Trinity (seeing Neo turn to face an Agent): What's he doing?
Morpheus: He's beginning to believe.
Today's Wall St. Journal reports, JPMorgan will accept Gold as a type of collateral:
Gold hasn't reinvented itself as a currency yet. But it is getting closer.
J.P. Morgan Chase & Co. (NYSE: JPM - News) said it will allow clients to use the metal as collateral in some transactions. For example, a hedge fund wanting to borrow money for a short period can put up gold as collateral and use the borrowings to invest elsewhere, betting on making a better return. Typically, banks accept only Treasury bonds and stocks in such agreements.
By making the announcement, J.P. Morgan is effectively saying gold is as rock solid an investment as triple-A rated Treasurys, adding to a movement that places gold at the top tier of asset classes.
Alexander Bain famously (at least in my view) argued: Belief is often accompanied by strong emotion, yet emotion, as such, does not amount to believing. Fictitious narratives may stir the mind more strongly than real; we may disbelieve and yet tremble...... We are thus driven to the alternative query— Is, or is not, Belief essentially related to Action, that is, volition? I answer, it is. Preparedness to act upon what we affirm is admitted on all hands to be the sole, the genuine, the unmistakable criterion of belief. Columbus shewed his belief in the roundness of the earth, and in the existence of an unbroken ocean between Europe and the east coast of Asia, when he undertook his voyages. The Emotions and The Will
In other words- under this head- by adopting this policy, and acting upon it, JPM is demonstrating its belief in Gold as an asset class.
For their next trick I hear they plan on re-inventing the wheel.
Staying in Henny Youngman banker mode (Take my money--Please!) JPM just figured out that Gold might be as valuable as triple-A rated Treasuries (Take my money and give me your Gold-- Please!!).
The WSJ authors add (and the hits just keep on coming): In the past, worries about a lack of liquidity in the gold market have prevented banks from taking gold as collateral. But as investors piled into the market in recent years, the market has deepened.
But seriously folks, there's no liquidity in the Gold market, just Gold, on one side, and liquidity, on the other. Prices in that market, which have risen by roughly 500% since 2001, explaining, perhaps JPM's policy shift, reflect participants belief in the relative values thereof (Gold vs. liquidity).
Sadly, JPM might discover, as Neo did in the Matrix, that the "real world" of specie collateral is, for bankers, drab and gray compared to the exciting times of the Financial Matrix year 1999.
As Morpheus might put it, you've been living in a dream world JPMorgan. Welcome to the credit desert of the real (money, that is).
To wax explicit (and make this essay actionable), if JPM has finally gotten around to seeing the virtues of Gold collateral based trading, it will be in their interest to see it holds its value. If you haven't gotten on the Gold train yet, you might want to consider it.
Remember, it ain't a bubble until the big banks get involved.
Full Disclosure: Long Gold, no position in JPM
Showing posts with label JPM. Show all posts
Showing posts with label JPM. Show all posts
Tuesday, February 08, 2011
Friday, April 23, 2010
TBTF Requires a Controlled Demolition
If shareholders realized they they are getting the same shaft as depositors a major impediment to true bank reform could be swept away. Senior bank employees are using complexity of operations (which is more myth than reality) to hobble shareholder control and progressive era legislation to hobble depositor control.
Let the senior financiers keep their salaries and bonuses, and let them do with their banks what they will. If, however, their bank fails, let the bankers themselves fail. Let the value of their houses, cars, yachts, paintings, etc. be assigned to the firm's creditors. James Grant: Let the Bankers Fail
As the news of Wall Street's underhanded dealings goes mainstream thanks to the SEC's case against Goldman Sachs, the idea of letting the bankers fail never seemed so sweet to so many in recent history. Yet, failure might have nasty consequences. Just as one wouldn't want a skyscraper to topple over in a crowded city, one wouldn't want the TBTF banks to collapse. Better, I think, to effect a controlled demolition.
