collateral protection mechanism itself can trigger contagion both within and across tightly linked firms. A bank or large hedge fund faced with a substantial margin call in one market or security might liquidate positions in other, more liquid securities in order to meet its obligations. If substantial enough, this can cascade through the markets and the trading books of interlinked investment banks, causing broader market sell-offs and further associated margin calls. This sensitivity is exacerbated by the highly leveraged financial profiles of most major financial market participants, especially the large trading banks and derivatives dealers.

Third, the ineluctably bilateral nature of many of these structured products and derivatives means that, no matter how careful and conservative any one investment bank is in structuring and managing its risk profile, nobody can be assured they are not transacting with another AIG Financial Products or, less dramatically, that systemically dangerous net exposures are not accumulating in disturbing quarters. The chief reasons that AIGFP’s collapse exacerbated the financial crisis were because it did not post collateral (due to its AAA credit rating), it transacted in difficult-to-value, illiquid markets, and it accumulated huge net exposure to mortgage-backed securities. And yet investment banks and others gleefully piled into counterparty credit exposure with AIGFP (the “dumb money”) until it cried uncle. Wall Street piled into copycat trades and lending relationships with Long-Term Capital Management, too, in a 1998 dress rehearsal for 2008’s systemic collapse. The very nature of secretive, cutthroat competition in my industry means that none of us want to share information that might reveal the existence of unsafe concentrations of credit risk in the system.3 How else can one explain why French-Belgian bank Dexia was able to write so many interest rate swaps that it required a government margin call bailout to the tune of $22 billion? Last month.

* * *

The practice of counterparty risk management on Wall Street has improved mightily since the Panic of 2008. Given that disaster, it damn well better have. But given the nature of massively connected, highly leveraged investment banks acting as conduits and collectors of the risk of the financial system, and their historical blindness to risks like counterparty exposure and risk concentration which were the very risks which nearly killed them (and us), I am loathe to take them entirely at their word that everything is hunky-dory now. Short of requiring all derivatives and structured products to be cleared through global exchanges (with associated net position limits and centralized margin posting) and sharply limiting overall financial leverage at trading banks, I do not see a failsafe solution to this conundrum. Investment banks are bred in the bone to be highly competitive and take substantial risks. Their competitive risk taking added materially to the accumulation of dangerous stresses and vulnerabilities preceding the crisis, and there is no reason to believe it will not do so again.

I would be delighted to be proved wrong about this by those who know much more about the plumbing of the financial system than I do.4 What is to prevent the occurrence of another AIG Financial Products? How can existing system controls prevent or dampen the cascade of credit failures through the system? Are potential leverage-induced death spirals limited to markets with illiquid, opaquely valued securities? If so, what prevents them from spilling over via contagion into other markets? What is to prevent a major securities or derivatives market meltdown from forcing another massive government bailout?

And if you are brave, knowledgeable, and/or foolish enough to try to answer these questions, please keep in mind the admonition of another very clever man whom few now trust:

There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don't know we don't know.

A wise man learns to plan for all three.

Related reading:
Committee on the Global Financial System, The role of margin requirements and haircuts in procyclicality (BIS CGFS Papers No. 36, March 2010)
Selling More CDS on Europe Debt Raises Risk for U.S. Banks (Bloomberg, November 1, 2011)

An early response:
Brandon Adams, Response for @Epicurean Deal (November 5, 2011)

1 An economy is simply the set of organizing principles and rules which a society establishes to allocate and employ resources for the benefit of its members. How these rules are established and maintained is politics. To assert otherwise, or claim as some do that society and politics have no proper claim on the organization or maintenance of economic activity (e.g., via regulation or taxation), is the height of folly or disingenuousness.
2 Those among you who cannot comprehend this concept and who would prefer to call me much less flattering names than “dreamer” are welcome to stock up on canned peaches and armor-piercing ammunition and join your fellow nutcases in Galt’s Gulch. The rest of us will come annihilate you when we can spare a moment. (Or just let you starve to death.)
3 For example, my best and most comprehensive source to-date for understanding the intricacies of the issues under discussion would not allow me to share them directly, in part because (s)he believed some of the generic information (s)he provided could provide a competitive advantage. And you people think I’m secretive.
4 All reasonable, informed, and specific responses are heartily welcome. I may publish or link to the most informative and interesting of these here. Please direct your responses to the email address found on this site, or notify me on Twitter (@EpicureanDeal) or by email if you have published it on another site. Please indicate if you would prefer no attribution.

© 2011 The Epicurean Dealmaker. All rights reserved.

Friday, November 4, 2011

Tort Reform

Overheard this morning at breakfast:
Lawyer #1: “Being a litigator is like cleaning the Augean Stables: it’s not particularly pleasant work, but you know you’ll always have a job.”

Lawyer #2: “That’s nothing. You should try representing investment bankers. It’s like being a streetsweeper in the Rose Parade: you have to deal with a neverending parade of horses’ asses, and you’re always cleaning up their shit.”

I love lawyer jokes. Especially when they’re told by lawyers.

Happy Friday.

© 2011 The Epicurean Dealmaker. All rights reserved.