Random ramblings on the market

Death by a thousand cuts

2011-08-19T22:09:00.000-07:00

The banking industry in New York is dying. It is death by a thousand cuts and indiscriminate layoffs. If you ask Goldman Sachs, they are only top-grading, and getting rid of the bottom segment of the industry. In reality, the bottom feeders are really at the top, making these decisions to cut. The banking industry has been in-bred, and corrupted for years with crony capitalism, and nepotism being the main talents for survival. Anyone that has any real talent, capability, or ethics, has been systematically purged from the system.

So now we finally have the inevitable death throes of the industry. After facing the reality of the consequences of their actions in 2008, and refusing to accept this reality, finally Bankers are at a point where the golden goose is not laying any more eggs. So instead of trying to save the industry, they have decided to kill the goose, and make a last meal of whatever remains.

It is all fine in the free market text books, to allow for a hire and fire environment, that allows a bloated manufacturing firm to trim their costs, and remain competitive in a global environment. However, we are talking about banking and not manufacturing. These same banks were hiring last year. In reality, they have no idea how many people they need, because they have no idea as to their purpose in the economy. The Wall street firms are just serving up BS, and consequently there is no set number of people required to do this job. It is an extremely variable number.

The real reason the banks costs are high is because of the number of Managing Directors on the payroll. Do the math. If you have a thousand MD's earning over a million dollars a piece, that is a billion dollars in expense. It is hard to make any money when your costs are so high. Instead of turning out thousands of low level grunts into the streets, they need to lose the MD's. Since the MD's are the ones doing the firing, this is not likely to happen unless you have a very brave CEO.
Since the situation is as it is, we need the government to mandate (hey if the firms did what was good for them, we would not need big government to step in) that for every thousand workers they fire, they need to lose an MD.

The current situation is bad on many levels. Due to the bottom feeders having moved up to running the firm, they have no other talents besides surviving at all costs. They do not have any actual technical abilities to run anything. So after each round of firing, they have to go back in the market and hire some people back, because someone has to do the work! Then we go to the next round of firings because the MD cost situation will continue to be a drag on the firm. Which is why we are seeing these endless hire and fire cycles.

The other option that the firms are following, is to move all the support jobs offshore, so that atleast on a short-term basis, the cost situation is alleviated. Which brings us back to why this will kill the industry in New York. The derivative products that the banks are peddling,despite their fancy names, can really be whittled down to four or key five asset classes - Equities, interest rate derivatives like interest rate swaps, Foreign Exchange products, Commodities and the infamous credit derivatives. These products are pretty much commoditised on the front-end, and a used car salesman could peddle them. No real irreplaceable talent is required to trade or sell these products. The real technical know-how which differentiates one firm from another is in the infrastructure, systems, regulatory framework, Accounting and everything else that has been built-up in the Banking industry, over the last century. If all of these functions are moved offshore, then how long will it take your overseas competition to pick up the front-end of the business, and own the industry end-to-end ? All we will have left will be proprietary hedge funds, masquerading as brokers and Banks.

There was actually a brave soul at Lehman, who suggested that if the Bankers skipped their bonuses for one year, they could save the firm. He/she was laughed out of the firm. Obviously, it made more sense for the MD's to simply change the flag, and get paid by someone else, rather than sacrifice their bonus for one year and save the firm that had enriched them for so many years. Nothing can save this industry without a real change in the leadership.

Obama needs to print dollars

2011-08-07T20:31:00.001-07:00

That is the only way out. Print more dollars and weaken the almighty dollar. There is no point trying to tax the rich. Firstly you cannot simply tax them on their assets just for being rich.. You can only tax income. Most of these people have their income tied up as carried interest in hedge funds. That is capital gain and not current income. The CEO's and other corporate highly talented people get paid in stock, or options - again capital gain. So there is no easy way of getting these people to share.

So, there you have it. Banks will not lend and the rich will not share the tax burden plus they have their tea party puppets peddling trickle down economics in Congress. That is a perpetual stalemate. If this was a game of chess, you would simply resign at this point.