While he has been opining about finance more wisely and for far longer than I, Mr. Grant's ire may be somewhat misdirected (although the effect of his proposed renewal of the fear of God seems a wise idea) at shareholders, when senior bank employees are those whose behavior must be modified. They take the least risk and benefit the most.
Explaining the problem's emergence, Mr. Grant draws our attention to the FDIC, an institution ostensibly designed to benefit the man on the street whose limited life savings might be lost in a bank failure. An additional effect, however, was to shield bank owners from liability, at state expense.
Another key effect, particularly when the lender of last resort (in the US, the Federal Reserve) supports banks rather than credit markets more generally, was to dampen depositors' desire and hamstring their capacity to demolish a bank. It is no surprise that the vigor with which Big Finance worked to repeal Glass Steagle was not directed at FDIC or Federal Reserve legislation.
Banking is a curious business, as Louis Brandeis noted in Other People's Money: The goose that lays golden eggs has been considered a most valuable possession. But even more profitable is the privilege of taking the golden eggs laid by someone else's goose. Bankers, by which he meant bank shareholders, combined their equity capital with deposits, in 1929 at a deposit to equity ratio of roughly 10 to 1 and kept a majority of the profits thereof.
Prior to Fed support of banks, depositors had a significant controlling interest (whether they were aware of this is another issue). A bank run was the means by which they exerted this control. As noted, this control was greatly diminished (but not lost), and obscured by the Fed and FDIC.
Of course, what is good for the goose is good for the gander. Bank shareholders had it good for a while, but lately they too have been getting the shaft from senior bank employees, who may not have any investment in the bank. As noted here, (full article here) at the Big 4 US Banks (BAC, C, JPM, WFC) depositors were paid $25B on their investment of $2.5T, shareholders were paid $18B on their investment of $660B and employees were paid $111B for their time.
If shareholders realized they they are getting the same shaft as depositors a major impediment to true bank reform could be swept away. Senior bank employees are using complexity of operations (which is more myth than reality) to hobble shareholder control and progressive era legislation to hobble depositor control. Simon Johnson and James Kwak should take note. Explaining that shareholders' interests are aligned with depositors' might ignite the controlled demolition of TBTF.
Why should senior bank employees with the least "skin in the game" reap the largest benefits?
A controlled demolition of TBTF might proceed something like this:
1) Depositors could begin to reassert their lost control by withdrawing money from the Big Banks (there already is such a movement underway).
2) Minimally, shareholders could begin to reassert their lost control by wiser appointments to the Boards of Directors with the view that cost control includes direction as well as magnitude (to wit, why should shareholders pay for lobbying which enriches employees and not them). Preferably, sell the shares and reinvest the capital in various smaller banks, presumably some of whom might be the recipients of moved depositor funds and none of whom have significant derivatives' exposure. In a controlled demolition of TBTF, the numerous banks left standing should benefit significantly.
3) Depositors and shareholders could understand that institution size dilutes control and allows employees to usurp control leaving you (or the state) to deal with the risk.
4) If an aligned group of depositors (aka voters) and shareholders (aka those funding the lobbying) demanded action, change would come. One key change: The Fed would need to stop supporting banks and instead support markets mitigating collateral damage from the demolition. They should open lines of communication with the hundreds of banks with assets between $1B and $100B. They will also need to deal with foreign depositors at the TBTF banks and begin to unravel the nightmare of derivatives (admittedly a task easier said than done).
Instead of a full frontal approach, TBTF should be imploded from within. Those with "skin in the game" need to take back control.
It's your money, and only your wisdom (not the government's or bank employees') will keep it safe and perhaps allow it to grow. Concentration of money occurs when investment is passive. Move Your Money!
One might even consider moving one's money out of the banking system entirely during the renovation through the purchase of Gold.
Let the senior financiers keep their salaries and bonuses, and let them do with their banks what they will. If, however, their bank fails, let the bankers themselves fail. Let the value of their houses, cars, yachts, paintings, etc. be assigned to the firm's creditors. James Grant: Let the Bankers Fail
As the news of Wall Street's underhanded dealings goes mainstream thanks to the SEC's case against Goldman Sachs, the idea of letting the bankers fail never seemed so sweet to so many in recent history. Yet, failure might have nasty consequences. Just as one wouldn't want a skyscraper to topple over in a crowded city, one wouldn't want the TBTF banks to collapse. Better, I think, to effect a controlled demolition.
