50 Ways to Leave Your Lover

She said it’s really not my habit to intrude
Furthermore, I hope my meaning
Won’t be lost or misconstrued
But I’ll repeat myself
At the risk of being crude
There must be
Fifty ways to leave your lover
Fifty ways to leave your lover

— Paul Simon, “Fifty Ways to Leave Your Lover”

In the unlikely event Your Humble Blogosopher were ever called upon, O Indulgent Ones, to develop a required reading syllabus on risk management for senior executives and government regulators of financial institutions, I am untroubled to admit I would fail to include even one textbook or how-to manual of the mathematical ilk which purport to convey the principles of that noble calling. There are plenty of such already to be found on the bookshelves of industry practitioners and regulators, replete with concise derivations of Itō’s lemma, elegant mathematical notation, and perfunctory handwaving about the real behavior of real human beings in real market contexts. As I am not eager to advance the wisdom common to most of this literature—that greed, fear, and other messy human behaviors can be ignored in favor of a market model based on the diffusion of gas molecules in a box—I would search for inspiration elsewhere.

Instead, I would be much more interested in collating writings and writers who I feel might inculcate a healthy fear of hubris, an aversion to overconfidence, and a deeply uncertain view of the ontological underpinnings of our epistemological beliefs. In other words, Dear Readers, I would like to scare the everlovin’ bejesus out of anyone who has the presumption to be a risk manager.

Leading candidates for my syllabus would include cautionary authors and works like David Hume, Oedipus Rex, War and Peace, and anything by Montaigne. And, I am pleased to say, this little gem of a commencement address by Atul Gawande:

Scientists have given a new name to the deaths that occur in surgery after something goes wrong—whether it is an infection or some bizarre twist of the stomach. They call them a “failure to rescue.” More than anything, this is what distinguished the great from the mediocre. They didn’t fail less. They rescued more.

This may in fact be the real story of human and societal improvement. We talk a lot about “risk management”—a nice hygienic phrase. But in the end, risk is necessary. Things can and will go wrong. Yet some have a better capacity to prepare for the possibility, to limit the damage, and to sometimes even retrieve success from failure.

When things go wrong, there seem to be three main pitfalls to avoid, three ways to fail to rescue. You could choose a wrong plan, an inadequate plan, or no plan at all. Say you’re cooking and you inadvertently set a grease pan on fire. Throwing gasoline on the fire would be a completely wrong plan. Trying to blow the fire out would be inadequate. And ignoring it—“Fire? What fire?”—would be no plan at all.

There is fourth major pitfall, one which Mr. Gawande is perhaps too diplomatic to mention: insisting, in the face of incontrovertible evidence to the contrary, that the something going wrong is only doing so because other people (or things) are not acting according to plan. The common corollary to this position is that it is not your theory which is wrong, but nature is behaving unexpectedly or people are acting “irrationally.” We have seen this video before, and it wasn’t convincing the first time.

* * *

As the cleverer among you might suspect, I have said similar things at this location in the past. The point of risk management is not to prevent failure, for that is impossible. The point is to have a plan ready to manage and control failure when it inevitably comes.

It is my belief that many quants, hedge fund managers, and investment bankers came to believe—consciously or not—that, by explicitly embracing and accounting for chance, they had tamed it. They spent countless millions of man hours designing and implementing elaborate mathematical models and risk control systems based on aleatory principles that could predict, with remarkable accuracy, the variation in return and behavior of securities and derivatives under normal circumstances. They spoke confidently about “value at risk” and “maximum expected daily trading loss” as if they knew what they were talking about. As if those terms actually meant anything. And then they trotted off to their bank, or their prime broker, or the Discount Window to borrow a couple more turns of leverage against their proprietary positions.

But you cannot tame chance. That is what makes it chance. At base, implicitly attributing the kind of predictability these individuals seemed to ascribe to chance was a fundamental error, a category-mistake.

To use an example from the not-so-distant past, could the principals at now-defunct hedge fund Long Term Capital not see that pegging the odds of losing all their capital in one year at 10²⁴-to-1 against was ludicrous on its face? (And I am not arguing that Myron Scholes and the other LTCM propeller heads picked the wrong distribution for their probability estimates, as if settling on a Levy skew alpha-stable distribution with α = 1.8 and β = 0.931 would have been more accurate than a lognormal one.) In all intellectual honesty, how could they possibly know? Hubris, yes, but more importantly epistemic blindness was at play here.

For even if you have guessed (or calculated) the probabilities correctly, giving one-in-ten-million odds that a life-destroying asteroid will hit Earth in the next ten years does you no good when a Manhattan-sized meteorite is discovered hurtling toward Rio de Janeiro the following day. In retrospect, it seems pretty clear that it is far more important to plan how you intend to deal with an unlikely event when and if it does happen than to shrug and say it will probably never happen. Disaster planning and scenario testing are far more valuable risk management practices than fine-tuning the estimated volatility inputs to your CDO trading model.

Doctors like Mr. Gawande seem to have an instinctive handle on how to cope with the unexpected, probably in large part because they have seen or heard of so many “impossible” complications arising in a hospital context. They have a healthy respect for the unpredictability of the human body, and a healthy appreciation of the limits of their own knowledge and ability to predict its behavior. In one respect they benefit from a larger dataset of experiences to call upon than financial risk managers: people have heart attacks, surgical complications, and rare diseases with much higher frequency than we suffer from globe-rattling financial collapses. But the so-called Masters of the Universe could learn a lot from the humility of doctors, not only about how to prevent disasters from occurring, but more importantly how to recover from them when they do.

... we need to rediscover a little more respect (and fear) for the ineluctable and irreducible operations of chance in our lives, including in the markets. We need to keep reminding ourselves that having a 95% confidence level that our hedge fund will not lose more than 100 million dollars in a day does not mean it won’t lose $500 million tomorrow, or $75 million a day for ten days in a row. We need to rediscover that well-understood probabilities are usually more stable in the long run, so the whipsaw of short term events doesn’t blow us up before we can profit on our longer-term investments.

And it’s a good idea to have a plan, a direction in which you’d like to go. But it’s always a better idea to have back-up plans as well, alternate routes you have mapped out in case your main chance doesn’t work out as expected. Keep those in your back pocket, so you don’t frighten the Congressmen or limited partners you rely on into paralyzed immobility. But keep them nevertheless.