Anyway, printing dollars is the best way to redistribute. Inflation will make your worthless homes more expensive relative to the mortgages. Stocks will go up since prices are in nominal dollars, so everyone's 401k will look a lot healthier. The dollar will weaken and make US goods more competitive. Saudi Arabia and China will lose the real value of their Treasury holdings - we will pause here to shed a tear for them. There you have done it - you screwed the banks on the mortgages, hedge fund managers on their billions stashed away in dollars and some other countries that you do not particularly care for. Sure grandpa's social security checks will be worth less but hey the current plan calls for throwing grandpa over the cliff anyway. This way will be somewhat slower.

So Obama, get your hands on that printing press...

Prime Broker lending

2011-04-22T09:21:00.000-07:00

Dodd Frank is making a lot of noise about making sure that Banks and Broker dealers should put up enough collateral to fund their exposures. The setting up of exchanges to clear Otc trades is supposed to solve the "credit crisis" problem. But the real funding for Brokers and hedge funds happens in what is called the "Prime Brokerage " market. This is the cesspool that the regulators should really be regulating. All the money from the safe Banking vehicle, along with their excellent credit, gets channeled into their Broker dealer arm and on to this Prime Broker market. Here they sell this credit for Prime Broker fees from hedge funds and others, in exchange for funding.

So what you may ask, is the big deal ? This is some complicated mechanism that market participants use to fund their positions. Well the big deal is leverage, poor credit management and large exposures. The very problems that caused the crisis.

Lets start from the beginning. When a speculator, Hedge fund A, takes a position in a Bond, they do not put up the entire face value of the Bond. They borrow the money and buy the Bond, then enter a repurchase agreement with one of the Banks where they sell the Bond today and buy it back tomorrow, then take the cash and pay off their borrowing. Is that too complex - lets take a step back. I want to go long a Bond, but I borrow money from my banker friend to buy it, and then I do a trade with him selling it every night and buying it back in the morning. The difference in price between what I sell at night and buy it back in the morning equals interest that I pay my Banker friend for his kindness. If I do this with stocks, it is a little more expensive. Basically you buy the stocks, pay for it in cash, then you can lend the stock out in the stock lending market up to a maximum of 50% of the value of the position. You get 50% of your cash back, and pay down your borrowing by 50%.

The point of all this is that if you have the credit and relationships in the market, you can take any positions you want. When a Bank lends money, it needs to keep at least 8% of the face amount as regulatory capital. There are all kinds of rules being setup through Basel II & Basel III to make the Banks safe. But the real risk, which is in the Broker dealer market (remember Lehman was a broker- dealer) is simply not addressed. The Repo borrowing that I described above is not limited to “safe” Treasury Bonds. Basically, any kind of junk paper that is issued by the Banks through securitization, ends up in the Repo market. If a Broker/Bank issues a dud note backed by subprime mortgages, a hedge fund that bought that note would then turn around and give the same note back to the Bank, and ask for cash in the Repo market. The Bank/Broker that has one arm that issues the note and another arm that funds borrowings in the Repo market, cannot refuse to take back its own paper as collateral.

So net result is that the speculators can take all kinds of dangerous and illiquid positions and then have the Banks fund it through the Repo market. The Repo and Stock Loan funding markets need to be regulated to ensure that speculators do not take excessively risky positions. Leaving this market up to the self-regulation of Banks is leaving the Barn door open after the last set of horses have bolted and you just spent a ton of money buying new horses. The Bankers have every incentive to put the Bank at risk in exchange for prime broker fees. Hey, if the Bank blows up, we all know the terrible consequences. Basically you get a large Bonus for pulling the Bank through troubled times while Uncle Sam will step in to pick up the check.

Hey Dodd-Frank, nevermind over regulating the banks. Look at the Broker-dealer, Hedge fund Prime brokerage funding nexus.

