I know this was all long ago, but I read the transcript of David Einhorn's speech and his argument with the Lehman CFO, only recently (google it- all very very curious). I am just wondering if certain salient aspects of this episode were ever noted
1. Everyone knew that this guy was short Lehman stock. Is it okay for a hedge fund manager to be short a stock and then publicly attack a company in a market that was already jittery.
2. If transparency was the issue, why was David not obliged to disclose how many shares of Lehman was his firm short, and how much he stood to gain by creating negative sentiment on Lehman.
3. How can a hedge fund, whose financials are not transparent to anybody, claim to crusade for more transparency from its rivals, the investment banks ?
4. If you short a stock, how can you claim to be a champion for shareholder rights when all the shareholders are actually long the stock ?
The guy claims the SEC harassed him but his entire behavior during the Lehman episode could not by any stretch of the imagination, be considered ethical.
5. All that fuss about Level 3 assets. Nobody even knew what a Level 3 asset was at that point in time. The classification of assets into three levels was a lame attempt by the Accounting boards to try to understand what kind of casino Wall street was running through derivatives. But it was certainly not the hard science that the hedge fund Manager was trying to make it out to be, in his attacks in Lehman Brothers.
6. The Lehman CFO was obviously not qualified, but just goes to show what kind of people get promoted on Wall street, where the CFO cannot do simple arithmetic.
All in all, the whole episode was a reflection of the pathetic state of affairs in the Financial industry, where the blind were leading the blind.
Monday, December 21, 2009
Why you need to pay Bankers
The problem is with the CAPM. According to this theory, there is only one market portfolio. Consequently, all stocks are equivalent as long as they are part of a portfolio. So a low margin retail business, or a failing airline business is compared to an investment bank. Comparisons are based on an antiquated Accounting system. So a Balance sheet asset for a steel company is compared to the Balance sheet asset for a Derivative business.
Anyway, to come to the point, obviously the Financial company, which has no real assets to risk, will be more profitable, than the other industrial or even technology company. So, if just to make people happy, Bankers are paid less, then the residual profit will go to increase shareholder profits. But these shareholders are not demanding those additional profits. They do not even want those additional profits. Why else would they bid up Goldman Sachs to $150+ or whatever other ridiculous price at which it is currently trading. They do not need the additional return because according to the CAPM (Capital Asset pricing Model), they do not need that much additional return since the risk of this stock, has been mitigated through being part of the market portfolio.
So, since the shareholders do not need this money, the only competitive differential from one bank to another, is how much it pays its bankers. What is Citigroup going to do to compete once it has repaid the TARP money ? it is not going to launch a marketing campaign. Nor is it going to invent a new super financial product. It is simply going to pay more than the rest of the street to attract "talent". This is the easiest way for the CEO of any Bank to stay competitive. All that the "talent" is doing (which is mostly used car Salesmen masquerading as Financial geniuses), is moving their book of customer accounts to the highest bidder.
So there you see in a nutshell, what the people and the Politicians simply do not understand, is why you need to pay Bankers.
Anyway, to come to the point, obviously the Financial company, which has no real assets to risk, will be more profitable, than the other industrial or even technology company. So, if just to make people happy, Bankers are paid less, then the residual profit will go to increase shareholder profits. But these shareholders are not demanding those additional profits. They do not even want those additional profits. Why else would they bid up Goldman Sachs to $150+ or whatever other ridiculous price at which it is currently trading. They do not need the additional return because according to the CAPM (Capital Asset pricing Model), they do not need that much additional return since the risk of this stock, has been mitigated through being part of the market portfolio.
So, since the shareholders do not need this money, the only competitive differential from one bank to another, is how much it pays its bankers. What is Citigroup going to do to compete once it has repaid the TARP money ? it is not going to launch a marketing campaign. Nor is it going to invent a new super financial product. It is simply going to pay more than the rest of the street to attract "talent". This is the easiest way for the CEO of any Bank to stay competitive. All that the "talent" is doing (which is mostly used car Salesmen masquerading as Financial geniuses), is moving their book of customer accounts to the highest bidder.
So there you see in a nutshell, what the people and the Politicians simply do not understand, is why you need to pay Bankers.
Thursday, October 8, 2009
Interest rate swaps
In a previous post I stated that interest rate swaps are easy to understand. They are, but I guess they are not really a widely understood concept. So let me take a shot here at explaining an interest rate swap.
First you need to understand interest rates. If you borrow money you pay interest on it. If you borrow money today and return it tomorrow, you will pay a lower interest rate than if you borrow money today and return it after a year. There are many scientific reasons why this is the case, but mostly it is because we do not trust you. You cannot get very far in a day, but you could probably be in Mexico by year-end.