While he has been opining about finance more wisely and for far longer than I, Mr. Grant's ire may be somewhat misdirected (although the effect of his proposed renewal of the fear of God seems a wise idea) at shareholders, when senior bank employees are those whose behavior must be modified. They take the least risk and benefit the most.
Explaining the problem's emergence, Mr. Grant draws our attention to the FDIC, an institution ostensibly designed to benefit the man on the street whose limited life savings might be lost in a bank failure. An additional effect, however, was to shield bank owners from liability, at state expense.
Another key effect, particularly when the lender of last resort (in the US, the Federal Reserve) supports banks rather than credit markets more generally, was to dampen depositors' desire and hamstring their capacity to demolish a bank. It is no surprise that the vigor with which Big Finance worked to repeal Glass Steagle was not directed at FDIC or Federal Reserve legislation.
Banking is a curious business, as Louis Brandeis noted in Other People's Money: The goose that lays golden eggs has been considered a most valuable possession. But even more profitable is the privilege of taking the golden eggs laid by someone else's goose. Bankers, by which he meant bank shareholders, combined their equity capital with deposits, in 1929 at a deposit to equity ratio of roughly 10 to 1 and kept a majority of the profits thereof.
Prior to Fed support of banks, depositors had a significant controlling interest (whether they were aware of this is another issue). A bank run was the means by which they exerted this control. As noted, this control was greatly diminished (but not lost), and obscured by the Fed and FDIC.
Of course, what is good for the goose is good for the gander. Bank shareholders had it good for a while, but lately they too have been getting the shaft from senior bank employees, who may not have any investment in the bank. As noted here, (full article here) at the Big 4 US Banks (BAC, C, JPM, WFC) depositors were paid $25B on their investment of $2.5T, shareholders were paid $18B on their investment of $660B and employees were paid $111B for their time.
If shareholders realized they they are getting the same shaft as depositors a major impediment to true bank reform could be swept away. Senior bank employees are using complexity of operations (which is more myth than reality) to hobble shareholder control and progressive era legislation to hobble depositor control. Simon Johnson and James Kwak should take note. Explaining that shareholders' interests are aligned with depositors' might ignite the controlled demolition of TBTF.
Why should senior bank employees with the least "skin in the game" reap the largest benefits?
A controlled demolition of TBTF might proceed something like this:
1) Depositors could begin to reassert their lost control by withdrawing money from the Big Banks (there already is such a movement underway).
2) Minimally, shareholders could begin to reassert their lost control by wiser appointments to the Boards of Directors with the view that cost control includes direction as well as magnitude (to wit, why should shareholders pay for lobbying which enriches employees and not them). Preferably, sell the shares and reinvest the capital in various smaller banks, presumably some of whom might be the recipients of moved depositor funds and none of whom have significant derivatives' exposure. In a controlled demolition of TBTF, the numerous banks left standing should benefit significantly.
3) Depositors and shareholders could understand that institution size dilutes control and allows employees to usurp control leaving you (or the state) to deal with the risk.
4) If an aligned group of depositors (aka voters) and shareholders (aka those funding the lobbying) demanded action, change would come. One key change: The Fed would need to stop supporting banks and instead support markets mitigating collateral damage from the demolition. They should open lines of communication with the hundreds of banks with assets between $1B and $100B. They will also need to deal with foreign depositors at the TBTF banks and begin to unravel the nightmare of derivatives (admittedly a task easier said than done).
Instead of a full frontal approach, TBTF should be imploded from within. Those with "skin in the game" need to take back control.
It's your money, and only your wisdom (not the government's or bank employees') will keep it safe and perhaps allow it to grow. Concentration of money occurs when investment is passive. Move Your Money!
One might even consider moving one's money out of the banking system entirely during the renovation through the purchase of Gold.