The American dream is the root cause of expensive healthcare

2011-02-10T10:28:00.000-08:00

So here is my thesis - I think this country is just too big. So we have all these small towns each with their own school, fire station, police station and hospital. This is just too expensive to maintain. Specifically healthcare, is really a luxury item. I was talking to this doctor friend of mine and asked him why medical services do not follow the law of economics. If a certain good becomes expensive you should be able to flood the market with supply and bring down the price of the good. So for instance, if doctors are expensive, why not import cheaper doctors from overseas and bring down the cost ? Paradoxically, for medical providers, the cost goes up when you increase the number of providers. The private healthcare system we have in place is based on capitation. This means that regardless of whether you fall sick or not, each doctor gets paid on capitation. They get paid per number of members, regardless of whether their services are used. So the trick to controlling costs is to reduce the number of providers. It is not possible to maintain a system of having millions of small towns each of them with thousands of podiatrisits, Physical therapists, all kinds of specialists and hospitals without causing a huge cost burden. So comparing the US healthcare system to any geographically smaller country's system is meaningless. We need to understand that maintaining the suburban life along with the availability of all these medical services, is a luxury. We can either suck it up, and pay for medicare, as it is a necessary item to maintian our standard of living. In that case, stop whining about the costs, and especially stop bitching about Obama's public healthcare plan. You do not want to create a system of haves and have-nots in healthcare. That is a recipe for social unrest. Otherwise, give up the current system and go to a National scheme that has fewer specialists, and other high-end doctors. This is what works for Canada, and other such systems. We cannot have it both ways.

Will New York be competitive in the future for Global Banking ?

2011-01-29T16:21:00.000-08:00

Here is the problem with New York. Payroll taxes and healthcare benefits. The big global Financial centers currently are London, Singapore/Tokyo, & New York. Now that the dollar is depreciating fast against both European and Asian currencies, New York should be a lot more competitive versus these centers. However, Payroll taxes plus healthcare costs are going to put NY at a permanent disadvantage versus these other centers. This is not going away anytime soon. These costs add up to atleast a 50%+ additional cost to hiriing US employees versus its global counterparts. This is not fair to some extent because healthcare is subsidized by the state in these other economies, that does not get recognised as a direct cost for the company. Anyway, when did any of these businesses consider fairness in the equation?

So, for a multinational bank, it will always make sense to keep most of their support functions (which is the major job creator) in one of the other regions. The only people that need to stay in New York are the Sales people. This is just to service the rich clients and big corporations in NY. If these clients and corporates were to leave, to lower tax jurisdictions, that would be the end of the NY financial industry. Trading has already moved to the electronic world and traditional Traders are anyway giving way to machines. Sales can pretty much be done from anywhere. So long term, I can only see decline and urban decay, if New York continues to rely on the financial indsutry for its existence. The city will need to reinvent itself drastically if there is any long term plan to stay in business.

Why do Investment Banks hire and fire ?

2011-01-29T15:55:00.000-08:00

The answer is short termism. The IB's and broker/dealers suffer from very short termism. A traditional bank takes in deposits, builds a reputation for cautious and prudent investment, and then lends to credit worthy counterparties for the long-term. However, an Investment Bank or broker/dealer makes all its money in fees...and gambling (also called proprietary trading). Consequently, they have absolutely no way of predicting their revenues for the next year. Sure, you can do back of the envelope calculations about the size of the market, and market-share. The truth is that the Shamans in their finance department, and their counterparts in Senior Management, have no clue as to their projected revenues. The best guesstimate is to take last year's numbers, and add a "stretch" target.

All these investment banks are run by former Salesmen. Their projections are always rosy and optimistic, and never really based on any objective assessment of the market. So, the only variable under their control is the operating budget which they use and abuse to make the numbers tie. So if the revenue numbers came in above estimate, as was the case last year, when the government was giving away free money, and the competition had thinned due to the crisis, all these IB's were on a crazy hiring spree. No long term need for it, no vision, no strategy. They held career super days where they hired fifty people in one day, to resource all kinds of grand expansion plans. Ofcourse, they made sure to pay themselves big bonuses for doing such a great job in puting together all the "talent". Now when the market came back to reality, and the revenues are nowhere near predicted, these same visionaries are on a firing spree. The long knives are out, and scores are being settled. Its every pirate for himself, and for his team ( these guys have gang affiliations that would put the Bloods and the Cripps to shame).

Anyway, do not buy all the BS about how they are upgrading and top grading etc. It is all about the money. The guys that have both hands in the till, are stuffing their pockets as fast as they can. Government regulation is so far behind that these guys will be long gone to their favorite secret island, by the time this next party is over. Onward to the next crisis!

Bull in a China shop

2010-11-26T17:28:00.000-08:00

China is the big new bogeyman. How do we deal with China? How did we deal with Japan? Japan was going to buy up the United States. Japanese manufacturing was invincible. The Japanese worker was an incredible perfectionist machine. You could not compete with that kind of perfection. So we learnt Kaizen, JIT and a whole lot of other BS. But in the end, Japan just fizzled out. No world domination.