So anyway, we now have a market where you can borrow at a specific rate for each length(also called tenor) of borrowing. So you have an overnight rate and a one year rate and a two year rate and so on. This is called the yield curve. So far I think we are all good.
Now we come to the complex math that only rocket scientists can understand. We will need examples to understand this. If you have a 6 month rate of 5% and a one year rate of 10%, this implies a 6month rate, 6 month forward, of around 15%. How did this happen ? Well you can break the one year period into two 6month periods. The first 6months have an interest rate of 5% and the second six months have a rate of 15%, so that the average rate over the one year is 10%. My math is not accurate as I did some rough examples to illustrate the concept. However, you get the gist of it. This 15% rate is called the 6 month "forward rate". If I have a 6month rate quoted in the market, and I have a one year rate quoted in the market, then it implies that there is a 6month forward rate which is some kind of average between the two. It will be higher than the other two rates but that is getting too technical.
So anyway, all across the yield curve, all the way to thirty years, there exists these forward rates. What an interest rate swap does is that it agrees to exhange these forward rates for a Fixed rate. So if you have a floating rate mortgage that resets every 6months, I can swap your floating rate for a fixed rate. You will obviously pay me handsomely for this piece of Financial wizardry where you pay me a fixed rate to take away the risk of your ever changing floating rate. However, this fixed rate that I offer you on the swap will still be lower than if you were to go out and try to get a fixed rate for thirty years.
So there you have it - Interest rate swaps for dummies. Leave me your questions. Why is it necessary for you to understand this ? Ever since the Federal government decided to let interest rates float in the name of a free market, you pretty much have no choice but to understand this complication. It is like having to understand your taxes, a mutual fund, a 401k fund. The free market makes things complicated and dangerous for an innocent, naive or ignorant public.
Btw..look at the financials of all the major Wall street firms and ask them how much of their earnings come from plain vanilla interest rate swaps. Then listen to their arguments about how they are absolutely forced to pay top dollar to keep their "talent" from gong to the competition. They would have you believe all the dollars are going towards keeping extreme brainâcs continuously occupied, in this very complex business. Believe you me, the only talent involved here is in keeping the world spinning...around Wall street. There are mostly shamans and snake oil salesmen, that get to keep the top dollar, for producing absolutely nothing. Many of them probably do not even know the math behind the above simple product. All they know is that dim lighting and cheap merchandise are all that is required to turn a profit. Also, a monopoly in the business, helps keep profits high and competition out of sight.
First you need to understand interest rates. If you borrow money you pay interest on it. If you borrow money today and return it tomorrow, you will pay a lower interest rate than if you borrow money today and return it after a year. There are many scientific reasons why this is the case, but mostly it is because we do not trust you. You cannot get very far in a day, but you could probably be in Mexico by year-end.
So anyway, we now have a market where you can borrow at a specific rate for each length(also called tenor) of borrowing. So you have an overnight rate and a one year rate and a two year rate and so on. This is called the yield curve. So far I think we are all good.
Now we come to the complex math that only rocket scientists can understand. We will need examples to understand this. If you have a 6 month rate of 5% and a one year rate of 10%, this implies a 6month rate, 6 month forward, of around 15%. How did this happen ? Well you can break the one year period into two 6month periods. The first 6months have an interest rate of 5% and the second six months have a rate of 15%, so that the average rate over the one year is 10%. My math is not accurate as I did some rough examples to illustrate the concept. However, you get the gist of it. This 15% rate is called the 6 month "forward rate". If I have a 6month rate quoted in the market, and I have a one year rate quoted in the market, then it implies that there is a 6month forward rate which is some kind of average between the two. It will be higher than the other two rates but that is getting too technical.
So anyway, all across the yield curve, all the way to thirty years, there exists these forward rates. What an interest rate swap does is that it agrees to exhange these forward rates for a Fixed rate. So if you have a floating rate mortgage that resets every 6months, I can swap your floating rate for a fixed rate. You will obviously pay me handsomely for this piece of Financial wizardry where you pay me a fixed rate to take away the risk of your ever changing floating rate. However, this fixed rate that I offer you on the swap will still be lower than if you were to go out and try to get a fixed rate for thirty years.
So there you have it - Interest rate swaps for dummies. Leave me your questions. Why is it necessary for you to understand this ? Ever since the Federal government decided to let interest rates float in the name of a free market, you pretty much have no choice but to understand this complication. It is like having to understand your taxes, a mutual fund, a 401k fund. The free market makes things complicated and dangerous for an innocent, naive or ignorant public.