We probably have more than enough risk managers in the global financial system nowadays.

But we sure as hell need a lot more risk doctors.

Related reading:
Why So Serious? (December 10, 2008)
Nobody Expects the Spanish Inquisition (May 24, 2007)
P(x) = 1/1,000,000,000,000,000,000,000,000 (May 9, 2007)


© 2012 The Epicurean Dealmaker. All rights reserved.

Apocalypse, Ciao!

Francie Stevens: “I’ve never caught a jewel thief before! It’s stimulating! It’s like... It’s like...”
John Robie: “Like sitting in a hot tub?”

— To Catch A Thief

Part of the real pleasure of the interwebs for me, O Dearly Beloved, is the occasional opportunity Your Muddle-Headed Correspondent has to engage in a stimulating conversation with one or more individuals who are clearly more intelligent, better read, and cleverer arguers than Yours Truly. I tend to gain a lot from such interactions, if only a better understanding of my own opinions and the limitations of my knowledge and intelligence. They tend to generate a crush of sensations, including excitement, the sheer terror of discovery that I am out of my depth, and an urgent desire to land a couple of cheap shots on the champion before I scramble out of the ring to safety.

Today’s reflections are inspired by the response Carolyn Sissoko made to my recent post on unlimited liability in finance. While I am not equipped to address some of her points—especially on the topic of what she sees as the increasingly pernicious use of collateral by modern financial intermediaries—I would like to venture a few remarks and intuitions, in the spirit of a novice fighter taking a couple tentative jabs at Mike Tyson. Hopefully she will be gracious enough to let me run away thereafter.

First, Ms Sissoko uses historical evidence (what’s that?) to demonstrate that a regime of unlimited liability is not necessarily inconsistent with low required rates of return on capital:

The system of unlimited liability banking grew up in an environment with usury laws, so interest rates (on short-term debt) did not exceed 5% per annum. Market rates often fell as low as 2%. It’s far from clear that low interest rates for borrowers are inconsistent with unlimited liability on the part of lenders who choose to use their ability to borrow to leverage their returns (i.e. to act as partial reserve banks).

But I think this point misses the thrust of my previous argument. My intuition about unlimited liability is that capital providers subject to it have a natural limit to the amount of credit they are willing to extend regardless of price. Each lender sets her individual limit based on her estimation of the likelihood of loss beyond initial capital invested. Beyond that there is no price at which she would be willing to lend. This certainly would be my preference: if I faced the loss of my home and possessions, penury, and utter ruination, you can damn well be sure I would not extend just one more loan to capture an extra fifty, hundred, or even thousand basis points of yield. I do not think I am alone among heartless, flinty-eyed rentiers in this regard. The historical evidence Andrew Haldane cites from early 19th century Britain is entirely consistent with this: compared to the situation today, banks were massively overequitized and highly liquid, and bank assets and hence lending were a very low proportion of the economy. If my intuition is correct, it may well be that prevailing market rates of interest during that period evidence less that capital was plentiful and demand fully satisfied and more that supply and demand were balanced in a regime of artificially limited supply. Certainly Mr. Haldane contends—based upon what, I do not know—that the system of unlimited liability was not capable of supplying the growing need for capital during the rapid industrialization of the mid 19th century.

I strongly suspect that if we attempted to reimpose a regime of unlimited liability on capital providers nowadays, the pool of capital available to the economy would shrink, and likely dramatically. People with capital would simply become unwilling to lend to or invest in risky projects beyond a certain point, and the evidence from 19th century Western industrial societies seems to indicate that point would be at a dramatically lower level than we have become used to over the past 70 years. Unlimited liability could well be massively contractionary. This, I assume we all can agree, would not be a good thing.

* * *

Second, Ms Sissoko rather loses me when she asserts that

from a theoretic point of view, a banking system doesn’t need capital, it needs trust (aka credit). If the institutional framework is carefully structured (that is, debts are enforceable, outright fraud is disincentivized/rare, etc.) there is no shortage of capital — capital is created out of thin air by a plethora of unsecured, but trustworthy, promises. Effectively, capital is cheap, because the institutional structure of finance reduces the risk of losses to a minimum.

It may be that the intestinal parasite (me) within the dinosaur simply cannot conceive of a world without dinosaurs or dinosaur intestines, but I don’t get this. Capital is, in my understanding, at base a buffer against loss. Perhaps capital and bank lending vanishes when you sum all of its offsetting accounts across the entire economy, but capital serves a very important protective function at the “local” level of real creditors and borrowers. Capital absorbs loss, and either stops or slows the propagation of that loss through the daisy chain of economic interrelationships economic actors maintain. It is like the collapsible drums filled with water at the top of a freeway exit, whose function is to slow or impede the destructive progress of a runaway car. Sure, a runaway car will eventually stop of its own accord due to friction and gravity—if not another car or building—but do we really want to conclude from this that crash drums aren’t desireable or necessary?

I presume Ms Sissoko would counter that, with appropriate care and attention, we could design freeways and perhaps even cars so that we need not worry about collisions or runaways, but I fear that implies a level of omniscience—and systemic rigidity—which I find hard to credit. Financial loss is triggered both endogenously and exogenously. Being unable to anticipate all the ways financial loss can occur and directions from which it can come, I would much prefer to have various pools of capital sitting around the system, hopefully helpfully positioned between me and disaster. Besides, without capital, how can we enforce incentives? Capital belongs to someone. I thought the point was to reduce unnecessary systemic risk by presenting those positioned to create the risk of loss in the first place with incentives not to do so recklessly. How else can we do this except by making them the first to bear that loss; i.e., lose their capital?

* * *

One of the most pernicious effects, in my opinion, of the evolution of limited liability in the financial system, and the consequent transfer of more and more tail risk to society at large, has been the weakening of our understanding of the price of risk. Now don’t kid yourself: society always stands as the loss-absorber of last resort, under any capital, economic, or financial regime, because there are some losses which are too large for any system to absorb. (Think about a kilometer-wide asteroid hitting New York City or Los Angeles, for example.) After all, financial losses happen to a society. But the drawback of risk assumed by government and taxpayers is that it is not explicitly priced. Leading up to the recent financial crisis, as financial actors’ capital at risk shrank and society assumed ever more tail risk, more and more of the spectrum of possible financial loss fell outside the capital markets’ risk pricing mechanisms. Risk, whether from risky investment projects, financial leverage, or whatnot, looked cheap because an increasing portion of it was not being priced. We all levered up and engaged in riskier activities because we thought those activities had somehow got less risky. Remember the “Great Moderation?” It turns out instead we were just hiding a lot of potential loss out of sight, in the Grandma’s attic of a taxpayer backstop.