Why is China different? China is a communist machine. China does not play fair. The Chinese use state funding and cheap slave labor to over produce goods and flood world markets (mostly American markets). Well whose fault is that? Do we actually need to wake up at 4am and stampede over living people to get that Tom Tom GPS for an additional fifty bucks off ? Just pay the additional fifty bucks. Or better still just use the Rand Mcnally Atlas. It is a lot more fun than the GPS.

But regardless of the people’s incorrect priorities, we do have two opposite economic models selling goods in the same market. We have a Capitalist consumer that is supposed to consume the maximum amount of output (irrespective of whether they need all this junk) versus a Communist model of production where the goal is to simply produce goods without regard to profitability. The Communist machine has no shareholder Accountability, no cost of research, no payroll taxes. Nothing. All it needs to do is over produce everything and run all other competition out of business.

It is the same as letting hedge funds play in the same market as Mutual funds. One group has no rules and no restrictions and the other has so many restrictions that they can barely move. So one wins and the other loses, as the game is not fair.

So the answer we need is to level the playing field. We can continue to cry about the currency manipulation. That is not going to help, because we do not control the currency markets. So the answer is to raise tariffs on Chinese goods. Use the tariffs to subsidize our manufacturing and over produce goods to offset the drop in supply from China. Use regulation to force companies like Walmart to buy at least fifty percent of their goods from US manufacturing. This will be a temporary fix but it will give the Chinese a clear message that the US is serious about fixing the asymmetrical trade equation. Also, we can use technology to become more efficient low cost producers.

The other option is to leave things as is and wait for a natural change in Chinese consumers. As the Chinese become richer, they will consume more. This is already evident in the over-heated real estate market in Shanghai and other places. There is absolutely nothing to indicate that the Chinese consumer is any more sensible in their consumption than the US consumer. As consumption increases in China, the pro democratic and other social movements will weaken the Communist machine. So there maybe a natural end to this bogeyman. Do not panic just yet.

Why is QE (Quantitative easing) not working ?

2010-11-26T17:00:00.000-08:00

Banks are not lending. Why are Banks not lending – because they can (not lend). Banks can afford to not lend, atleast for a while. Banks are very contra useful entities. They will lend when you do not want them to lend and they will squeeze out all access to liquidity when you need it the most. Very perverse, but that is just the nature of the beast.

Ok so to go back to basics. Banks create money. Money is not longer just the total supply of paper money. Money is the number of times this stock of money circulates. This is the infamous bank multiplier, where the bank keeps a small fraction in reserve and lends the rest of the money out. So the same stock of money expands to none or 12 times (whatever is the multiplier). So now we have the opposite problem. Banks call in their loans and keep the money, to shore up their capital. So our money supply is contracting, by several multiples. It does not matter if you reduce interest rates to zero. The banks are not going to lend. People are not going to borrow.

So now that interest rates are zero, we have to look for new tricks. The new trick is quantitative easing. The Treasury issues Bonds. The Fed prints money and buys the Bonds. This increases the stock of money. But that does nothing for the multiplier. A little extra paper money floating around is not going to offset the contraction resulting from the Banks calling back their loans. At the same time we have regulators asking the Banks to increase their cash reserves – the exact opposite of what we need the Banks to do now! As usual we bolt and lock the stable door securely after the horse is several miles away in the next town.

Basic fallacies. The President can create jobs. Why and how did we ever get this notion that the President is supposed to create jobs. Can you go back in history and point to one President has had a real impact on the economy ? Sure all of them have claimed to create jobs. But that is just political rhetoric to get elected. Nobody should take this kind of claim seriously. If any of the Republicans are going to point to their god Ronald Regan as having created jobs. Please! Ronald Regan is the man who along with Maggie Thatcher sold all your jobs to China. Sure it made his economic numbers look good, but we are all paying the price of that genius thinking.

Second fallacy. The Fed chairman has a magic silver bullet to kill the ghost of Recessions. Alan Greenspan was a fake shaman who played to the CNBC galleries. The truth is that the Fed chairman can only do so much with monetary policy. The Fed cannot make the Banks lend. Only the Banks can create money and only the Banks can make other banks lend.

So what is the answer great one ? Will we never see the end of this economic funk and see happier times ? Of course we will. There is a natural order of things. As prices fall, they will hit a bottom. People will wake up one morning and say, the heck with it, let me go out and borrow and start buying things again. They just need confidence that the world is not ending today. Soon the banks will run out of accruals on their old loans and need to lend again. Some upstart bank will figure out they need to get on top of the rankings by lending more aggressively. And everything will work again – magic!

