This Situation Absolutely Requires a Really Futile and Stupid Gesture

Bluto: “Hey! What’s this lyin’ around shit?”
Stork: “What the hell we supposed to do, ya moron?”
D-Day: “War’s over, man. Wormer dropped the big one.”
Bluto: “What? Over? Did you say ‘over’? Nothing is over until we decide it is! Was it over when the… Germans bombed Pearl Harbor? Hell no!”
Otter: [aside] “Germans?”
Boon: “Forget it, he’s rolling.”
Bluto: “And it ain’t over now. ’Cause when the goin’ gets tough…”
Bluto: “…”
Bluto: “…”
Bluto: “The tough get goin’! Who’s with me? Let’s go!”

— Animal House

Hamilton Nolan posted a really stupid piece on Gawker this past week.¹

Apparently the editor of our culture’s preeminent forum for snark and sarcasm was so outraged by Forbes’ annual encomium to the highest-earning hedge fund managers that he burst a gasket. I guess the shock was so great Mr. Nolan dropped a slice of gluten-free artisanal toast buttered with the tears of free range lambs raised on an anarchosyndicalist commune in Vermont face down on a rug woven by one-armed Peruvian orphans from the frayed fibers of their broken dreams. Or so I presume, given the fulsomeness of his resulting vitriol. Unfortunately for this forum, at least, Mr. Nolan’s righteous indignation was not matched by a similar zeal to get the most basic facts about the situation correct.

So the unsuspecting Whole Foods customers who read Mr. Nolan’s work were subjected to howlers like this:

Here is what George Soros’ fund did last year to earn him $4 billion: it underperformed the S&P 500 index by 8%. In other words, Soros charged his investors fees that are well over 1000% higher than what they could have paid for a simple index fund that would have earned them more money.

Which is amusing since, as Mr. Nolan subsequently appended in a parenthetical correction to those very words, George Soros only manages his own money. I mean, I suppose it is shocking Mr. Soros had the audacity to charge himself and his charitable foundations zero dollars for the privilege of earning only four billion dollars when he could have earned significantly more, but I suspect even the meanest intelligence would find the towering indignation inspired by the preceding sentences dissipating somewhat once he realizes exactly what that means. (Perhaps Mr. Nolan counts on his fellow snark and outrage aficionados to miss the embarrassing reveal…)

But this failure to do the most basic fact checking—i.e., reading the goddamn Forbes article he cites—is not the worst of Mr. Nolan’s sloppy misrepresentations. Even he seems to shrug off the fact that thousands of rich institutions and individuals seem content to pay billions of dollars in fees to hedge fund managers for results which, in aggregate, have underperformed the general stock market.² No, what really pisses Hamilton Nolan off is the notion these greedy plutocrats are stealing food out of the mouths of hungry refugees by paying preferentially low tax rates on their filthy lucre. He points out, correctly, that alternative asset managers like hedge fund managers benefit from the treatment of their performance fees as carried interest. Carried interest, for those of you ignorant of it, enables the managers of certain investment partnerships to treat the performance fees they earn (typically 20% of the positive returns they earn for their limited partners) for tax purposes as capital gains, presumably on the theory they are returns to the “sweat equity” (i.e., not real money) that managers contribute to the partnership. This can be advantageous to the extent these managers, like those in private equity and venture capital partnerships, generate returns over a period of several years, which can then be taxed at preferentially low long-term capital gains rates.

But what Mr. Nolan fails to recognize is most hedge funds earn the bulk of their returns by rapid trading of liquid investments and assets like stocks, bonds, commodities, derivatives, and anything else for which a willing counterparty can be persuaded to part with a bushel of folding money. They are trading vehicles, which means most of the capital gains they earn via performance fees are treated as short-term capital gains. And short-term capital gains, under our current tax code, are taxed at the same rates as ordinary income.

Which means, technically speaking, that Hamilton Nolan is full of shit.

* * *

Now this is not to say the treatment of performance fees for alternative asset managers as capital gains via the mechanism of carried interest makes much sense or is good tax policy. I have argued strenuously in the past that performance fees earned by professional managers with no underlying capital at risk should be treated as what they clearly are: ordinary income for services rendered. The current tax regime is patently unfair, and the counterarguments offered by interested parties involved are weak and self-serving. But this does not invalidate the fact that, under the law, hedge fund managers who trade their clients’ money actively (that is, most of them) pay the equivalent of ordinary income rates on their performance fee income.³ Private equity plutocrats—who, interestingly enough, tend to make less money every year and have lower net worth than the best hedge fund managers—are the ones who benefit disproportionately from the current biases of the tax code. But Mr. Nolan is not attacking them.

Nor is it to deny that hedge fund managers, like any other person richer than Croesus, have the money and means to pay legions of lawyers and accountants millions of dollars to structure elaborate tax shelters and help them defer or evade billions in taxes. But this is not limited to hedge fund managers: it is a privilege enjoyed by any rich and politically powerful person who is willing to spend a tiny fraction of their income to shield the bulk of it from the taxman. You may thank the complexity of our tax code and the ingenuity of clever men and women willing to delve deep in its bowels for that.

* * *

At the end of the day, O Dearly Beloved and Excessively Tolerant Readers, what really annoys me about Hamilton Nolan’s poorly researched and badly premised hit piece is that its own strongest feature—a deep suspicion of and revulsion toward enormous sums of money flowing to tiny numbers of human beings while billions struggle to make ends meet—is almost completely undermined by its almost comical disregard for the facts. Growing wealth and income inequality around the world is engendering serious sociopolitical conflict, but attacking the wrong people for the wrong reasons with the wrong arguments will do nothing to address it.