I continue to maintain two important things about financial risk. First, that it is incompressible; that is, a certain level of risk is ineluctably tied to the pursuit of a particular level of returns. No matter how you slice it, you cannot reduce the risk associated with a certain return. If it looks like risk is lower than you anticipated based on past history, rest assured it has not declined. You have either transferred it to someone else (e.g., through derivatives, in which case you have transferred some of your return, as well), or you have just lost track of some of it (perhaps by shifting it onto taxpayers). Second, that the risk-return relationship obtains at a society-wide level, as well. It may very well be the case that we unknowingly assumed more risk than we are comfortable with as a society, because we lost track of some of it by shifting it outside the financial markets, unpriced, onto our own backs. We pursued a growth and consumption agenda that was a lot riskier, in retrospect, than we believed at the time. But lowering the risk of loss we are willing to accept as a society will have ironclad implications on the types of returns we enjoy.

Surely there is a happy medium between a low-growth, capital-constrained economy hobbled by unlimited liability to capital providers and the reckless bacchanal we financed with “other” people’s money up to the financial crisis.¹ But make no mistake, the decisions we make about how we allocate, limit, and distribute financial risk throughout society—including how much to put financial intermediaries on the hook—will reverberate broadly through the system and ultimately affect our very living standards and prospects:

So part of the conversation we continue not to have in the public domain is what kind of returns—in the broadest sense—we desire for our economy and society, and therefore what level of risk we are willing to tolerate. Sure, we could turn the entire banking industry into a regulated utility, with mandated minimum equity levels, maximum allowed returns on equity, and limits on institutional size and interconnectedness (assuming we can understand, monitor, and control such parameters, which may be a slightly heroic assumption). But what knock-on effects would that have on investors, on businesses in search of risk capital for their growth projects, on consumers, and on the economy at large? Dampen the incentives and ability of financial intermediaries to originate, take on, and distribute investment risk, and it is not clear to me that overall risk-taking (i.e., investment) in the economy will not go down. But if that happens, are we not explicitly or implicitly settling for less growth and fewer wealth creation opportunities in the economy overall? Is that really the outcome we are seeking?

By this, I do not mean to say our current system works well, or that the level of risk inherent in the financial system is appropriate or even efficiently distributed given our overall economic return objectives. But it does mean that we need to be a little more thorough, and a little more honest with ourselves and our opponents in debate, in thinking about the consequences of individual actions or “solutions” we advocate imposing on financial intermediaries. For consequences will flow inexorably in directions we do not—and perhaps even cannot—anticipate, and we will be remiss—and even no less irresponsible than the people who allowed the recent financial crisis to happen in the first place—if we do not make provision to address them.

But cheer up. Things could be a lot worse.

Related reading:
Carolyn Sissoko, A little fear is a good thing (Synthetic Assets, February 4, 2012)
The Blind Men and the Elephant (June 21, 2011)


¹ Oops. I guess it was our money all along, after all.

© 2012 The Epicurean Dealmaker. All rights reserved.

Leverage This

Jessie Stevens: “It was exciting at first, but you know now I think it’s more exciting to have them stolen.”
John Robie: “Yes, because you can’t lose financially as long as Hughson is around to make out the check.”
Jessie Stevens: “Well I’d be crazy to take this attitude if I did.”

— To Catch A Thief

I have had an absorbing day thinking about moral hazard, unlimited liability, and the modern financial system, O Dearest and Most Inquisitive of Readers. My thoughts have been guided by two intriguing articles; one, a blog post by Carolyn Sissoko at Synthetic Assets in response to Steve Randy Waldman’s recent pieces on opacity in finance, and two, a speech given by Andrew Haldane of the Bank of England last October. Both have enlightened me immeasurably about the long-term history of banking and finance, of which, I am mildly chagrined to admit, I have apparently been woefully ignorant. Such are the shortcomings of a Modern Man of Action.

Having little to recommend me as a guide to the fields of financial history or economics generally, I will spare you my amateurish glosses on each of these pieces, and encourage you instead to read them yourselves. Suffice it to say that I found their narratives of the transformation of banking and other financial intermediaries from their original state as small partnerships sharing unlimited liability to today’s limited liability corporations fascinating. For one thing, I was unaware of the common intermediate step, which obtained from roughly the second half of the 19th century through the 1930s, in which bank shareholders were subject to “extended liability,” which required them to put up additional (but not unlimited) capital in the event it was required to meet the bank’s obligations. While this system—and the unlimited liability regime which preceded it—did not prevent the occurrence of numerous bank runs and financial panics during this period, Ms Sissoko contends that it performed pretty well as a shock absorber for the financial system. Bank losses hit bank shareholders and partners first, often with the effect of bankrupting them, and depositors were able to recover their monies, albeit with notable delays. Naturally, as one might suspect, having liability in excess of direct capital invested encouraged an excess of caution among banks in the loans they underwrote.

Andrew Haldane explains:

Bank balance sheets were heavily cushioned. Equity capital often accounted for as much as a half of all liabilities, while cash and liquid securities frequently accounted for as much as 30% of banks’ assets. Banking was a low-concentration, low-leverage, high-liquidity business. A broadly-similar pattern was evident across banking systems in the United States and in Europe.

This governance and balance sheet structure was mutually compatible. Due to unlimited liability, control rights were exercised by investors whose personal wealth was literally on the line. That generated potent incentives to be prudent with depositors’ money. Nowhere was this better illustrated than in the asset and liability make-up of the balance sheet. The market, amorphously but effectively, exercised discipline.

It was given a helping hand by market-based prudential safeguards. Directors of a bank had the capacity to vet share transfers, excluding owners without sufficiently deep pockets to bear the risk. Shareholders also maintained their liability after the transfer of their shares. This put shareholders firmly on the hook, a hook they then used to hold in check managers. Managers monitored shareholders and shareholders managers. In this way, the 19th century banking model aligned risk-taking incentives.

