Tuesday, September 15, 2009

The Lessons of Lehman...and Leeson

Unfortunately, there are some in the financial industry who are misreading this moment. Instead of learning the lessons of Lehman and the crisis from which we're still recovering, they're choosing to ignore those lessons. President Obama

I burst out laughing when I read the above line in the President's speech yesterday. "The lessons of Lehman!" I thought, "he's got to be joking." I have no doubt Big Finance took that lesson straight to heart.

Let's consider the meaning of the "lessons of Lehman." Given the context, I suspect the President wants Big Finance to see the demise of Lehman as an object lesson- as one might warn a friend trying to ride out a hurricane in New Orleans by reminding him to remember the lessons of Katrina. If this friend had just moved to New Orleans and was unfamiliar with Gulf Coast hurricanes, the "lessons of Katrina" reminder would likely be sufficient.

If, however, this friend owned a house in the French Quarter and had ridden out Katrina the reminder of the lessons thereof might evoke a chuckle and a quick retort, "Katrina taught me that the French Quarter is safe." "The lesson of Lehman," Big Finance CEOs might chuckle to themselves, "is to make sure we're too big to fail." Lehman's balance sheet wasn't big enough, thus failure was an option for them, but not for the biggest banks.

Or so they seem to think.

One of the reasons I didn't write much over the past few months (besides a general laziness and desire to enjoy the summer) was a strong feeling, whenever I looked at the data, of watching a horrible car crash in slow motion. Better, I thought, to avert my eyes.

Yesterday I spent a few hours filling up my spread sheets and catching up on policy speeches and decided the feeling that came over me wasn't as if I was watching a slow motion car crash. I feel now as if I'm a position clerk for Nick Leeson, the bane of Barings Bank, and everyone in the country works for them.

As is my wont, when a feeling like that hits me a quick Google search for "Nick Leeson" is just a few clicks away. Among the more familiar reports I was surprised to find a scholarly examination of the event from NYU's Stern School of Business, about which, more later.

In the movie, Rogue Trader, Nick Leeson explains the secret of his success in a sound bite Big Finance would love, "You keep doubling up, and sooner or later you're bound to win." In the event, Mr. Leeson found this not to be true as the losses on his long position in Nikkei futures (and related derivatives) exploded after the Kobe Earthquake sent the Japanese market plunging early in 1995.

The lesson of Leeson is that doubling up is no guarantee of success. Indeed, according to the NYU paper: Our interest in Mr. Leeson comes from the fact that doubling strategies are potentially dangerous from a systemic point of view. An important attribute of doubling strategies is that the inevitable and devastating loss is preceded by a period of high returns with low volatility. Conditional on the bad event not having happened (yet), the doubler’s investment performance appears to indicate significant investment skill. The doubler may then become too big to fail, both from the perspective of the investment firm and from the market regulators, so that the inevitable failure can have catastrophic effects, both for the firm and for the market. Among other things, this has important consequences for the effectiveness of Value at Risk-controls. Being able to track and take out these traders sooner, would limit possible systemic risks.

Of course, I'm not arguing that Big Finance is doubling up on a hidden (losing) long position in the Nikkei. Their losses are reasonably well known (if not well quantified) and, at least with respect to real estate, not about to turn into profits any time soon. This rogue is out in the open.

Like Leeson, Big Finance doesn't consider liquidation, which would realize the losses, an option. Like Leeson (whose book would make a great study in a Psych course), Big Finance would have us believe their motives are pure. I, however, find this view from the NYU paper interesting: That managers take additional risks to escape from a threatening situation is a well known theme in the field of managerial decision making. For example, Shapira (1997) and Kahneman and Tversky (1986, p. S258) show that people will take greater risks to escape losses than to secure gains. As a consequence, people's behavior tends to change in unexpected and unattractive ways when they are confronted with increasing losses. Thus in finance, where many occupations are high-wire acts, the fear of falling is constantly in the background and sometimes can lure people into disastrous activities. Individuals can become gripped by a frantic panic and may try to conceal these losses, or double up their bets like crazed gamblers trying to punt their way out of their mounting debts. This is the classic gambler’s fallacy.

There are, however, differences between the two.