Polemics can focus the mind wonderfully, but they must be based in truth if they are going to persuade anyone. One of my favorite non-finance bloggers about academia and culture, Freddie deBoer, wrote an illuminating essay about this very issue in academia not long ago:

This is the problem with speaking the “emotional truth,” a common invocation for adjunct essayists and part of a lot of rhetorically counterproductive strategies that, I’m sorry to say, creep into this genre a lot. The emotional truth is invoked on the ground in the day-to-day discussions I have with adjuncts. People will make claims that I know to be factually inaccurate, or will advance ideas that I find politically misguided, and I will push back. When confronted, they will say something like “I am entitled to my anger,” leaping back and forth from a position of making a dispassionate economic analysis to a position of emotional truth that I am therefore, in their minds, obliged not to contradict. There are all sorts of ways bad arguments and misleading information get excused in these debates– “it’s agitprop! it’s not intended to be factual! it’s meant first to provoke!”– and I think each of these, while certainly understandable, are ultimately unproductive. And they have made this argumentative space one of bullying and rejection.

To extend Mr. deBoer’s analysis, most of the people involved in the analysis, practice, and regulation of finance “are people who think that facts matter, and so when you are loose with the facts, you make it harder to get their support.” Yeah, like impossible. Most of us—even those who might otherwise be sympathetic to your analysis or agenda—just throw up our hands and ignore you. If you can’t argue from the facts, you are simply pandering to your own anger and the prejudices of the uninformed elements in your audience. You may be penning compelling polemics, but you are wasting every serious person’s time, and you certainly aren’t convincing them. In addition, you make it easier for them to discard everything you write or say, because your argument is riddled with silly, obvious omissions, misrepresentations, and untruths. Your potential allies think you’re a harmful idiot, and your enemies gleefully disregard any valid points you might make because you are a careless, misleading boob.

Polemics are fine, but don’t neglect the foundation of facts you must build them upon. Otherwise you’ll become like Matt Taibbi:⁴ beloved by those who don’t know anything and scorned by those who do.

Related reading:
Tax Breaks for Everyone! (June 14, 2007)
The Taxman Cometh (July 11, 2007)


¹ “Gawker?!”, you gasp. Yes, yes, I know: most of you do not visit these pages with the view to enjoying the spectacle of me beating up the feebleminded, but I do have a larger agenda. Besides, it’s fun to go slumming on occasion. I promise I won’t make a habit of it.
² A more intellectually honest and curious journalist might explore why so many presumably silly rich people allocate so much money to hedge funds and other alternative investments. That same journalist might find it revealing that the class of such assets allows one access on occasion to consistent outperformance which handily trumps average market returns. That journalist might also find it suggestive that rich folk such as Mr. Soros and his former clients are happy to trade volatility and uncertainty of investment returns for the opportunity to make tons of money when their manager is right. Finally, that journalist might discover that hedge funds invest in a much broader and more diverse universe of asset returns than simple stock market indices, which can be handy when the latter are pissing the bed. But I suppose we must not hold Mr. Nolan to such unrealistic standards.
³ And on the distributed returns they earn on the personal capital they invest in their own hedge funds. It is quite common in hedge fund land for managers to have very large portions of their personal net worth invested in their own funds. This is one good reason to admire these swashbucklers: they eat their own cooking and put their own capital at risk alongside that of their investors.
⁴ Or Matt Taibbi Junior. Say what you will about Mr. Taibbi, who also undercuts his own far more effective polemics with a highly tendentious style of argument that runs roughshod over the truth, at least he tends to do research. I very much doubt he would have stumbled over the elementary source of Mr. Soros’s income.

© 2014 The Epicurean Dealmaker. All rights reserved.

A Good Offense

Kind-hearted people might of course think there was some ingenious way to disarm or defeat the enemy without too much bloodshed, and might imagine this is the true goal of the art of war. Pleasant as it sounds, it is a fallacy that must be exposed: war is such a dangerous business that the mistakes which come from kindness are the very worst.

* *
If defense is the stronger form of war, yet has a negative object, it follows that it should be used only so long as weakness compels, and be abandoned as soon as we are strong enough to pursue a positive object.

— Carl von Clausewitz, Vom Kriege

Consider, Dear Reader, the question embedded in the mouse-over caption to the photo above: Should we consider a tank destroyer—a machine designed to destroy tanks—to be a defensive weapon or an offensive weapon? The Jagdpanther was designed and employed by the Wehrmacht during World War II primarily as a hunter-killer of Allied tanks. Heavily armored against frontal assault, highly mobile, and equipped with a powerful main gun fixed in a low-profile, turretless unibody chassis, the Hunting Panther was designed to lie in ambush for enemy tanks and knock them out in one-on-one frontal duels. Its design was ill-suited for infantry support, general patrolling, or massed attack across open country. Given that the tanks it opposed were usually employed in offensive thrusts, one could say the Jagdpanther was primarily a defensive weapon. And yet it was also a mobile cannon par excellence: a weapon purpose built to deliver armor-penetrating or high explosive shells against sundry targets mobile and fixed, none of which necessarily had to be an opposing tank. (Eighty-eight millimeter rounds could kill enemy infantry and destroy artillery emplacements just as neatly as they disabled tanks.) Of course the Germans could and did use the SdKfz 173 for offense. It was a weapon.

It is true that most weapons and implements of war are usually designed to be primarily offensive or defensive in nature. A shield’s primary use is to defend, a sword’s is to attack. And yet a sword can be used to parry; a shield can be used to bludgeon or chop. Offense and defense are different modes of use—that is, tactics—not intrinsic properties of the tools we employ.

The same is true, by analogy, of financial instruments and trades. A trade can be made for offensive purposes—speculation or investment¹—or defensive ones, as a hedge. Speculation increases an investor’s risk exposure; hedging reduces it. And yet the same trade or financial instrument can be used in either way at different times and under different circumstances. Selling a thousand shares of Apple Computer can either be a perfect hedge, when it liquidates an existing long position, or rank speculation, when it initiates an open short sale. Context—and the other positions in an investor’s portfolio—is everything. This is very poorly understood by the common man or woman.