Given the common diagnosis of the recent financial crisis as arising, at least in part, from excess risk taking by commercial and investment banks due to misaligned managerial incentives and the (ultimately correct) perception that society would step in to cover bank obligations during a panic, it is tempting to view such a regime as preferable to the one we have now.

But before we force Jamie Dimon to sell his houses and cars to stem a run on JP Morgan, it is important to understand why unlimited and even extended liability banking was replaced. According to Haldane, unlimited liability proved “rather too effective as a brake on risk-taking” and insufficient to the provision of credit in the face of increased societal demands for “capital to finance investment in infrastructure, including railways.” Society’s demand for growth investment began to outstrip the appetite of the wealthy to provide it. Subsequent solutions—first, to extend unlimited liability to a broader shareholder base, and second, to cap liability at two to three times the investor’s initial investment—merely compounded the problem, by bringing in investors without the financial resources to sustain periodic losses and exacerbating panics by calling capital from investors under duress. Banks and other financial intermediaries like investment banks consolidated as their economies grew, and the span of control problem inherent in vetting ever increasing shareholder bases became unmanageable. So, by the 1930s, our current system of large, limited liability financial institutions with dispersed and anonymous shareholder bases was largely in place.

* * *

The question I am left with is the following: given that historical precedent (and common sense) seems to indicate that restricting banking to those wealthy enough to sustain personal losses well in excess of the amounts they invest in such activity limits credit provision, why should we believe there are enough risk-loving wealthy people nowadays to support the enormous credit demands of our national and global economies? To use a more limited example, why should we believe there are enough wealthy investment bankers eager and willing to support the capital requirements of ten mini-Goldman Sachs, each with one tenth the assets of the Vampire Squid? More importantly, where are the wealthy commercial and retail bankers eager and willing to support the lending activity of 1,000 mini-JP Morgans, each with one one-thousandth the assets of the House of Dimon? Certainly one can imagine there are lots of retail depositors and wholesale creditors who would be eager to lend to such personally backstopped institutions, but why would a shareholder with potentially unlimited liability—to the extent of her entire personal and family net worth—be remotely interested in borrowing ten times her equity in order to earn 12% on her money?

Hedge funds cannot fill the gap, either: they manage other people’s money. Why would those other people—mostly institutional investors like pension funds, insurance companies, university endowments, and the like—be remotely interested in assuming unlimited liability? For one thing, it would violate their own fiduciary duty: for the most part, it’s not their money, either. It’s firefighters’, teachers’, and pensioners’ money. Do you really think those people want to take unlimited risk? As Steve Waldman says, those people want safety.

Certainly there is a good argument for aligning the payouts and incentives of persons who engage in risky activities more closely with outcomes. It is a noble and desireable objective to undo the privatization of returns and the socialization of risk that we find ourselves plagued with nowadays. But I worry that those who argue for a wholesale return to unlimited liability for the owners of financial intermediaries simply have not thought out the problem of scale inherent in the current global economy.

Plus, I thought we all agreed we don’t like being under the thumb of the very rich. Do we really want to go back to Potter’s Falls?

Related reading:
Carolyn Sissoko, In defense of banking... (Synthetic Assets, January 30, 2012)
Andrew Haldane, Control rights (and wrongs) (The Bank of England, October 24, 2011)


© 2012 The Epicurean Dealmaker. All rights reserved.

All Together Now

“Do you mean, sir, that these birds are cannibals?”

“That’s an odd question, young Master,” the banker said. “I merely said the birds drink blood. It doen’t have to be the blood of their own kind, does it?”

“It was not an odd question,” Paul said, and Jessica noted the brittle riposte quality of her training exposed in his voice. “Most educated people know that the worst potential competition for any young organism can come from its own kind.” He deliberately forked a bite of food from his companion’s plate, ate it. “They are eating from the same bowl. They have the same basic requirements.”

— Frank Herbert, Dune

Steve Randy Waldman got me thinking today.¹

In an extensive follow-up piece to a previous post on complexity in finance, Steve answers objections to and elaborates on his argument that not only is opacity integral to the financial system of a complex society, it is essential. You may recall the core of his original idea:

Finance has always been complex. More precisely it has always been opaque, and complexity is a means of rationalizing opacity in societies that pretend to transparency. Opacity is absolutely essential to modern finance. It is a feature not a bug until we radically change the way we mobilize economic risk-bearing. The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear.

Financial systems help us overcome a collective action problem. In a world of investment projects whose costs and risks are perfectly transparent, most individuals would be frightened. Real enterprise is very risky. Further, the probability of success of any one project depends upon the degree to which other projects are simultaneously underway. A budding industrialist in an agrarian society who tries to build a car factory will fail. Her peers will be unable to supply the inputs required to make the thing work. If by some miracle she gets the factory up and running, her customer-base of low capital, low productivity farm workers will be unable to afford the end product. Successful real investment does not occur via isolated projects, but in waves, forward thrusts by cohorts of optimists, most of whom crash and burn, some of whom do great things for the world and make their investors wealthy. But the winners depend upon the existence of the losers: In a world where there was no Qwest overbuilding fiber, there would have been no Amazon losing a nickel on every sale and making it up on volume. Even in the context of an astonishing tech boom, Amazon was a pretty iffy investment in 1997. It would have been an absurd investment without the growth and momentum generated by thousands of peers, some of whom fared well but most of whom did not.

I think Steve’s analysis and critique are essentially correct. However, I am much less sanguine than he seems to be when it comes to eliminating much of the opacity and associated “kleptocracy” he finds in our current financial system. My pessimism is based on two rather sizeable barriers: human history, and human nature.

* * *

Human beings, we are told, evolved as social animals. From the very first dawn on the ancient savannah, our ancestors must have struggled with the solution to problems of collective action: how to provide security, shelter, food, and comfort to the members of the group or tribe. Given the natural variability among members of any population—whether along simple biological dimensions of age, infirmity, and strength, or more abstract qualities like ambition, skill, and desire—humans must have come to adopt and practice the division of labor early and often. Some would stay behind to protect the encampment, make and mend clothing, and build and maintain shelter while others foraged or hunted for food. Each member of the tribe would cede some of his or her personal agency to other individuals or groups in exchange for reciprocal aid. In this way, the group became stronger than any one of its members. In this way, through trial-and-error invention of division of labor according to comparative advantage, human groupings created social surplus, and complex societies were born.