Unlike Leeson, Big Finance has a supporter who agrees that liquidation isn't an option in the form of the Fed. If Nick had the Fed on his side he could have held on for a few more years (although current levels around 10K for the N225 suggest a loss orders of magnitude larger). The Fed (and Treasury) upon discovering the huge losses, not only provided liquidity to Big Finance, they provided capital support and relaxed accounting rules. As many others have covered (so I'll be brief) this support is unprecedented and ongoing. The "tide" of liquidity is high, as Warren Buffett might put it, and financial markets have responded (albeit with far less bang per buck).

Thus Bernanke, Geithner and even President Obama are engaged in a bit of cautious back-slapping.

This back slapping reminds me of another scene in Rogue Trader: 1994 is coming to a close and Leeson is long Nikkei futures and short Nikkei calls. The price is shown in big numbers, dominating the screen. He cheers and congratulates his team as as the Nikkei keeps rising and closes on its high.

In the NYU paper on the event the authors write: Leeson first sold options on the Nikkei index in October 1992, but his activity in this market really started in the second half of 1993. The value of the option portfolio fluctuated wildly over time, but it had mostly been positive. The highest value was reached by the end of December 1994, when the total value of the options was approximately US$178 million. Mainly due to the Kobe Earthquake, this reversed to a loss of approximately US$108 million by the end of February 1995 (SR App. 3K, p.179)

Given that he wasn't unwinding his risk into the rally, the cheers and back-slapping in December 1994 proved a bit premature. I'm pretty sure if he tried to unwind his position the market would have reversed.

Given that Big Finance isn't unwinding its balance sheet (I know that position can't be unwound without serious market damage) in the current environment, I suspect Bernanke's victory laps and Obama's reassurances may also prove premature, if, as I suspect, the transfer of "toxic" debt to the Fed proves as successful as similar operations in Japan. The reason for this, I surmise, is that such transfers merely buy time, which, when the losses are a large percentage of GDP, is only useful if one can grow out of the problem (which would require rapid growth) or if underlying conditions which created the loss, reverse.

These "underlying conditions" are the crux of the issue. When positions sizes are small enough for a given market, managers can play (and win) under the greater fool theory. The illusion of demand can be created long enough to sell out (or vice versa). However, when positions grow such that they cannot be dumped, the greater fool theory is disproved- you are the greatest fool. This doesn't necessarily guarantee a loss. It does, however, bring finance back to its beginning- the bets must prove out in the real sector.

Thus my concern.

Leeson bet the ranch on Japan returning to its go-go days. But Japan was an aging population with high wealth concentration in the aftermath of a bubble- a perfect recipe for risk aversion. Fortunately, Japan could self-finance and until recently seemed reasonably content to be a mature economy.

Big Finance, in a far more profound sense, has bet the ranch (our ranch) on the US returning to its go-go days. But the US (somewhat obscured by looser immigration standards) is an aging population with high wealth concentration. From whence will come the next productivity enhancing investments that (importantly) can operate within the existing capital structure (since liquidation is off the table). The computer and related communication boom was a perfect way to extend the life of the post WWII infrastructure, but those productivity effects are in the past.

Unfortunately, unlike Japan, we cannot self-finance. We need those capital markets flowing, however inspired.

Thus we took a page from the BoJ playbook and adopted a ZIRP (the world's reserve currency managers opt for a zero interest rate policy....amazing), and the effects are manifesting. Cheap $ finance is already working its magic in the commodity and equity markets. Gold is trading at $1000 as the US$ nears all time lows.

We're inflating all right, but the US real sector will be last in line to catch those flows- the conduits are broken. In the 90s above trend employment growth came, as noted, from the Tech boom, albeit with income gains that were far lower than in previous post WWII expansions. During this century there was no above trend employment growth and income is lower. The real estate wealth effect kept people happy on the margin but that is over too. Once a critical mass of the population is underwater on their mortgages real estate inflation will lag, not lead, more general inflation- an effect we would have experienced in the 90s but for the Tech Boom.

As a comic aside, we are like a team of old baseball players who just got purchased by Steinbrenner and don't want to be replaced by newer younger guys.

I think we're going to experience a stagflation like we have never seen.

But first, we will see a Leeson-esque collapse, first of the US$, and then, when they try to tighten to save it, of large chunks of Big Finance.

Sudden and swift.

I could, of course, be wrong.

Have a nice day.