* * *

Hence we get the recent spectacle of financial journalists and market participants falling all over themselves to condemn with morbid fascination the large scale market interventions of J.P. Morgan Chase’s London-based chief investment office. Adding to the camera-ready copy of these stories, this trading team reportedly roiling the markets with its enormous volume and net positions apparently enjoys the leadership of a man some call the “London Whale” and others “Voldemort.” An eager journalist on the financial beat could not ask for more.

Of course the solitary string of outrage which journalists and their hedge fund sources—pot, meet kettle—keep harping on is that somehow J.P. Morgan is using the trading activities of its CIO to circumvent the regulatory and moral limitations on proprietary trading by systematically important financial institutions embodied if not yet enforced in the Volcker Rule. Jamie Dimon, as befits the fiduciary duties which accompany his lofty pay grade and authority in J.P. Morgan’s executive suite, of course denies that the London Whale or any of his minnows are doing any such thing. I am sure it will disappoint the anti-capitalist firebrands in my audience to hear that, subject to further stipulations, qualifications, and cautions noted below, I feel compelled to give ol’ Jamie the benefit of the doubt here.

For the assertion, which Mr. Dimon seems to be promoting, that his chief investment office is putting on massive securities and derivatives trades to hedge the bank’s already existing underlying risk exposures makes complete sense. Have you looked at J.P. Morgan’s balance sheet lately, O Curious and Inquisitive Reader? As of March 31, 2012, the redoubtable House of Morgan boasted total investments (consisting of deposits with other banks, debt and equity instruments, derivatives, and securities) of $953 billion, net loans outstanding of $687 billion, and other assorted doodads which added up to an impressive-in-this-or-any-other-world-you-can-think-of 2.3 TRILLION DOLLARS of total assets. That’s a lotta simoleons, children.

And while the mysteries of generally accepted accounting principles, trade secrets, and legal smokescreens prevent a humble outsider such as Your Humble Bloggist from penetrating the veil of opacity to any meaningful extent, I think it’s safe to assume a hell of a lot of those bright, shiny assets represent proprietary risk trades which the House of Dimon put on for the sake of its beloved and long-suffering corporate, governmental, and investment clients. Most people just don’t seem to get it, but even normal, everyday corporate lending is proprietary investing. A bank creates an income-producing asset for itself by lending money to a client. Loans are risky assets: the borrower may not pay principal and interest back on time (or at all), and the lender exposes itself to market-based interest rate risk either directly through the form of the loan’s interest payment mechanism (fixed or floating) or indirectly via its own funding requirements (banks borrow money to lend it, you know) or both. A normal commercial lending bank is by definition shot through with all sorts of risk, even when it shuns the racier ends of the swimming pool like securities and derivatives trading or structured products.

This becomes especially clear when you consider the funding side of a normal bank. J.P. Morgan did not create or purchase all those assets with $2.3 trillion in loose change it just had lying around the house. It borrowed over $2.1 trillion from anyone it could get its hands on—retail and commercial depositors ($1.1 trillion), corporate lenders ($726 billion), and trade creditors, plus $182 billion from gullible common shareholders—and went shopping. The bank is, to use an industry term of art, leveraged up the wazoo.²

But this is just the ordinary magic of a traditional bank’s business model: borrow cheap, flexible funding from as many naive savers as you can muster, and lend it out at higher rates to the desperate and underfunded. The magic—and the returns—come from the fact that the risks a modern bank assumes on the funding and the lending side are very different, often highly volatile, and incommensurate with leaving early on Thursday for afternoon golf. Identification, management, and control of borrowing and lending risks are core to the activities of lending banks. That is what they get paid for; that is how they earn their returns.³

* * *

Now given that Jamie’s Army is brooding over something slightly more than umpty bajillion dollars of proprietary investment assets tottering precariously on their balance sheet, you can be damn sure that I and everyone else with a natural aversion to Stone Age living conditions sure as hell hope J.P. Morgan is hedging the shit out of those assets. You can also be sure that a loan book of $687 billion and an investment portfolio a cat’s whisker shy of a trillion dollars offers numerous and substantial opportunties for its risk management group to put on enormous hedging trades in the markets. I would be shocked to learn that J.P. Morgan wasn’t moving the markets.

The only caveat to mention is that hedging is a tricky and mercurial thing. As I alluded above, the only “perfect” hedge for a trade or position is to unwind it completely, with the original counterparty or one who carries no residual risk. You can perfectly hedge your purchase of 1,000 shares of Apple only by selling them completely, for cash. The same is true for each and every individual financial asset: it can only be completely and irrevocably hedged by unwinding that particular asset or, as is sometimes done in the derivatives market, by immunizing it with an identical, offsetting mirror-image asset with the same counterparty. Anything else introduces one or more forms of what is broadly known as basis risk. Basis risk can take many different forms: credit risk, from different counterparties; interest rate risk, from different durations (e.g., long vs short); collateral risk; and, overarching and encompassing most of these, correlation risk. The latter is easiest envisioned in the case where an investor hedges her portfolio of individual stocks against a general market decline by buying a notional amount of S&P index puts equivalent to her portfolio value. But her success will depend entirely on how her individual stocks behave in relation to the portfolio hedge. If they move down in lockstep with the S&P, she will have protected her portfolio’s value, but if they decline while the S&P stays flat or rises, she will have suffered the worst of both outcomes, loss on both her portfolio and her protective puts.