Over the course of human history, we have developed numerous systems and institutions to address recurring problems of collective action. We developed standing governments to organize and direct our individual efforts toward persistent common goals, like safety, security, and other large challenges. We developed politics as a means for people to make collective decisions about authority and power in government and elsewhere. We built economies as a means to organize collective and individual economic action toward sustained or increasing prosperity. We developed judicial systems to adjudicate inevitable disputes and promote the cause of justice. Each and every one of these systems requires the individual citizen to surrender a portion of his will and agency to the collective. And each and every one of these entities creates, thrives on, and indeed cannot function without opacity.

Think about it: Do you know how and why decisions are made and actions are taken inside government bureaucracies? Do you know what takes place in smoke filled rooms among politicians and lobbyists, whose horses are traded and for what? Do you trust politicians to have your best interests or even the interests of the people who elect them at heart? Do you trust big business of any sort—insurance companies, oil companies, auto manufacturers, pick an industry—not to cut corners when it increases shareholder returns or executive pay? For that matter, do you trust your local auto repair shop to install the brand new muffler it charges you for, and not a refurbished one? Do you really believe our judicial system promotes justice? Do you trust lawyers?

Each of these social institutions creates opacity through the simple mechanism of dividing people into insiders and outsiders. The insiders have the advantage of knowing how things really work, how to “work the system,” and how to profit—economically, socially, and/or politically—from it. Information asymmetry (the source of opacity) is built into the very fabric of the division of labor in complex societies. Furthermore, creating specialized entities to handle collective tasks each of us individually neither can nor wants to address creates institutions whose primary aims become self-preservation and continued aggregation of power. Just like in finance, insiders’ privileged position and knowledge enable them to extract rents. It’s just that rents accruing to insiders in areas other than finance can take the form of social prestige, political power, and legal authority, in addition to undeserved money.

* * *

None of this should be particularly surprising to anyone who takes the time to reflect on it. Why do we tolerate opacity in our collective social institutions and rent-seeking (if not outright corruption) in the people who work there? Because, I must believe, after thousands of years of experimenting, we have not come up with any better way. No-one except a criminal really likes a rent-seeker, and no-one but a politician’s spouse likes a corrupt politician, but collectively we have come to accept the occasional example as the price we must pay in order to outsource the prosecution of certain of our interests to other people. It is a convenience tax. And just like any tax, we whine and complain about it, but we pay. “You can’t trust bankers/lawyers/politicians/bureaucrats/pick-an-actor.” Only when the basic services they provide collapse, or the excess rents they extract become too egregious, do we take up our pitchfork and torch to revisit the social contract.

The problem of opacity and rent-seeking by the insiders of the social institutions we empower to promote our collective good is less bad than it might be—and, therefore, more durable as a feature of complex society—for a number of reasons. For one thing, most people in such privileged positions of power really are not crooked cheats simply out for themselves. Most government bureaucrats, politicians, businesspeople, lawyers, and bankers really do believe they are providing a useful and perhaps even noble service. They view their privileges and socioeconomic rents not as perks unjustifiably pilfered, but as concrete confirmation of the worth and value which society—the people, the voters, the market, etc.—places upon their efforts. They think they deserve them.² Given that society allows or even encourages such actors to enjoy such special privileges, it is hard to argue that they are wrong.

For another, the tax which insiders extract for these services is, in the main, relatively small compared to the good their actions provide to the collective. Steve Waldman himself admits that:

Over the broad scope of history, societies with financial systems that mobilize capital opaquely and at very large scale have completely dominated those that have relied only upon consenting risk assumption by well-informed individuals. Industrialization occurs in societies with corrupt and fragile big banks, or else in societies where the state coerces and obscures risk-bearing and reward-shifting on a large-scale, or (more usually) both. China is a great present day example. That does not mean it would be impossible to develop a set of institutions that would be both effective and transparent. But it does mean developing such a system is an ambitious and ahistorical project, not a mere matter of “fixing what’s broken”. Under present arrangements, transparency and what we perceive as effectiveness stand in opposition to one another. It is incoherent to demand transparency and expect “more” macroeconomically stimulative intermediation from our current financial system.

Starkly put, what is a few billion dollars of excess compensation, here and there, if it enables the growth and prosperity of trillions of dollars of global economic activity?³

* * *

Finance is a critical function in today’s complex global economy. It is clear it stumbled badly in performing its basic function, and it seems beyond argument that it has far outgrown its proper place in the socioeconomic sphere and its share, deserved and undeserved, of the economic pie. But I find it hard to imagine any meaningful function performed by the financial system which can be purified into a transparent, corruption-free zone. Among government, politics, economy, and law, modern finance is a relative newcomer in the panoply of social institutions designed to promote the collective good. Given that no-one has demonstrated the ability to make any one of those older systems meaningfully transparent and corruption-free, I remain highly skeptical that we can do so with finance.

Yes, Steve, I admit the baby in the bathwater is fat, obnoxious, and ugly.⁴ But it is our baby. Do you still want to throw it out?


¹ Yes, believe it or not, it does happen on occasion. Steve is particularly good at triggering it, because he normally has such interesting things to say.
² Hence, e.g., the outraged sensibilities of financiers when you ask them to justify their relatively stratospheric pay: “But that’s what the market bears!” In other words, “I’m worth it!”
³ Especially if, as recent data seem to suggest, intragenerational wealth accumulation is more volatile and intergenerational wealth accumulation is less certain than it used to be. Personally, I am far less bothered by the rise and fall in one or two generations of self-made (finance) billionaires than I would be by the reestablishment of multigenerational dynastic wealth and all the sclerotic, corrupt sociopolitical accompaniments that would bring.
⁴ Steve also objects that our current financial system is incompetent when it comes to allocating systematic risk. He uses the examples of misallocating capital to faddish investments and the sticking of the unemployed and the indebted taxpayer with the biggest portion of the bill due from the collapse of the housing sector. But this misinterprets the proper role of the finance sector. The proper role is as servant to investors and users of capital. Investment bankers don’t sit in a back room, picking winners and losers like Chinese government ministers; we respond to capital supply and demand. Sure, such a system is widely acknowledged to be wasteful and subject to bubbles and fads, but it also has a long-term record of success I would stack up against any centrally planned economy’s any day. Given a choice between the (fallible) wisdom of crowds and the whim of a rent-collecting government technocrat insulated from market forces, I’ll take the crowds any day. Also, given that finance serves the broader society, why should we be surprised when it responds to the dictates of power by sticking failures to the little guy? That’s just politics.