Btw..look at the financials of all the major Wall street firms and ask them how much of their earnings come from plain vanilla interest rate swaps. Then listen to their arguments about how they are absolutely forced to pay top dollar to keep their "talent" from gong to the competition. They would have you believe all the dollars are going towards keeping extreme brainâcs continuously occupied, in this very complex business. Believe you me, the only talent involved here is in keeping the world spinning...around Wall street. There are mostly shamans and snake oil salesmen, that get to keep the top dollar, for producing absolutely nothing. Many of them probably do not even know the math behind the above simple product. All they know is that dim lighting and cheap merchandise are all that is required to turn a profit. Also, a monopoly in the business, helps keep profits high and competition out of sight.
Wednesday, October 7, 2009
Free interest rate swaps for the retail market
Free market efficiency does not work in the derivatives market. Free markets require a very large number of players to be efficient. When interest rates were deregulated in 1980's, no thought was given to how Banks and especially the Agencies, Fannie & Freddie would hedge their interest rate exposures. The free market came up with interest rate derivatives because they saw an opportunity to make money. We should give them credit for Financial innovation - free markets do work in this respect.
However, it has been thirty years since this innovation. Banks and Broker dealers have profited from this deregulation for all of these three decades. It is about time the patent on this simple product expired and the benefits of this product are distributed to all.
There is no point trying to limit Wall street wizards to smaller compensation packages simply by asking them to feel ashamed of their greed. The best way to beat them at their game is to join them.
These wizards are not making money on their really exotic products - this is the dirty secret that the media and lawmakers have completely missed. They are making money on really simple vanilla interest rate products. More disclosure in the Financial statements by actual product line would dispel any myths about their money-making abilities. They are making money from a basic financial product, an interest rate swap, which could be valued by a high school student after a couple of hours of training in simple interest calculations. If the government is really serious about going after Wall street, they should address the structure of the derivatives market. It does not make sense for the Agencies F& F to buy trillions of dollars worth of Mortgages from the public and then go to a small number of Banks, brokers and hedge funds, to offset their interest rate risk. Obviously, the few select providers of this product reap windfall gains, by overpricing it. The plutocracy (reference to Michael Moore's film) owns a monopoly that is fr@#king golden. The whole thing is smoke and mirrors, foisted on an ignorant public by vested interests.
There is a very good argument to allow interest rate derivatives for the retail public. Firstly, it is quite bogus to create a system where every one of our assets have a floating price and then to claim that only sophisticated investors can have access to the products that will hedge the risk of the basic products. Every one of us has exposure to floating interest rate risk through credit card balances, variable rate loans or ARM's. We should be allowed to go directly into the market and offset this interest risk. The main barrier to entry is the small size of our trades. The Fed should force Wall street to provide a channel where these small trades are also allowed equal access to the market. This will provide depth in the market and kill Wall streets' monopoly, and consequently there will be no need for a witchhunt to bring down paychecks.
Leave the exotic products to the wizards. None of those products make any real money. The only restriction should be that these products are confined to a non-banking entity, not commingled with any public money. Everyone should be forced to post collateral and all players in the market should have complete recourse to the assets of the promoters of each others' entitites. They should only be allowed to play in their own market where the public is not exposed to the results of their exotic experiments. That will cool the market for these products in a few short days.
However, it has been thirty years since this innovation. Banks and Broker dealers have profited from this deregulation for all of these three decades. It is about time the patent on this simple product expired and the benefits of this product are distributed to all.
There is no point trying to limit Wall street wizards to smaller compensation packages simply by asking them to feel ashamed of their greed. The best way to beat them at their game is to join them.
These wizards are not making money on their really exotic products - this is the dirty secret that the media and lawmakers have completely missed. They are making money on really simple vanilla interest rate products. More disclosure in the Financial statements by actual product line would dispel any myths about their money-making abilities. They are making money from a basic financial product, an interest rate swap, which could be valued by a high school student after a couple of hours of training in simple interest calculations. If the government is really serious about going after Wall street, they should address the structure of the derivatives market. It does not make sense for the Agencies F& F to buy trillions of dollars worth of Mortgages from the public and then go to a small number of Banks, brokers and hedge funds, to offset their interest rate risk. Obviously, the few select providers of this product reap windfall gains, by overpricing it. The plutocracy (reference to Michael Moore's film) owns a monopoly that is fr@#king golden. The whole thing is smoke and mirrors, foisted on an ignorant public by vested interests.
There is a very good argument to allow interest rate derivatives for the retail public. Firstly, it is quite bogus to create a system where every one of our assets have a floating price and then to claim that only sophisticated investors can have access to the products that will hedge the risk of the basic products. Every one of us has exposure to floating interest rate risk through credit card balances, variable rate loans or ARM's. We should be allowed to go directly into the market and offset this interest risk. The main barrier to entry is the small size of our trades. The Fed should force Wall street to provide a channel where these small trades are also allowed equal access to the market. This will provide depth in the market and kill Wall streets' monopoly, and consequently there will be no need for a witchhunt to bring down paychecks.