The trick is that portfolio hedging is normally far more efficient and cost-effective than hedging each and every individual position in a risk book. While this concept seems to befuddle the occasional journalist, it seems to have penetrated even the thick skulls of the rule makers in Congress, who have carved out aggregated position hedging from activities banned by the Volcker Rule. After all, if one looks at commercial and universal banks as entities which manage the mismatch of assets and liabilities in their business for fun and profit, one can see that, in some important sense, it is the job of such financial intermediaries to generate returns by managing basis risk. In the argot of the market, banks are long the basis risk of financial intermediation.

But by that very token, examining the risk portfolio of a large financial institution can never be as simple as totting up each individual portfolio position and netting it against its very own particular hedge. Banks and investment banks manage risk across multiple dimensions, and one hedge or set of hedges may have (partial) hedging properties for numerous unrelated positions. They do so dynamically, too, since the basis risk which was well understood yesterday may diverge or uncouple drastically tomorrow. Market crashes and financial panics seem to have the nasty effect of driving return correlations to one across all financial assets and asset classes, which can bollocks up an otherwise nifty risk model no end. The monitoring and control function of regulators is made more problematic by portfolio risk management practices, too, since a trade which looks like a sensible and effective hedge in the context of the overall risk book may look like the rankest proprietary speculation in isolation. Needless to say, the counterparty to a trade by a big commercial or investment bank usually doesn’t have the beginning of an inkling of a whisper of a clue why and for what purpose Big Mondo Bank is calling him up. And you can forget about journalists.

In like fashion, a Russian tank commander on the outskirts of Warsaw in 1945 probably didn’t have the least notion whether the Jagdpanther fired its 88 at him because it was attacking, defending, or just range finding. Sorry to say, the reason didn’t matter much if an antitank round blew him to smithereens.

Fortunes of war.


¹ For the purposes of this discussion, I consider “investment” and “speculation” to be one and the same thing. Both entail the assumption of risk in pursuit of return, as opposed to hedging, which entails the reduction of risk. That investment has a respectable connotation in our current culture and speculation does not is none of my concern. All investment—which constitutes a bet upon an uncertain future—is speculative. It would be wise for everyone to remember this.
² Although by the standards of its industry, its profligate European peers, and the wild-eyed lunatics in pure investment banking, J.P. Morgan is downright conservative in its leverage ratio. The absolute numbers are what give any prudent person the bends. It’s all how you look at it.
³ Never forget, children: risk and return are conjoined twins. You can’t have one without the other. If you can’t identify the risks underlying a particular return, you’re either missing something, or I have a very attractive bridge crossing the East River I would like to sell you.

© 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.

Investment Banks of the Plain

Robert Rauschenberg, Monogram, 1955–1959

Awww...

Passion aficionado and sesquibajillionaire Ken Griffin has finally “given up his dream”—according to a slightly breathless New York Times DealBook—to create an investment bank with the heft and prestige of Goldman Sachs. According to reports, he is shutting down the sell-side equity research division of his hedge fund, Citadel Securities, and putting his runty investment bankers out on his front lawn in a cardboard box marked “PUPPIES – 20¢ Eech, or Free 2 a Gud Home.”

Somewhere, Lloyd Blankfein is heaving a sigh of relief... — No, scratch that. He’s saying “Ken who? He was trying to build what?”

I mean seriously, people, the only sleep Lloyd Blankfein and the other CEOs of established Wall Street firms lost over Griffin’s quixotic quest these past three years has been prior to industry social functions—like the Robin Hood Foundation gala, where hedgies compare the size of their penises charitable contributions in public—where they’ve had to listen to him boast about how he was going to eat their lunches, before asking in a hushed aside whether they knew any good candidates to head his pissant investment bank. And the only reason they lost sleep, and didn’t spin on their heels and sprint away the minute they caught sight of him, was because the hedge fund side of his business was such a monstrous (potential) contributor to their sales and trading and prime brokerage revenues.

In contrast, Ken Griffin’s investment bank was a bad joke.

* * *Now, an onlooker sympathetic to Griffin’s chief premise—that there was an opening in 2008 for another major investment bank, one which could compete with reputationally damaged, financially weakened giants like Goldman, Morgan Stanley, and Bank of America Merrill Lynch in the immediate aftermath of the financial meltdown ¹—might claim that Ken’s fundamental error was one of execution, not conception. Certainly, he seems to have made a monumental hash of the most important task before him: hiring the right professionals to staff his folly. Over the course of its brief existence, Citadel Securities became an industry laughingstock for the frequency with which Griffin hired and fired the heads of his bank and senior business unit managers. You just can’t do that if you intend to build an investment banking franchise, for the simple reason that no-one below the level of Master of the Universe who doesn’t have fully portable compensation and a self-sustaining reputation will risk their career to work for such a shitshow. And any MoU worth his or her salt won’t sign up either, because whatever ruinously excess pay Griffin had to offer to lure them in wouldn’t be worth the brain damage of adapting to a constant merry-go-round in the executive suite.

Corporate finance and M&A are labor intensive in a way the typical capital markets salesman or trader has no idea: you need good people below you programming the models, writing and producing the pitchbooks, and handling the myriad details of an active deal process to run any sort of functioning business underwriting new issues and doing deals. You just don’t sashay into the office at 7:30 am every morning, plug your headset into the turret phone, fire up the MBS derivative valuation model, and try to make some money. We chase clients and opportunities for years before we see revenue dollar one, and much of the time we never earn anything. But like Woody Allen supposedly said about life, 80% of investment banking is just showing up: year-in, year-out, building presence, reliability, and credibility with clients so that when they eventually do have a deal to do, you have a decent chance of winning it.