© 2012 The Epicurean Dealmaker. All rights reserved.

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 (1995)

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.

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.

I Think I've Said This Before

Ho-Fucking-Hum.

Let me tell you, Dearest and Most Patient Readers, that notwithstanding my admirable innate modesty, unstudied intellectual humility, and staggeringly handsome physical appearance, it is beyond boring to be proved right time and time again as often as I have been. Even if I were a lesser man—prone to having my head turned by the adulation and adoration of the admiring masses, which I am most certainly not—I might begin to find the repeated ruminations of slower and lesser minds than my own on subjects which I have definitively and decisively disposed of now and forever somewhat enervating and—dare I say it?—even dispiriting.

Even today we find Andrew Ross Sorkin, of the Liberal East Coast Establishment's Business and Finance Digest of Record, DealBook, revisiting well-trod ground. He worries at length, and finds the fact that government regulators of the financial sector of our economy and their supposed regulatees not only share bodily fluids and intimacies not to be named in a family newspaper with each other on frequent occasion but also, mirabile dictu, share paychecks and other commonalities normally associated with working for each other's organizations on a regular, rotational, and, dare we say it, even predictable basis to be of a disturbing and even alarming nature.

And I say: No fucking shit.

But I also say: What about it? Where would you propose we find adequately qualified people to staff the regulatory bodies of our fair if somewhat befuddled commonwealth?

Where do you think we will find people who: a) know what the fuck they are talking about; b) know how the fuck to talk to/yell at/kick in the gonads the assholes they need to talk to/yell at/kick without worrying whether they can make the current lease payment on their late-model Subaru in suburban New Jersey if said regulatee makes a stink up the lobbyist/Capitol Hill staffer/Congress(wo)man food chain about said regulator's "disrespectful" behavior; and c) can tell Lloyd Blankfein or his current equivalent on Wall Street to take a flying fuck in a rolling donut if he doesn't like the tone, content, or approach of said regulator's interactions with his overpriced legal flunkies on items of regulatory interest and concern?

The Legal Aid Society of NYU Law School? The Public Defender's office? Puh-fucking-leeze.

In order to properly regulate the Masters of the Universe (aka Big Swinging Dicks) of the financial sector, you simply must have a stable of ill-mannered, hyperintelligent, nail-eating, blood-spitting, old-lady-tripping, extremely bad-tempered mutated sea bass ex-investment bankers and private sector lawyers who can go toe-to-toe with these self-protecting, self-"regulating", self-pleasuring assholes on their own terms. I'm sorry, but the well-meaning corporate lawyers and career civil servants who currently staff the SEC and like regulators simply are not up to the task of telling Jamie Dimon and his General Counsel to go fuck a goat in the information hall of Grand Central Station if he doesn't like the settlement terms/discussion/cup of coffee they are offering. Give me 25 ex-bankers like me, and 10 ex-flesh-eating Wall Street lawyers like Economics of Contempt, and I will not only have Jamie Dimon and Lloyd Blankfein eating like kittens out of my horny, calloused hands, but I will also have them delivering flowers to your Great Aunt Petunia in Astoria on a weekly fucking basis.

It'll cost you. And it'll rattle the cages of bureaucratic precedent and protocol, but is that really such a bad thing? Nowadays?

It's just not that hard.

* * *

Go read this, right fucking now. Write a goddamn book report, and deliver me a nice, crisp memo on the topic in the morning.

Do I have to do everything for you people?

Related reading:
Poachers Turned Gamekeepers (March 16, 2010)


© 2011 The Epicurean Dealmaker. All rights reserved.

The Blind Men and the Elephant

A HINDOO FABLE.

I.

IT was six men of Indostan
To learning much inclined,
Who went to see the Elephant
(Though all of them were blind),
That each by observation
Might satisfy his mind.

II.

The First approached the Elephant,
And happening to fall
Against his broad and sturdy side,
At once began to bawl:
"God bless me!—but the Elephant
Is very like a wall!"

III.

The Second, feeling of the tusk,
Cried:"Ho!—what have we here
So very round and smooth and sharp?
To me 't is mighty clear
This wonder of an Elephant
Is very like a spear!"

IV.

The Third approached the animal,
And happening to take
The squirming trunk within his hands,
Thus boldly up and spake:
"I see," quoth he, "the Elephant
Is very like a snake!"

V.

The Fourth reached out his eager hand,
And felt about the knee.
"What most this wondrous beast is like
Is mighty plain," quoth he;
"'T is clear enough the Elephant
Is very like a tree!"

VI.

The Fifth, who chanced to touch the ear,
Said: "E'en the blindest man
Can tell what this resembles most;
Deny the fact who can,
This marvel of an Elephant
Is very like a fan!"

VII.

The Sixth no sooner had begun
About the beast to grope,
Than, seizing on the swinging tail
That fell within his scope,
"I see," quoth he, "the Elephant
Is very like a rope!"

VIII.

And so these men of Indostan
Disputed loud and long,
Each in his own opinion
Exceeding stiff and strong,
Though each was partly in the right,
And all were in the wrong!

MORAL.

So, oft in theologic wars
The disputants, I ween,
Rail on in utter ignorance
Of what each other mean,
And prate about an Elephant
Not one of them has seen!

— John Godfrey Saxe, The Blind Men and the Elephant

Beware, O Dearly Beloved, those endlessly multiplying pundits who propose single-method solutions to the problem of financial reform. "The" answer is not minimum equity capital requirements, liquidity controls, return on equity caps, compensation reform, leverage or size limits, portfolio risk monitoring, or even slipping saltpeter into the lattes of testosterone-addled traders so they act more like risk-averse women. The answer—pace the sexual lobotomization of traders which many in society may wish for other reasons—is likely to be a combination of all of those reforms (and more), implemented in a dynamic and flexible regulatory structure which can respond and adapt to changing conditions.