So Mr. Bernanke my advice to you is don’t just do something. Stand there and let things take their natural course. And Mr. Obama I know things may not come up to speed by re-election time. But there is squat you can do about it. Easier to take a step back and talk sense to the sensible part of the population. Get the fear index down. And don’t make silly promises that you will not be able to keep. You should be just fine.

How to fix the rising cost of college education

2010-06-14T18:46:00.000-07:00

Ok. Here is a solution. We add four more years to the local High Schools so that now we have sixteen years of schooling. Take four years out of from class one to four and let the younger kids be home-schooled.

Sure we will lose choice among colleges and majors. This is another socialist solution. But face it - kids do not learn anything in today's colleges. It is just a glorified High school. A very expensive one at that.

Maybe you go to another state for college - just to keep it interesting. We can have SAT's and competition etc, but the state would pay for college. What do you think ?

Risk weighted Assets

2010-04-14T20:08:00.000-07:00

You call it WRA, I call it RWA. What does it all mean ? Risk weighted assets are a fictitious concept that is used to measure a Bank's capital. To understand what this is, let us first understand how a Bank holds capital.

Simple example. Depositors put a million in my bank, I lend out nine hundred thousand. A hundred thousand is my safety net. I take in ten such deposits and I lend out ten such loans and I am sitting on a million bucks as reserve. I am playing a game here, because as long as all ten of my depositors do not come asking for money, I am good to cover the one guy that shows up. This is the traditional banking model.

Now if I do a derivative with one counterparty, and I do an offsetting derivative with another counterparty, do I need capital ? Not at the beginning, because in the beginning the derivative has no value. But as the market moves and the derivative has value, I am effectively lending to one guy and borrowing from the other. So, similar to my above simple example, I need to hold capital. This is where RWA -risk weighted asset comes in. If the value of my derivative is 1Million today, I do not necessarily have to hold a 100 thousand in reserve for it. Depending on the derivative and some amorphous rules, I am free to come up with a black box model, that will tell me how much reserve to hold. This number could be zero, could be ten bucks or could be a million. The beauty of it is that it is entirely up to me to calculate this number. This is the RWA for this contract. So I take some vaguely estimated probability of default, and multiply it by an equally made up loss given default, and come up with a perfectly random number. The smaller this amount that I need to hold in reserve, the more profitable I will look.

So now let us look at a scenario, where we have ten large investment banks, all doing a simple product like a fixed to floating swap. Nevermind credit default swaps. They are all producing the same simple widget. It was invented a long time ago and one widget is as good as another. You cannot even pretend that a swap produced by Goldman sachs smells any sweeter than that produced by the creit union down the corner. So, the only way to be more profitable than the other guy, besides selling snake oil to unsuspecting widows, Municipalities etc (adding a few extra bps when they are not looking) is for the wizards to play with the RWA numbers. The more profits you squeeze out of less capital, the better you look. The skill is in the capital management or the number management.

And we are so shocked that these banks were so thinly capitalized during the crisis! Look at the capital they hold against trillion dollar balance sheets. My advice to regulators - Force Banks/Investment Banks to hold more capital. Dont buy their stupid Value at risk VAR nonsense. Anybody with half a brain knows that Var is not real finance. VAR is like looking for inner beauty at a Miss America Pageant . True risk management is Credit risk Management. How much due diligence did you do when you lent out the firm's money to a perfect stranger ? That is the true essence of a Banker. Good judgement and hard work done before lending out money. You dont learn that in a crash course case study at an Ivy league MBA.

And these whiners actually want to say the rating agencies made me buy all those crap securities. Only a regulator or a Bloomberg correspondent would buy that kind of BS.

The BASEL II & BASEL infinity versions are supposed to solve the RWA problem. That is laughable. They set a blind elephant to hunt down a very lithe cheetah, in a particularly dark part of the forest. No hope of them catching anything before the next crisis. It is really touching though the faith that people put in these silly charms to ward off the evil eye. Like for instance the Sarbanes Oxley controls to prevent Accounting scandals. That SOX thing really worked man - except for Lehman, Bear Stearns and the rest of them.