Also, unlike much of capital markets, investment banking (corporate finance and M&A, natch) does not lend itself well to economies of scale. It takes approximately the same effort and labor to execute the sale of a $150 million company that it does to sell a $5 billion one. In fact, given the usual relative lack of sophistication and experience of smaller clients, it often takes more. It is a further truism that every deal is different: there are no clients in M&A or equity underwriting where a banker can take a prior deal summary down from the shelf, dust it off, and present it to the client to win the deal. Finally, the scale and financial heft of an investment bank matters less to most clients in selecting new issue underwriters and M&A advisors than does its reputation, credibility, and track record. This is one reason why deals on my side of the house are rarely won by the bank offering the lowest price, and why prices for IPO underwriting and M&A deals remain stuck stubbornly at the same levels they have been for 30 years.

* * *Notwithstanding my undeniable joy in busting their balls, I admire talented traders and hedge fund managers immensely. They have a rare and distinct skill set and personality which is tailor-made for success in today’s global financial markets. But almost to a man, they are lousy at building real operating businesses. One of the key psychological traits of top traders—their ability to change their minds on the fly, experiment with risk where they see financial opportunity, and change business models as often as they change clothes—is fundamentally incompatible with building stable operating businesses where success and profitability rely upon consistent execution and sustained market presence. Hedge fund managers I know treat operating committee meetings like investment committee meetings: this strategy isn’t working, let’s shut it down; this market is on fire, let’s throw another 20 people at it and see if we can make money; here’s a talented banker in an industry we have never covered, let’s hire her and see whether she can build a business by herself before we give her any resources. You just can’t run a real business—including, believe it or not, an investment banking business—like that. It’s stupid to try.

I suspect Ken Griffin failed at building the next Goldman Sachs for a number of reasons. For one, he misunderstood the source of Goldman’s (and others’) success in investment banking. He thought it derived from their gigantic, market-moving presence in global financial markets. Instead, Goldman has maintained a market-leading spot in M&A and underwriting almost in spite of their position as one of the world's largest hedge funds. Goldman is strong in those areas because it has always been strong there, because it has been a premier advisory bank for almost its entire history. If anything, Goldman's strength as a white shoe advisory boutique enabled its evolution into a world-straddling financial behemoth, not the reverse.

Second, Griffin’s undeniable talents as a hedge fund manager and trader made him far too mercurial to be the strategic visionary behind a major investment bank. While I would not discount the corrosive effect of his famous temper on employee relations, I guarantee you the main reason so many senior investment bankers left so quickly from Citadel is that Ken kept changing his mind about strategy and tactics. Investment banking just isn’t that hard. You pick a strategy, you pick the right personnel to execute it, and you wait. Investment banking on my side of the house requires the virtues of an investor: careful thought, committed investment, and patience. I know few top-flight traders who possess anywhere near the required measure of the latter.²

* * *In any event, the reverse of Ken Griffin’s strategy—building a world class hedge fund within a full-service investment bank—hasn’t worked out very well either. As soon as a trader gets enough experience and reputation to strike out on his own, he’s gone. Good hedge fund traders who can make money on their own don’t need or want the massive infrastructure, byzantine bureacracy, compliance strictures, and cap on upside compensation which a modern global investment bank demands for its very existence. Perhaps if Mr. Griffin had spent a little more time trying to understand the incompatibility of banks and hedge funds from this, very well-documented direction, he might have spared himself a few years and several hundred million dollars worth of trouble. But then again, I suppose he’ll just chalk it up to just one more bad trade in a lifetime of many: no harm, no foul.

Investment banking + hedge funds. Like most unnatural acts, it always sounds better in concept than it turns out in execution. And it always hurts way more than you expected.


¹ I would not be one of them. Investment banking has never wanted for ass-chafing competition in any of the 20+ years I have practiced in it. I daydream fondly about the day it will.
² Most of them would ask, “Why throw good money after bad?” I (and other investment bankers) would retort, “If the strategy is correct, you have to give it time to bear fruit.” You may guess that traders and investment bankers rarely agree.

© 2011 The Epicurean Dealmaker. All rights reserved.

A Client Is Not a Counterparty

I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description ["hard-core pornography"]; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it, and the motion picture involved in this case is not that.

— Justice Potter Stewart

Jesse Eisinger put up an interesting piece yesterday at DealBook, reporting on a series of transactions conducted by Goldman Sachs in 2008 and 2010. He uses it to illustrate what he and many other people seem to view as an insoluble dilemma: how to distinguish between market-making by investment banks and proprietary trading. The distinction is an important one, as Mr. Eisinger explains, because the so-called Volcker Rule in the new Dodd-Frank financial regulation regime severely limits investment banks' proprietary trading and investment activities.

I will let Mr. Eisinger explain:

The story starts in summer 2008. Bear Stearns had collapsed. The housing bubble was bursting. So was another bubble, in loans to high-risk companies. Banks, which had doled out overly generous loans to high-risk corporations, would get stuck with losses on many of these.

During this period, Goldman Sachs bundled a bunch of these loans into a special concoction called CELF Partnership — or CELF-interested.

Of the 1.5 billion euro deal (about $2 billion today), 1.2 billion euros came from Goldman’s own balance sheet. Goldman whipped the deal out the door in July 2008.

Just two months later, the financial crisis roared to a boil and the assets backing the CELF bonds, like all such investments, wilted. Those who bought into the CELF deal were sitting on paper losses.

The CELF deal got interesting this year. The big investor in the deal, a Dutch pension fund, wanted out. It owned the triple-A rated portion of the CELF deal.

The investor went back to the underwriter, Goldman, and after an auction, the firm bought it from its client. Because the market had declined, the investor took a loss.

In addition to buying the triple-A position, Goldman also bought some of the equity, or the bottom part of the deal. The equity carried ownership rights. Goldman bought enough equity to become the majority holder of the deal.

As majority equity owner, Goldman unwound the securitization and liquidated the securities.