For the fundamental truth which most commentators continue to overlook is that the global financial system is much more like our illustrative friend Panic Pete than an elephant. When you squeeze Mr. Pete in one spot, the squishy gel inside his rubbery body causes his other parts to bulge out. Squeeze him in those newly bulging areas, and he will return to his original form or bulge unexpectedly in new directions. Why? Because the gel inside of him is incompressible. Squeezing the flexible outer skin does not cause the toy to shrink. It just forces it into a new configuration. Likewise, the fundamental quantity in the global financial system which we are concerned with, and which we properly wish to control, is risk. But, given any specific level of return, risk is incompressible.

If you want to achieve a particular return, you necessarily assume a commensurate and ineluctable level of risk, whether the instrument of your investment is a single stock, a capital project, an individual business operation, an asset class, or indeed an entire economy. And what does return mean in the context of an economy? It means growth, increase in productivity, and real economic returns in addition to secondary (or even potentially illusory) investment returns. Investing in a business, an industry, or an economy is risky. There is no guarantee you will achieve your aims or desired returns, whatever those returns may be. There are no guarantees, period.

* * *

So part of the conversation we continue not to have in the public domain is what kind of returns—in the broadest sense—we desire for our economy and society, and therefore what level of risk we are willing to tolerate. Sure, we could turn the entire banking industry into a regulated utility, with mandated minimum equity levels, maximum allowed returns on equity, and limits on institutional size and interconnectedness (assuming we can understand, monitor, and control such parameters, which may be a slightly heroic assumption). But what knock-on effects would that have on investors, on businesses in search of risk capital for their growth projects, on consumers, and on the economy at large? Dampen the incentives and ability of financial intermediaries to originate, take on, and distribute investment risk, and it is not clear to me that overall risk-taking (i.e., investment) in the economy will not go down.¹ But if that happens, are we not explicitly or implicitly settling for less growth and fewer wealth creation opportunities in the economy overall? ² Is that really the outcome we are seeking?

By this, I do not mean to say our current system works well, or that the level of risk inherent in the financial system is appropriate or even efficiently distributed given our overall economic return objectives. But it does mean that we need to be a little more thorough, and a little more honest with ourselves and our opponents in debate, in thinking about the consequences of individual actions or "solutions" we advocate imposing on financial intermediaries. For consequences will flow inexorably in directions we do not—and perhaps even cannot—anticipate, and we will be remiss—and even no less irresponsible than the people who allowed the recent financial crisis to happen in the first place ³—if we do not make provision to address them.

* * *

Squeezing Panic Pete is fun. It's a great stress-reliever, too. It just so happens to be a lousy regulatory reform agenda.


¹ "Go down" = become more expensive, less frequent, less available, more difficult, etc.
² I do not speak of wealth distribution here, which is another socioeconomic debate admitting of other solutions which are not necessarily connected to the measures we decide to implement in financial reform.
³ Wait. That was all of us, wasn't it? Oops.

© 2011 The Epicurean Dealmaker. All rights reserved.

You All Know Brutus and Cassius Are Honorable Men

Much as it pains me to say it, O Gentle Readers of Tender Sensibilities, I'm afraid I must agree for once with those shills for the private plutocracy equity industry over at the Private Equity Growth Capital Council. They recently released a comment letter to the SEC's proposed rules on incentive-based compensation arrangements at systemically important financial institutions, which the Dodd-Frank financial reform act defines as any financial institution with at least $1 billion in assets.

In March, the Securities and Exchange Commission unveiled a plan to crack down on the kind of big bonuses that encouraged excessive risk-taking before the financial crisis. The proposed rules, which are expected to be completed over the next few months, are aimed at big banks and brokerage firms that nearly toppled in 2008. But technically, the proposal applies to any financial firm with more than $1 billion in assets, sweeping up private equity firms, too.

In fact, given the growth of private equity over the past three decades, such a rule, should it be implemented, would likely sweep up a substantial percentage of the industry's players, affecting numerous firms well beyond the industry titans included in the PEGCC's membership roster.

But the DealBook article mistakenly emphasizes the wrong points in summarizing the PEGCC's remarks, focusing on the assertion that private equity paychecks "pale in comparison to bonuses at big banks" (an extremely dubious assertion, at best) and that PE pay is determined in direct negotiation with sophisticated institutional investors, unlike bank pay which is railroaded by sleeping shareholders in the dead of night (true, but entirely beside the point). Instead, the PEGCC letter itself makes the salient point comprehensively and at length: while private equity firms may be "systemically important" in some sense, they pose very few systemic risks to the financial system at large, and these pale in comparison to the risks which large commercial and investment banks threaten.

This statement of facts, while self-serving, happens to be true. With certain important caveats, which I outline below, I agree that private equity firms' compensation arrangements should not be subject to regulation under Dodd-Frank.

* * *

In order to understand why, we must first address the structure of the private equity industry. There are basically three entities through which private equity operates in the markets: private equity firms, also known as "financial sponsors"; private equity funds which financial sponsors use as vehicles to do their investing; and individual portfolio companies which PE firms and their funds invest in. The PE firm itself is a relatively small entity, comprised of a surprisingly small number of professionals and support staff. (Even the biggest multi-billion dollar firms usually have only a few hundred employees.) Its task is twofold: i) raise money from institutional investors ("limited partners," or LPs) for discrete, limited-life funds and then ii) go do the hard work of investing that money in individual portfolio companies. Because a PE firm normally acts as the general partner of each of the funds it raises, financial sponsors are often known as General Partners or GPs in the trade. It is also worth noting that a PE firm will often manage more than one fund at a time: an older one, fully invested, where its job is to wind down the portfolio of existing company investments and either liquidate failing ones or sell the winners and return remaining funds to the fund investors, and a newer one, where its task is to put the available funds to work in new business investments.

The material point concerning traditional financial sponsors, however, is that while the professionals who do the work reside in those entities, the firms themselves have very little money or assets of their own. The money, and the investments it enables, reside legally in the private equity funds which the general partners manage for their limited partners. Private equity firms normally get paid what is known as "2-and-20": an annual 2% management fee, calculated on the total amount of money committed ¹ to the fund (e.g., $20 million per year on a $1 billion fund), and 20% "carried interest," which amounts to a 20% stake in the profits earned by the investments in the fund, after the management fee and certain preferred returns are paid to the LPs. While the management fee is intended to pay the light bills, the staff salaries, and all the operating expenses the sponsors run up by looking at hundreds of companies per year in the course of actually investing in just a few—and is mostly used for just such expenses—you can see that very large firms, with funds clocking in north of $10 billion, can actually make very good money just from management fees alone.