The Euro is an impostor - the dollar is the king of the world!

2010-01-15T19:26:00.000-08:00

We have all heard the doomsday predictions. The Chinese are unloading the dollar. The Saudis will price Oil in Euros. The anti-dollar has arrived. Bye bye American Peso.

But hang on a minute. What are they hanging their hat on ? The Euro ? A conglomeration of dysfunctional Europeans, who can barely stand each other ? The Greek tragedy that is now unfolding is just a precursor of things to come. Wait till we have some real disagreements say when the French unemployment starts peaking just when the German economy is smoking hot. How can economic policy be co-ordinated without a real political union ?

Anyone who invests their life's savings in the Euro because they do not like Obama's profligate policies, are taking a huge risk. It would make more sense to buy the Saudi Riyal. At least that is backed with Oil for some time to come. What does the Euro offer you ? A bunch of Socialists with institutionalized under-employment. There is no military might, no budding superpower, no dynamic entrepreneurship, to back its value. There is no case for the Euro.

DMO's have a great business model

2010-01-15T18:06:00.000-08:00

I called my DMO the other day. I was terribly upset with my Dentist. Instead of charging me 40% of the total cost she had charged me 60%, in error. Now she refused to give me back my 20%, saying that there were some additional costs that had not been included in the original charge. I felt terribly scammed. She was keeping my 20%.

So I called my DMO. The friendly representative on the other line explained to me all the details of my plan. He also went off on a side discourse about tooth numbers. Did you know that tooth numbers 1 thru 6 have a different insurance coverage from the rest of the crowd ?

Anyway, the guy assured me that my dentist should waste no time in sending in her claim ..btw ..forgot to mention - this was for a crown replacement. Anyway, this guy impressed on me that it was absolutely imperative that my dentist send in her claim soon. They would not process a claim if it was later than two years. When I conveyed this to my dentist, she was amused. I realised why when I saw the amount the DMO had paid her - a princely sum of $15.

Now we all know that Dentists make a sinful amount of money, working just four days a week. So how does this scam really work ? The way it works is that the DMO is just a roll of customers - like a marketing database. We are actually paying a $1000 + bucks a year to be part of a customer database. The two cleanings a year is all that is covered by this plan. Once the Dentist gets you on the client list, the only way for them tomake money is by crown replacements, tooth extractions and other high value ( probably unnecessary treatments). It is like taking your car to the local mechanic - not the honest one. The one with gambling debts.

And all those percentages, 60% or 40%. To quote Newman from Seinfeld about zipcodes - the secret is that they are meaningless! Theoretically, the dentist could double your cost and then give you a 50% discount,because you are a preferred customer from the DMO.

Well that was my rant for the day. Maybe, everyone else already knows this scam and I am the last one in on it.

The hedge fund manager vs the Lehman CFO

2009-12-21T11:15:00.000-08:00

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.

Why you need to pay Bankers

2009-12-21T10:57:00.000-08:00

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.

Interest rate swaps

2009-10-08T19:38:00.000-07:00

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.

Free interest rate swaps for the retail market

2009-10-07T17:28:00.000-07:00

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.

Credit default swaps should only be allowed with an offsetting credit exposure

2009-10-03T13:55:00.000-07:00

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 ?

Equity compensation is the root of all Corporate evil

2009-08-28T14:21:00.000-07:00

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.

Are we there yet ?

2008-12-25T14:36:00.000-08:00

It is time to buy. But not yet. We must wait for the market to hit the bottom. Till then we need to bide our time and drink to it. Bottoms up!

Capitalism has run out of capital. Ich machst nixt Das Kapital! (no it is not really German I just made something up from my Rosetta stone).

However note the profoundity of the statement - Capitalism has indeed run out of Capital! We need a new system. We need communism from China to provide us Capital. What happened to all our capital? Did someone madoff with it ?

We probably spent all our capital on Christmas gifts that nobody wants. We need to figure out a way to grow more capital. Capital does not grow on trees. It needs to be harnessed and managed so that it grows into more capital.

So it is not really a liquidity problem. We just need more money. Stop burning cash and conserve. Only way to build capital is by not wasting it.

Who gets a piece of the 700 billion ?

2008-09-27T22:59:00.000-07:00

Now that the Senate has passed this huge payout of taxpayer money, how does the loot get divvied up ?