Friday, April 16, 2010
Goldman Goes For The Jugular With Derivatives' Control
"Given that much of the financial contagion was fueled by uncertainty about counterparties' balance sheets," Goldman Chief Executive Officer Lloyd Blankfein and President Gary Cohn wrote in a letter at the beginning of the annual report, "we support measures that would require higher capital and liquidity levels, as well as the use of clearinghouses for standardized derivative transactions." Washington Examiner
I've spent countless hours taking Goldman (GS) "to the woodshed" for underhanded dealings (and I'll end this article that way) but they have always been astute traders. Their recent request for derivatives clearinghouses seems to me like a coup de grace administered to all other derivatives dealers.
When I was trading FX Options at Chase, J. Aron (owned by GS) was rightly regarded as one of the best derivatives dealers along side First Chicago (which was eventually swallowed up by UBS). They had the best models, and were religious about hedging away their risk.
I assume the past few years taught them that their biggest risk lies, not in the market, but in their counterparties. Their book might be well hedged, but if their counterparties default, they are doomed.
Thus, it seems to me, the request for clearinghouses. GS will force other dealers to use their models and risk mitigating tactics.
Let's assume they get their way. Other dealers, like JP Morgan (JPM), Bank of America (BAC) and Citibank (C), will likely find they haven't properly valued and hedged their books. The government, in its zeal to enact reform will likely be forced to pick up the cost of reducing these other banks' risk, and the banks themselves will likely find that GS is the last player standing.
Let's be cynical and assume that GS expects it will be the spring from which derivatives' regulators will be drawn. That would be one way to avoid embarrassing fraud charges from the SEC, (the coincidence is striking) and a way to watch what other dealers are doing, in the bargain.
Death by regulation.
If I were sitting at the negotiation table I'd be willing to give GS what it wants, with one proviso, the government will pick up the tab of reducing sector wide risks in derivatives if and only if size limits on banks, and separation of commercial banking from proprietary trading activities (i.e. the Volcker rules) are part of the bargain.
It might not hurt to later impose some strict limits on the revolving door between GS and the public sector.
Without such a bargain, the creation of clearinghouses will only further concentrate pricing control of these instruments, in the hands of GS. However skilled the GS boys currently are, monopoly control of derivatives will beg abuse down the road.
One coup de grace deserves another.
Disclosure: No positions in GS, JPM, BAC, or C
I've spent countless hours taking Goldman (GS) "to the woodshed" for underhanded dealings (and I'll end this article that way) but they have always been astute traders. Their recent request for derivatives clearinghouses seems to me like a coup de grace administered to all other derivatives dealers.
When I was trading FX Options at Chase, J. Aron (owned by GS) was rightly regarded as one of the best derivatives dealers along side First Chicago (which was eventually swallowed up by UBS). They had the best models, and were religious about hedging away their risk.
I assume the past few years taught them that their biggest risk lies, not in the market, but in their counterparties. Their book might be well hedged, but if their counterparties default, they are doomed.
Thus, it seems to me, the request for clearinghouses. GS will force other dealers to use their models and risk mitigating tactics.
Let's assume they get their way. Other dealers, like JP Morgan (JPM), Bank of America (BAC) and Citibank (C), will likely find they haven't properly valued and hedged their books. The government, in its zeal to enact reform will likely be forced to pick up the cost of reducing these other banks' risk, and the banks themselves will likely find that GS is the last player standing.
Let's be cynical and assume that GS expects it will be the spring from which derivatives' regulators will be drawn. That would be one way to avoid embarrassing fraud charges from the SEC, (the coincidence is striking) and a way to watch what other dealers are doing, in the bargain.
Death by regulation.
If I were sitting at the negotiation table I'd be willing to give GS what it wants, with one proviso, the government will pick up the tab of reducing sector wide risks in derivatives if and only if size limits on banks, and separation of commercial banking from proprietary trading activities (i.e. the Volcker rules) are part of the bargain.
It might not hurt to later impose some strict limits on the revolving door between GS and the public sector.