In fact, PE funds themselves really only act as accounting entities for the collection of portfolio investments within them. The real unit of investment of private equity is the portfolio company itself, which the PE firm buys either in whole or in part, with a substantial amount of equity taken from the LP fund and outside capital in the form of bank loans, high yield debt, or other debt financing. None of the portfolio companies in a PE fund cross-collateralizes the others—meaning if one goes bankrupt or liquidates, it has no effect on the entire portfolio or any other company within it. Lenders to leveraged buyouts look only to the credit of the company being bought, not to the fund in which the investment is made or the PE firm sponsoring the investment.

Therefore, you can see that notwithstanding the often substantial debt private equity firms take on in their investments, this leverage resides in carefully walled-off buckets at the level of each individual investment. If things go wrong with one company, it craters, but its cratering does not trigger a domino effect within any particular PE fund's portfolio, nor does it cause distress and financial contagion at the sponsor level. In almost all instances, neither PE firms nor PE funds take on debt of any kind for themselves. Therefore, they neither suffer financial distress nor have a mechanism to transmit such stress to the outside world. Sure, lenders to individual portfolio companies which go belly up are going to take it in the shorts, but that's where it ends. There are virtually no pathways of systemic financial contagion in the traditional private equity firm or its business.

This is accentuated by the fact that by participating in a PE fund, LPs agree to meet their funding commitments over the (normally 10-year) life of the fund and cannot contractually get their money back prior to its expiration. This is a material difference between the investment an institutional investor makes in traditional private equity and one it makes in a hedge fund. While hedge funds are gated, and have all sorts of mechanisms to delay investors from withdrawing their money at will, at the end of the day hedge fund investors normally have the ability to withdraw their money with limited notice. Investors in private equity do not. This makes a great deal of sense, of course, because hedge funds normally trade in relatively liquid assets, whereas private equity investments are almost the definition of long-term, illiquid investment.

* * *

Let's review. PE firms do not borrow money, and they have virtually no assets of their own. PE funds do not borrow either, and they call upon the irrevocable, unwithdrawable equity commitments of limited partners to fund investments in individual companies. PE investments (companies) are funded individually on a non-recourse basis to the fund and the financial sponsor. Lenders to PE company investments cannot cause a "run on the bank" at financial sponsors, and equity investors in PE funds cannot cause a run on the bank, either. Traditional PE firms and PE funds do not lend money to other entities, nor do they trade liquid securities, derivatives, or other financial instruments in any markets. Their investments in company buyouts are long-term, illiquid, and safe. At least from the financial system's point of view. ²

Therefore, what do we care about the risks private equity firms take in their investments? What do we care that other investors lend them way too much money at way too low interest rates with few or no covenants to fund their leveraged buyouts of companies? What do we care that giant institutional investors like CALPERS and Yale University give them hundreds of billions of dollars of equity to invest in risky buyouts? The answer is we shouldn't.

And since traditional private equity poses no material risk of financial contagion through highly liquid, interlinked debt and equity exposures which can be called at a moment's notice, why should we care how its executives are paid? Why should we care that they can get paid billions if their investments succeed? Why should we care if they make highly levered, risky investments in shaky businesses in order to make themselves and their limited partners rich? From the point of view of systemic financial risk, we shouldn't. Period. End of story.

* * *

HOWEVER, saying that traditional private equity, as a business and an investment class, does not add materially to systemic financial risk—which it does not—DOES NOT MEAN that we should not think carefully about the industry's incentives and the executive compensation practices which fall out of them. For one thing, my analysis above is based upon the well-established characteristics of traditional private equity: that is, leveraged buyouts and minority investments. But many of the largest financial sponsors have begun to build substantial businesses outside of traditional private equity—including trading (in-house hedge funds), real-estate, commodities, even investment banking—in pursuit of world-beating status as "alternative asset managers." The more they blur the line between their old identities and their new ones as highly-connected financial clearinghouses with multiple links into the global financial system and multiple pathways for financial contagion to spread, the less they can claim that their business model poses no risk to the system. And, therefore, the weaker their claim that regulators should not pay attention to how their executives are paid and how such pay practices may encourage the assumption of risk.

Lastly, of course, saying that traditional private equity compensation practices should not be subject to review and control by regulators because they do not foment systemic financial risk is not to say that there are not other good reasons to do so. Putting aside vexing issues of income inequality, stratospheric individual wealth creation for the poobahs at the top of the business, and the PEGCC's despicably meretricious advocacy of the ridiculously unfair tax treatment of carried interest, there is the social policy issue of the true value of private equity itself.

For while I have always admired the good which private equity investors can do for companies which are struggling, need to be fundamentally restructured, or face significant transformational challenges which are best conducted out of the glare of public scrutiny, I am also aware there is a strain within the business which is far less admirable. A strain which looks to the quick flip, the carving up of thriving businesses for the sum of their parts, the starving of growing businesses of the capital expenditures they need to expand, and the ruthless downsizing of employees driven by purely financial considerations. The pay structure and incentives of the industry definitely play into this dark side of private equity, too.

* * *

Saying private equity compensation should not lead to another potential financial crisis doesn't quite end the conversation, in my opinion. Not all the financial regulatory issues we address in the current environment should be restricted to the implementation of Dodd-Frank.


UPDATE June 11, 2011: Fixed reference to carried interest and added link to previous discussion.

¹ Important side note: when KKR, for example, raises a $10 billion fund, they do not receive $10 billion in cash up front from their limited partner investors which they invest in a bank savings account until they spend it. Rather, they obtain contractual commitments from their LPs to respond in a timely fashion to their capital calls when they make an investment. The LPs do pay the 2% management fee on their entire commitment from the beginning, however, whether the funds are invested or not.
² What causes bank runs? Liquid deposits. In other words, deposits (or loans) that can be withdrawn immediately by the depositor (lender). Illiquidity is a wonderful mechanism to prevent runs on the bank—whatever form a "bank" might take—if only because you can't withdraw it in times of stress.

© 2011 The Epicurean Dealmaker. All rights reserved.