Goldman made a bundle on the trade. Even though the CELF assets aren’t worth today what they were in 2008, there was enough money that in unwinding the trade, all the debt holders — including Goldman — got paid off in full. The holders of the equity were left with cents on the dollar. For Goldman, the trick was that it was worth a small loss on the equity to make a big gain on the debt.

So Goldman made money and some of its clients took a loss. At this point, few would be surprised by that.

Now, I am not personally familiar with this transaction, but I must say Mr. Eisinger obscures at least as much as he uncovers by the way he glosses over some of the key details in the story. I think it would be instructive to unpack his narrative. Perhaps we can learn a little more than we expect to about the distinction between market making and proprietary trading, after all.

* * *

First of all, we need to tease apart the various different roles Goldman Sachs played in this little drama. The fact that one firm played multiple roles does not prevent us from distinguishing among them, or pointing out the important differences each has.

The first clue comes from the fact that €1.2 billion of the corporate loans underlying the securities in question "came from Goldman's own balance sheet." This means one of two things: either Goldman purchased these corporate loans from the original lenders (or secondary market holders) for its own account, or it loaned the money itself to those corporations.¹ Now, whether you loan money directly or purchase loans from others, the economic upshot is the same: you are a lender. Also, and more to the point, you are an economic principal. A principal invests its own money for its own account. It puts its own capital at risk in pursuit of investment return, whether that takes the form of lending money to borrowers; buying and holding long-term, illiquid assets; or trading securities, commodities, and other financial instruments for investment gain. That last is commonly known as proprietary trading.

The second distinct role Goldman played in the transaction was to bundle its own loans (and €300 million from other parties) into the CELF securitization, slice the underlying loans into separate classes of security with different priority claims on the underlying pool of loans, and sell those securities to investors. These activities and their analogues are known in the trade as structured finance. They can be performed on behalf of an unrelated third party, in which case the structured financier acts as an agent, or they can be performed for yourself as principal, as in the case of Goldman's CELFs. Usually the firm which acts as structuring agent also sells the resulting securities to outside investors. Selling newly issued securities on behalf of another party—related or unrelated—is known as underwriting.

Underwriting is one of the oldest functions of investment banks. Traditionally, it took the form of pure agency business: an investment bank would work with the issuer of new securities to shape them into a form and value attractive to the market, would arrange and assist the issuer in marketing the new securities to investors, and, in the end, would purchase the securities in bulk and then resell them to investors which it had already determined wished to buy them. The underwriter does in fact put its own balance sheet on the line, if only temporarily, by buying the securities and then reselling them. In this way, an underwriter does act as a principal. However, if it does its job properly, and develops and identifies adequate demand among third party investors for the securities prior to purchasing them, its risk is distinctly limited and quite fleeting. Underwriting is therefore properly understood primarily as an agency business. As an agent, the underwriter's primary obligation is to the issuer, to help create, market, and sell its new securities in such a way that the issuer can accomplish its financing objectives.

However, it is important to realize that the underwriter's success—and privileged position in the market as a trusted vendor of issuers' new securities offerings—depends heavily on its prior record in placing securities with third party investors. An investment bank which becomes known for underwriting low quality paper, crappy issuers, or overpriced securities can become a pariah with the investors who normally purchase such securities. They will not buy its offerings, or they will only buy them with heavy price discounts. This gets around to corporate issuers, and those companies will choose different investment banks to place their securities the next time they want to finance. Accordingly, you must understand that a traditional underwriter's interests—when it acts as a pure agent, or hired gun—are never 100% aligned with those of its issuer client. In many cases (not all), an issuer simply wants to receive the highest price possible for its securities. But the underwriter wants to sell securities that will make its clients on the other side of the Chinese wall—buy-side investors—happy, too. The underwriter, as pure middleman, must play a long game, and its success depends on pleasing both sides of the table. Usually that means displeasing each of them—issuer and investor alike—equally.

In addition, an underwriter usually bears at least an implicit obligation to investors to not only underwrite quality, reasonably priced securities but also to support those securities in aftermarket trading. In practice, this means offering an acceptable bid when an investor wants to sell the securities a bank has underwritten and, to a lesser extent, an acceptable offering price for future purchases. Supporting newly issued securities in the aftermarket leads neatly into the concept of market making.

* * *

Market making is the process through which an investment bank makes a two-way market in various securities and markets. In other words, it stands ready at all times to buy securities at an advertised purchase price and to sell those selfsame securities at an advertised selling price (which, understandably, in almost every instance is higher than the price at which it offers to buy). There are many reasons why investors want investment banks to perform this function, even in the age of fully automated electronic matching markets. The simplest is anonymity. Investor A usually does not want Investor B (or C or Z) to know it is liquidating its entire 50,000 share position of IBM. It can sell its shares to X Bank at 11:07:17 am and X can turn around and sell them all to Investor B at 11:07:32. Another is that markets for certain securities can be relatively illiquid. There may be no buyer for security Z for hours, days, or even weeks. Investor A can sell its Z to X Bank today, which will take those securities into inventory for eventual sale when a buyer materializes. A third is that many securities trading in the market—like the various tranches of the CELF offering—are relatively obscure or customized, and only the investment bank which underwrote them fully understands which other investors in the market buy and sell such securities, and at what price.

Now, unlike underwriting new securities, where an investment bank earns a fixed, predetermined percentage of the offering proceeds for its labor no matter what price the securities sell for, a market-making bank only profits to the extent it can sell securities in its market making operations for more than it purchases them for (adjusted, as always, for funding costs). Furthermore, a market-making bank cannot reduce its uncertainty about the securities' eventual selling price by pre-marketing them to investors like it does in a new issue offering. Just like underwriting, however, the market-making bank must use its capital to purchase securities and hold them in inventory until it can sell them. Market making is risky. Market making is a principal activity.