Obviously, since this is US taxpayer money, it should go only to US banks. Foreign banks should not be bailed out, so they can be let out of this equation.

Obviously, market gurus like Goldman, that had absolutely no CDO exposure cannot suddenly come up with "troubled" assets to sell. So they are out. Paulson would not bail out his former Bank - that would look so very suspicious!

So that leaves just Citigroup and Bank o fAmerica, maybe some other smaller players. These guys have already written down billions, so they might actually start reporting profits on the sale of these positions.

The curious part of this drama is how did they come up with the 700 Billion number. Did anybody ask for the calculations behind this number ?

Also, the point of the entire crisis was that nobody could put a good price on these assets. How is the Treasury planning to come up wih a price ? Conversely, if the Treasury knew the price of these assets, it could just tell the market these magical prices. Why do they need 700 billion to backup the prices ?

The correct way to do this was to de-securitize these assets and ban securitization. This package is going to simply get us out of this crisis and defer the crisis for another decade.

Securitization is the same as printing money. This flood will cause inflation and a further dollar collapse. It needs to be curtailed right away.

Why go after the Oil companies ?

2008-05-25T09:53:00.000-07:00

Higher oil prices have all the politicians eyeing the profits of oil companies. I am happy with the oil companies making some profits. That will encourage more capital to be invested in these companies, which is what we all want. We need to invest in Oil to solve our energy problems.

But oil prices are not being driven by the oil companies. Prices are being driven up by speculators, mostly global hedge funds. These guys do not invest their profits in the oil industry. They use leverage to drive up the prices of what are essential commodities for the rest of the world, and then disappear with their ill gotten gains. So all you agitated people, go after the hedge funds, not the oil companies. There lies the real villain of the piece.

Kerviel and the Back office control environment

2008-02-09T17:54:00.000-08:00

SocGen had one of the best risk management systems. Yet there was such a major failure of controls. No one knows how he was able to pick the locks. He had a perverse understanding of the "complex" control systems because of his experience in the middle office.

That is really hogwash. The Middle office teaches you how to book trades and how to calculate P&L. The Middle office does not teach you anything about the control system, as the controls are mostly in the Back-Office.

This is how derivative trades are actually controlled. Trader does a trade, presses a button and the system books it and sends it through to the Back-Office. Back-office calls the counterparty and confirms the details of the trade. At settlement, Back-office moves cash with the counter-party's Back-office. Trader estimates his Profit or loss, Middle-office confirms his profit or loss, and Back-office counts the cash. Its all very simple really, when you are counting just one widget.

In reality it works this way. Trader does a million trades. Sytem processes everything"STP' - straight through processing. Trader has no way to track the beans, so he relies on the system to calculate his Profit or loss. Very rough estimates are made based on the "risk". But as the complexity and volume increases, these estimates become less and less reliable. Middle Office has the same problem. Middle Office uses the very same systems to re-estiamte the P&L, and generally would like to agree with the Trader. Back-Office pays out the cash. All the outsourcing has resulted in the Back-office being in India, Buffalo, Singapore or some other unreachable place. Most of the time they are just paying out the cash as fast as the orders come in to settle. If something is missing they might track it, or they might let it go, depending on their situation. So cash is no longer counted, one major control does not really work.

The other control is the confirmation with the counterparty. Again, this is a Back-office function that has systematically been reduced to bare bones. Most places are back-logged on confirmations for atleast a few months. There are millions of trades with internal counterparties that are not tracked at all. There are old portfolis that no-one looks at, new ones that were opened without everyone knowing about it, dummy portfolio that should not have live trades and so on.

The point here is that we are not manufacturing cars, or making small loans out of the local credit Union. There the beans are generally counted and Accounted for at a higher level of accuracy. The derivative business is a lot of smoke and mirrors, filled with charlatans.

The kid fresh out of Ivy league schoool with a few sound bytes about how the market "thinks" gets to play with millions of dollars as a Trader. The CEO does not know the Trader's positions, the head of the desk may not know the extent of all the Trader's positions, the middle office person that does his P&L does not know a whole lto more, and the Back-office processor that pays out on these transactions does not know either. The truth is that no-one really knows or asks questions. As long as the numbers are positive, everyone gets paid. "Them that ask no questions, are'nt told no lies- so watch the wall my darling, as the gentlemen go by" - Smuggler's song. So it is really surprising that there are so few of these blow-ups.