Without such a bargain, the creation of clearinghouses will only further concentrate pricing control of these instruments, in the hands of GS. However skilled the GS boys currently are, monopoly control of derivatives will beg abuse down the road.
One coup de grace deserves another.
Disclosure: No positions in GS, JPM, BAC, or C
Tuesday, April 13, 2010
The Big School and Convertibility Lost
As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!"
Why then was this forbid? Why but to awe,
Why but to keep ye low and ignorant,
His worshippers; he knows that in the day
Ye Eate thereof, your Eyes that seem so cleere,
Yet are but dim, shall perfetly be then
Op'nd and cleerd, and ye shall be as Gods
Milton: Paradise Lost
There are, it may seem to a new student of economics, more schools of thought in the field than stars in the sky. I sometimes wonder if David Bohm, author of, inter alia, The Qualitative Infinity of Nature, might have felt more comfortable as an Economist than a Physicist. While the physical sciences, according to Thomas Kuhn, exhibit totalitarian tendencies with violent revolutions, Economics is far more democratic, tolerating, albeit not without disputes, multiple coincident schools of thought.
Of late, however, one school of economic thought has become increasingly dominant in policy making circles. The Big School holds that the larger a financial institution becomes the more protected it should be, and vice versa, the smaller a financial entity is, the less protection it should receive.
As an example of this (somewhat) facetious claim, consider the views of JPM's David Lowman: Like all loans, mortgage contracts are based on a promise to repay money borrowed. Importantly, there is no provision in the mortgage contract, express or implied, that the lender will restore equity or reduce the repayment amount if the value of the collateral – be it a home, a car or a stock market investment – depreciates. If we re-write the mortgage contract retroactively to restore equity to any mortgage borrower because the value of his or her home declined, what responsible lender will take the equity risk of financing mortgages in the future? What responsible regulator would want lenders to take such risk?
In other words, the same bank (there were, of course, others) whose inability to meet its contractual obligations a few years ago was such that it needed loans from, and preferential swapping of toxic for performing securities with, the Fed, equity support from the Treasury, and a release from the onerous task of marking securities to market, NOW thinks contracts, regulations and agreements are sacrosanct.
I wonder if the issue up for debate was deriviatives regulation or marking toxic assets to market, would any person from a bank end a paragraph with "what responsible regulator would want lenders to take such risks?"
Big School Rules.
In a Jonathon Demme film appropriately (for our purposes) titled "Stop Making Sense", the Talking Heads' David Byrne asked, "Well, how did I get here?"
The Big School took its cue from Kuhn and engaged not in democratic debate, but totalitarian revolt. They appropriated Walter Bagehot's views on the Central Bank's Lender of Last Resort facility in times of crisis but perverted them in the process. Instead of the outline presented in Lombard Street of "very large loans at very high rates" which, in modern times, became, "lend freely at a high rate", the Big School preaches the doctrine of "lending freely (to the banks) at a very low rate" thereby relieving the Central Bank of its responsibility to enforce prudence.
I may, however, be wrong in assuming the Big School appropriated their "lend freely (to the banks) at a very low rate" doctrine from Bagehot (they may simply have thought "lots of free money would sure be nice"), because this implies a reading thereof. If they had read Lombard Street they would have found these lines of concern about big banks, and management practices obscured from review:
The second misgiving, which many calm observers more and more feel as to our largest joint stock banks, fastens itself on their government. Is that government sufficient to lend well and keep safe so many millions?
All that the best board of directors can really accomplish [in the largest joint-stock banks] is to form a good decision on the points which the manager presents to them, and perhaps on a few others which one or two zealous members of their body may select for discussion
There is no more unsafe government for a bank than that of an eager and active manager, subject only to the supervision of a numerous board of directors, even though that board be excellent, for the manager may easily glide into dangerous and insecure transactions, nor can the board effectually check him.