And yet, investment banks traditionally thought of market making as a client service. An agency business. We put our capital at risk to facilitate the trading of our investing clients. In exchange, we earned a small commission, the occasional chance to put our capital to work in longer-term trades where we thought we had an edge, and—most importantly—priceless insight into the daily operations of particular securities markets, including the appetites, biases, and weaknesses of countless third party market participants. This insight is incredibly valuable, not only in market making itself, but also in making the investment bank possessing it a better informed underwriter for new securities. Securities markets are hotbeds of asymmetric information. The party with the best information has the greatest power. Market making can provide that power.

Now, historically what prevented investment banks from exploiting their privileged market position as the possessors of the best and most complete information to the fullest was relatively thin capitalization. But as markets got bigger and broader, and securities (and derivatives) got more complex, customized, and illiquid, investment banks' demand for capital became ever larger. In part, this was driven by their clients, who demanded they make markets in all the exotic new goodies their underwriting arms were frantically pushing out the front door. First they converted from private partnerships to publicly traded entities. Next, they merged with or converted into universal banks active across all markets: fixed income, equities, commodities, derivatives, currencies, etc. Complexity in particular—exemplified by exploding volumes in derivatives and structured securities—drastically increased the number and profitability of opportunities for the best positioned insiders—investment banks, natch—to profit from asymmetric information. Our clients demanded it, and we saw the opportunity. Large scale proprietary trading was born.

* * *

Enough with the history lecture. The major point you should take away from the dissertation above is that everything an investment bank normally does in securities markets requires it to put capital at risk. Low-risk, agency type businesses like underwriting and traditional market making lie on the same spectrum as full-blown proprietary trading, if only at different ends. There is no bright line between market making and prop trading, if only because a market maker may unintentionally take securities into inventory for a long time, because no buyer happens to be available, whereas a prop trader may make money by scalping basis points in high speed trading of liquid markets.

But the blurry line between market making and proprietary trading doesn't mean we can't identify proprietary investing—or, more specifically, acting like a principal investor—when we see it. The only time Goldman Sachs acted remotely like an agent in the scenario Jesse Eisinger described above was when it underwrote the original CELF securities offering in 2008. Even then, its client was Goldman Sachs itself, which sold the vast majority of loans underlying CELF to the securitization vehicle as principal. How interested do you think Goldman was in selling those securities to investors for an attractive price? Can you imagine its concerns as underwriter might have been subordinated to its interest as seller in getting the highest price? I can.

In any event, Goldman's actions in 2010 bear absolutely no resemblance to behaving like an agent when it purchased the outstanding CELF securities and liquidated them. It did not behave like a normal market maker, buying securities from one investor and selling them to another. It paid an arm's length price, determined after an auction run by a third party, to the investor it originally sold the AAA rated tranche to. It then triggered the liquidation of the securitization by purchasing a majority stake in its equity. With respect to the seller of the AAA tranche, it acted as a pure trading counterparty. A principal.

Therefore, Goldman's attempt to wrap its behavior in the holy shroud of client service:

"Our client decided to sell its investment," the firm said in a statement. "It took independent advice and ran a competitive sale process. We offered the highest price. This is a good example of helping a client achieve its objective, and underscores the critical importance banks play in using their capital to facilitate transactions on behalf of clients."

is nothing more than a patently disingenuous dodge.

By the same reasoning, my local pharmacist becomes my client every time I buy Preparation H to soothe the ass chapping Goldman Sachs gives me when they spout such pure, unadulterated horseshit.

I don't think so.


¹ It is a relatively recent development (within the last 15 years or so) that corporate loans have become widely traded. It used to be a bank which loaned the money to a corporate client kept the loan as an interest-earning asset on its balance sheet until maturity. The bank originated the loan and retained full risk exposure to the timely repayment of interest and principal by its debtor. Nowadays, banks and investment banks still originate such loans, but they often dispose of most if not all of the risk exposure by selling those loans or derivatives tied to them to third party investors. Some argue that this has materially weakened the credit risk underwriting process for corporate lending, since the banks which originate and quickly sell such paper have little incentive to truly determine the long-term creditworthiness of their borrowers. I cannot disagree.

© 2010 The Epicurean Dealmaker. All rights reserved.

Retainers of Fluidity

Of course, it's bad to be a criminal. Everyone knows that, and can swear that it's true. Criminals mess up the world. But they are, as well, retainers of fluidity. In fact, one might make the case that New York would not have shone without its legions of contrary devils polishing the lights of goodness with their inexplicable opposition and resistance. It might even be said that criminals are a necessary component of the balanced equation which steadily and beautifully eats up all the time that is thrown upon its steely back. They are the sugar and alcohol of a city, a red flash in the mosaic, lightning on a hot night. So was Pearly.

— Mark Helprin, Winter's Tale

Yeah, well, maybe not.¹

I can think of legions of pasty-faced 20-something hedge fund and proprietary traders who would love to style themselves as something as transgressive and oppositional as criminals. Most, much to their unknowing and likely never-to-be-known chagrin, are just nerdy parasites on the monetary surplus of a fat and lazy society.

Not that I'm judging, or anything.

Hahahahahahaha...

¹ After all, there is a difference between retainers of fluiditity and people who just retain fluid. Q.v. the nebbishes at Goldman Sachs.

© 2010 The Epicurean Dealmaker. All rights reserved.

H is for Hedge Fund

“Were the judgments we made reasonable ones?” a former top Harvard administrator asked me, rhetorically, addressing the sharp increase in expenses and capital commitments of the last decade. “At the time, I think they were reasonable judgments. It turns out, with the benefit of hindsight, you might have preferred less ambitious plans.” (Which is not to say that the administrator in question accepts a grain of responsibility for those judgments.) ...

