Friday, January 22, 2010

Sanity and Insanity at Macro Man

An excellent comment thread at Macro Man. The context: Macro is complaining because the Volcker plan will limit what banks can do, and try to separate out prop trading from taxpayer backstopped institutions.
And while it is probably imprudent to comment too much until the details are known, on the face of it [the Volcker plan's] draconian approach is both woefully misguided and appallingly naive. We can probably all agree that it's in no one's best interests to have a situation where a Lehman Brothers owns $50 billion+ in residential and commercial real estate turds, which brings down the firm and threatens the global financial system.

But there's a big difference between that and having a team of punters (not dissimilar to your author) who coordinate and utilize the market intelligence available to large banks (which is enormous and extremely valuable) to make informed bets in the marketplace.
In the comments, Gary smacks Macro down:
My junior guy, like myself, was unwilling to try to hedge the subordinate tranches from all the deals the securitization group was making. Obviously, securitizing toxic waste was a huge money maker as long as you pretended the risk wasn't there.

Every bank bought the toxic waste, put it in a REMIC/CDO/ABS whatever and sold off the senior tranches. The subordinate tranches stayed on the banks books and were hedged.

When the volume of deals got high enough, the true cost of hedging increased. Experienced traders of course wanted to pass that cost back to the securitization desk -- which would have made many deals less profitable if not unprofitable.

The solution was two fold -- "promote" the senior traders to some other department, get rid of the trained staff, and bring in yes men straight out of college. The newbies wouldn't realize the risk, much less the cost of that risk. They would be happy to book the accounting profits; that they were massively short gamma didn't bother them in the least.

Essentially, these guys were making money by being short straddles in size -- often 20-25 times the banks capital. As soon as there was any volatility, the banks were finished.

Later, the garbage was put into SIVs to conceal the risk (and its size) from the banks' balance sheets. To add fuel to the fire, the short straddles were "financed" with overnight money that would be pulled if (when) the risk became known.

Experienced traders knew this and didn't want their deferred compensation to get hit (deferred comp used to be common in many firms). So management replaced them with crony newbies were happy to go along.

The "banking" crisis occurred in 2003-2004 when these short straddle positions became many times larger than the banks themselves. It wasn't until 2007 when the accounting caught up to the risk

My former junior guy is doing quite well now at a hedge fund. The newbie the bank managers put in is now selling sunglasses in Florida. And the bank is now one of the many zombie banks being propped up at taxpayer expense

BTW Macro Man -- I have no idea how many bank CEOs tried to conceal their problems versus how many simply didn't understand the risk was on their books. I suspect (but could not prove) some of both.

Regardless, if you understand the culture / politics of big banks, then you know the department that is generating massive profits often runs the place. If the CEO "stands up to them", they mutiny and the CEOs job is in jeopardy -- either the group leaves and the firm's profits drop, or the group goes to the board of directors to get the CEO fired.

And there is no way to prove beyond a reasonable doubt that the securitization group really understood the risks -- they just knew one trader was willing and another was not. It sounds bad in 20/20 hindsight, but you can't prove anything beyond a reasonable doubt (i.e. in a court of law).

Even knowing my ex-CEO for years, I couldn't say for sure what he was thinking.

The corporate culture of big banks is why they should not be allowed to prop trade -- the culture prevents good risk management.

Private partnerships err on the side of being a little too cautious -- its their own money they are risking on something they don't understand.

Deferred comp systems only work if management doesn't have lucrative severance packages and if the comp is deferred many years (until the assets mature).

Big banks risk / accounting is decided by committee -- so its quality is completely politics. Ultimately, you have to decide whether to pick a fight and lose YOUR job; or do you keep quiet and let the suckers (aka shareholders) take the hit. Its a classic agency problem
The heart of banking is making loans that get paid back. Every element in their structure and regulatory environment should sharpen this goal, not dull it.


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