Our great joint stock banks are imprudent in so carefully concealing the details of their government, and in secluding those details from the risk of discussion. The answer, no doubt, will be, “Let well alone; as you have admitted, there hardly ever before was so great a success as these banks of ours; what more do you or can you want?” I can only say that I want further to confirm this great success and to make it secure for the future. At present there is at least the possibility of a great reaction. Supposing that, owing to defects in its government, one even of the greater London joint stock banks failed, there would be an instant suspicion of the whole system. One terra incognita being seen to be faulty, every other terra incognita would be suspected. If the real government of these banks had for years been known, and if the subsisting banks had been known not to be ruled by the bad mode of government which had ruined the bank that had fallen, then the ruin of that bank would not be hurtful. The other banks would be seen to be exempt from the cause which had destroyed it. But at present the ruin of one of these great banks would greatly impair the credit of all. Scarcely any one knows the precise government of any one; in no case has that government been described on authority; and the fall of one by grave misgovernment would be taken to show that the others might as easily be misgoverned also. And a tardy disclosure even of an admirable constitution would not much help the surviving banks: as it was extracted by necessity, it would be received with suspicion. A sceptical world would say, “Of course they say they are all perfect now; it would not do for them to say anything else”.
A read of Lombard Street would not have led to the Big School's conclusion that the Lender of Last Resort should, in times of crisis, lend only to the banks, and even insolvent ones.
Bagehot advised differently: A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to “this man and that man,” whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.
In other words, Bagehot argued the Central Bank's responsibility was to "the market", not the banks.
Further, he argued: the majority to be protected, are the “sound” people, the people who have good security to offer. He also speaks to the issue of unsound people, perhaps using a bit of wishful thinking: No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the “unsound” people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected;
While the fraction of business which is unsound today is likely larger than in Bagehot's England, I suspect most is sound. Unfortunately, the unsound elements, while small in practical classification (derivatives, mortgage backed securities, etc.) are huge in terms of currency relative to the whole economy.
Big School means Big Problems
Why, I wonder, did the other schools of thought so meekly submit to the Big School's totalitarian revolution? Perhaps the question might better be phrased, what problem(s) deemed intractable by most other schools of thought did the Big School solve.
My best guess; one of the problems the Big School solved is Triffin's Dilemma. Alternatively, a previous (temporary) "solution" of Triffin's Dilemma, the London Gold Pool, was brought back to life, a la Frankenstein's monster which begat Big School thinking.
Triffin's Dilemma states that when a national money is used as an international medium of exchange and international reserve there will be trade-offs between the national and global effects of the reserve currency issuer's monetary policy. Moreover, the reserve currency issuer nation would soon find that it had to run increasing current account deficits to provide liquidity to the rest of the world. This, in turn, would erode confidence in reserve currency convertibility, eventually leading to international currency instability and potentially a break down in world trade.
Robert Triffin forecast the breakdown of the Bretton Woods system based on this dilemma. Of late, his work has been cited by the PBOC.
Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries´ demand for reserve currencies. On the one hand,the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities on the other hand,they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists. Zhou Xiaochuan: hairman, Monetary Policy Committee of the People's Bank of China
Triffin, in the late 50s, called for the creation of a new global currency to act as international reserve, along the lines of Keynes' Bancor, or the IMF's SDR (deliberations for the creation of which were informed of his concerns), which, in my view, invites a whole new set of problems, but may still, barring a significantly large, in economic terms, country usurping the US$'s role, e.g. China (which invites similar problems, and leads to the US' loss of the exorbitant privilege), prove the best solution. A "free banking" system of competing moneys is another option.
As the US, not entirely without globally altruistic justification, did not want the Bancor in 1960 any more than it wanted it in 1945, the dilemma of convertibility fears was managed by illusion by way of intervention. The London Gold Pool was established in 1961 to keep the "market price" of Gold at $35 and thus reduce the incentive to demand promised convertibility from the Fed.
This worked until French demands for Gold were not satisfied. The cartel failed to maintain prices within the target and within a few years Nixon's closing of the Gold window ended US$-Gold convertibility.