“Apparently nobody in our financial office has read the story in Genesis about Joseph interpreting Pharaoh’s dream—you know, during the seven good years you save for the seven lean years,” remarked Alan Dershowitz, a professor at Harvard Law School since 1967. “And now they’re coming hat in hand, pleading to the faculty and students to bear the burden of cutbacks. It’s a scandal! It’s an absolute scandal, the way Harvard has handled this financial crisis.”

— Nina Munk, "Rich Harvard, Poor Harvard," Vanity Fair

At one point in her gripping account of the endowment train wreck and its aftermath at Harvard University, Nina Munk characterizes Harvard as "a distinguished, high-minded research university, arguably the greatest university in the nation." This is just the sort of a by-the-by assertion that makes Harvard partisans nod their heads and murmur "Of course" and the rest of us grind our teeth in various degrees of dismay, disbelief, and envy. Harvard itself makes no effort to dissuade people from this view, and its public mission seems to center around preserving and extending its reputation, legacy, and importance.

Which is why I am puzzled that Harvard has landed in the mess it has so loudly, sloppily, and apparently unexpectedly. You would think a university founded almost 375 years ago would take the long view in everything it does. You would think that it would be cautious, circumspect, and conservative, and that, in the words of that arch traditionalist, Rudyard Kipling, it would have learned to treat those two imposters, triumph and disaster, the same.

You would think that a mere setback of 25 or 30% in the endowment account—after years of outstanding, market-beating returns—would have been reserved for, or at least anticipated as theoretically possible. You would think that such a university would have made provisions for just such a rainy day. Apparently, you (and I) would be wrong.

* * *

Of course, there are other contenders for the throne of greatest university in the world, some of which have the unbridled temerity to site themselves outside the United States. So I thought it would be instructive to conduct, investment banker style, a quick comparable analysis of the leading hedge fund universities in the US with the oldest English-speaking university in the world, Oxford. The comparison, if I say so myself, is revealing.

	Harvard	Yale	Oxford 1
Year founded 2	1636	1701	1096/1167
Total students	20,320	11,446	20,014
Total staff	12,950	12,795	8,427
2008 FYE expenses (mm)	$3,465	$2,294	£749
Staff costs as % of expenses	47.9%	58.4%	53.8%
2008 FYE endowment (mm) 3	$36,927	$22,686	£654
% Expenses funded by endowment	34.7%	37.1%	4.5%
% Expenses funded by government 4	15.4%	19.7%	30.4%
Net fixed assets (mm)	$4,951	$3,200	£844
2008 FYE capital spending (mm)	$591	$569	£114

¹ Oxford's numbers do not offer a true apples-to-apples comparison to its American rivals, since the vast majority of the University's residential colleges are independent financial entities whose numbers are not reported in the University's consolidated reports. However, one can get a sense of the size of the omitted entities by noting that the colleges had aggregate income of £267 million in fiscal 2008 and aggregate endowments totaling £2.67 billion.
² Oxford states: "There is no clear date of foundation, but teaching existed at Oxford in some form in 1096 and developed rapidly from 1167, when Henry II banned English students from attending the University of Paris." Way to stick it to the French.
³ As of fiscal year end 2008, before everybody and their brother shit the bed. Current size estimates for Harvard's and Yale's endowments are $26 billion and $16 billion, respectively. No-one really cares how much Oxford's pissant little endowment lost since July 2008, except perhaps Oxford. It is worth noting that Oxford is currently undertaking an unprecedented capital campaign to raise—wait for it—another £1.25 billion. Woo-hoo!
⁴ The percent of last fiscal year expenses paid for with direct national government support and grants.

For one thing, the figures do little to persuade me that Yale pays much attention to the productivity of its labor force. More interesting, and more to the point, it appears that the oldest university manages to eke out its continuing reputation as one of the best around with a much smaller endowment than its competitors. Even adjusting for the unconsolidated endowments of Oxford's independent colleges, the University manages to educate over 20,000 students to some of the highest standards in the world using a mere $5 billion in treasure. Sure, Oxford relies on the UK (and, to a much lesser extent, the EU) government for a larger proportion of its operating expenses than the Yanks, but Harvard and Yale demonstrate no rugged go-it-alone individualism when it comes to Uncle Sam's largess. Again, adjusting for the Colleges' endowment income, it is not clear there is much difference at all.

So what's the difference? Cathedral building. Consider this, from Nina Munk:

Over the 20-year period from 1980 to 2000, Harvard University added nearly 3.2 million square feet of new space to its campus. But that’s nothing compared with the extravagance that followed. So far this decade, from 2000 through 2008, Harvard has added another 6.2 million square feet of new space, roughly equal to the total number of square feet occupied by the Pentagon. All across campus, one after another, new academic buildings have shot up. The price of these optimistic new projects: a breathtaking $4.3 billion.

In Allston, a Boston neighborhood just across the Charles River from the school’s main campus, you can view Harvard’s billion-dollar hole in the ground, a vast construction pit. It’s the foundation of Harvard’s most ambitious project of all: the sprawling Allston Science Complex, once scheduled to be completed by 2011 at a cost of $1.2 billion—but now on hold.

And this proud recitation, from Yale's fiscal 2008 report:

Capital spending on facilities in 2008 totaled $568.9 million. This represents a 52% increase over the 2007 spending level and the highest level of spending in the University’s history. This significant increase in capital spending reflects the University’s commitment to renovating its existing facilities while adding strategic new facilities to meet teaching, research, and residential needs.

The accompanying graph is a thing of beauty.



It seems that Harvard and Yale are in a race to determine which of them has the biggest edifice complex.

* *

This is Part 3 in a continuing series on the cost and funding of higher education in America.
Part 1: Et in Arcadia Ego
Part 2: VA • NI • TAS

© 2009 The Epicurean Dealmaker. All rights reserved.