Death by a thousand cuts

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

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...

Why is QE (Quantitative easing) not working ?

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.

Kerviel and the Back office control environment

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.