Leave the exotic products to the wizards. None of those products make any real money. The only restriction should be that these products are confined to a non-banking entity, not commingled with any public money. Everyone should be forced to post collateral and all players in the market should have complete recourse to the assets of the promoters of each others' entitites. They should only be allowed to play in their own market where the public is not exposed to the results of their exotic experiments. That will cool the market for these products in a few short days.
Saturday, October 3, 2009
Credit default swaps should only be allowed with an offsetting credit exposure
Michael Moore could not seem to pinpoint exactly what is wrong with a Credit default swap. Here are some pointers
1. A naked credit default swap (without an underlying exposure )creates the incentive to bankrupt companies.
Say we have a hypothetical strong company B that has issued very little debt. Maybe one five year bond. The stock is doing middlin to ok depending on the state of the overall market. However, it may still have short-term borrowings and lines of credit to finance its day to day activities.Say another smart master of the universe broker-dealer, lets say G, buys credit protection from dumb insurance company A. G has no real credit exposure to B. However, it has a clear incentive to buy a credit default swap (these are cheap relative to the Notional. The premiium is an accrual and does not have to be paid right away. It has to be paid over the life of the swap). G has every incentive to short the stock of B and create an artifical credit panic for B. If the market is shaky, the fundamentals of the company do not matter. Banks will pull the credit lines of Company B and push it into a liquidity crisis. G will get away with the equivalent of collecting protection money. If dumb insurance company A does not post collateral, its friends in the Federal government will post margin. Depends on how big and dumb is A (or just corrupt).
2. A CDS exchange will not solve the above problem.
3. A CDS should be allowed only for the legitimate creditors of the company to buy protection against any outstanding exposure. A naked CDS is evil. It should be banned atleast till the CDS market is symmetrical and very liquid.
4. A CDS should require upfront payment. If they quote a 1000% CDS spread, the guy buying a CDS should put up a 1000%. This will quickly cap all CDS rates to a 100% of the exposure. The 1000% default spread is a bogus number and should not be allowed as an indicative price.
So there. Can someone please forward to Obama, Barney Frank, Michael Moore and the other CDS-haters ?
1. A naked credit default swap (without an underlying exposure )creates the incentive to bankrupt companies.
Say we have a hypothetical strong company B that has issued very little debt. Maybe one five year bond. The stock is doing middlin to ok depending on the state of the overall market. However, it may still have short-term borrowings and lines of credit to finance its day to day activities.Say another smart master of the universe broker-dealer, lets say G, buys credit protection from dumb insurance company A. G has no real credit exposure to B. However, it has a clear incentive to buy a credit default swap (these are cheap relative to the Notional. The premiium is an accrual and does not have to be paid right away. It has to be paid over the life of the swap). G has every incentive to short the stock of B and create an artifical credit panic for B. If the market is shaky, the fundamentals of the company do not matter. Banks will pull the credit lines of Company B and push it into a liquidity crisis. G will get away with the equivalent of collecting protection money. If dumb insurance company A does not post collateral, its friends in the Federal government will post margin. Depends on how big and dumb is A (or just corrupt).
2. A CDS exchange will not solve the above problem.
3. A CDS should be allowed only for the legitimate creditors of the company to buy protection against any outstanding exposure. A naked CDS is evil. It should be banned atleast till the CDS market is symmetrical and very liquid.
4. A CDS should require upfront payment. If they quote a 1000% CDS spread, the guy buying a CDS should put up a 1000%. This will quickly cap all CDS rates to a 100% of the exposure. The 1000% default spread is a bogus number and should not be allowed as an indicative price.
So there. Can someone please forward to Obama, Barney Frank, Michael Moore and the other CDS-haters ?
Friday, August 28, 2009
Equity compensation is the root of all Corporate evil
What Obama and Barney Frank need to focus on is the nefarious practice of Bankers being compensated through restricted stock or stock options. The basic premise of equity compensation is that Manager interests are aligned with shareholder interests through this practice. This theory is flawed for the following reasons
1. The actual cash value of payments in shares are never recognised in the Financials of the company. Share payments are recognised as part of the capital account and not in the operational earnings, as a cost.
2. The amount paid is not a fixed expense amount. Instead, it is a share of the company.
3. You cannot give away the farm to align a managers interest with the owner. To provide an analogy, if I pay my housekeeper, a share in my property so as he does not damage my property, eventually he will own my house and I will be the housekeeper.This is the same concept.
1. The actual cash value of payments in shares are never recognised in the Financials of the company. Share payments are recognised as part of the capital account and not in the operational earnings, as a cost.
2. The amount paid is not a fixed expense amount. Instead, it is a share of the company.
3. You cannot give away the farm to align a managers interest with the owner. To provide an analogy, if I pay my housekeeper, a share in my property so as he does not damage my property, eventually he will own my house and I will be the housekeeper.This is the same concept.
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