I'll spare you the details of the 70s inflation and early 80s newfound stability. Suffice it to write that US$ reserves were accepted as semi-convertible- if not to Gold at a fixed price, at least to Gold and a basket of commodities with limited (until recently) fluctuations at new, higher prices.
In one (presumably easily accepted) respect, Big School banks that created and kept markets going in multiple new ($ based) investment vehicles helped sustain the sense of convertibility so long as those markets were trading. Markets to spend one's $s, even if one never shops there, engender a sense of stability.
Also coincident with this new found stability was the beginning of a business deal between J. Aron (purchased by Goldman Sachs in 1981) and Central Banks around the world. As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!" (pg. 258)
The book goes on to detail that J. Aron was actually making 8% on the deal with no money down, "it produced a nearly infinite rate of return." The book suggests they pulled a fast one on the central banks.
What Coyne may not have known was that at least some governments may well have done the deal for nothing. J. Aron offered to do what the London Gold Pool had done, and was willing to take the risk itself- a risk passed on in the merger to GS. An added benefit, assuming the deal worked as described, no gold had to actually be sold on the market, paper gold would suffice.
GS was not alone in this game. By the mid to late 80s when I was at Chase (now JPM), our Gold desk (fortunately positioned right behind the options desk where I worked) was playing the same game. Paper gold flooded the market.
One of the reasons I began working with GATA a decade ago was my observation (shared by them) of Gold's stubborn reluctance to rise in price despite the rapidly increasing external US$ reserves. If Gold was, as Triffin asserted, undervalued in the early 60s, surely, I thought, it was a steal in 2000 at $275.
Global US$ reserves have done nothing but rise since, at an increasing pace.
In 1978, Triffin and Mundell were warning of a sudden collapse of the US$ due to the growth of those reserves. Back then they wrote in astonishment of US$ reserves in the few hundreds of billions. Now, such reserves are measured in the trillions.
Without concrete data I can only speculate as to the extent of Central Bank gold leasing, or its effect on the price. In the past few years, the price of Gold has risen above $1000. Interestingly the price broke above the early 1980s high of $800 when problems began appearing in large US banks. The mid 2008 dollar squeeze in international markets capped its advance at that time, only to bring the US banking system to the brink of disaster.
How causal the coincidence proves to be remains a mystery. What seems certain is that, if Central Bank gold leasing is a policy aimed at extending the life of the US$ as global reserve currency, the banks so engaged cannot be allowed to fail, or the game is over.
Thus, I wonder how much effect, if any, the Gold leasing practices of the big NY banks had on the decision to make them too big to fail.
Have we dodged Triffin's dilemma by trying to maintain the illusion of convertibility only to invite a banking collapse worse than Bagehot's worse nightmare?
How will the US respond if an economy as large as China's needs a boost in international liquidity? How large might an IMF rescue package need to be to keep China from suffering a disastrous contraction? Would the US, as is its wont, allow the current account to widen further to ensure China repaid the IMF?
What if Japan needs IMF support?
How far off might such events be?
Big Questions for the Big School
Why then was this forbid? Why but to awe,
Why but to keep ye low and ignorant,
His worshippers; he knows that in the day
Ye Eate thereof, your Eyes that seem so cleere,
Yet are but dim, shall perfetly be then
Op'nd and cleerd, and ye shall be as Gods
Milton: Paradise Lost
There are, it may seem to a new student of economics, more schools of thought in the field than stars in the sky. I sometimes wonder if David Bohm, author of, inter alia, The Qualitative Infinity of Nature, might have felt more comfortable as an Economist than a Physicist. While the physical sciences, according to Thomas Kuhn, exhibit totalitarian tendencies with violent revolutions, Economics is far more democratic, tolerating, albeit not without disputes, multiple coincident schools of thought.
Of late, however, one school of economic thought has become increasingly dominant in policy making circles. The Big School holds that the larger a financial institution becomes the more protected it should be, and vice versa, the smaller a financial entity is, the less protection it should receive.
As an example of this (somewhat) facetious claim, consider the views of JPM's David Lowman: Like all loans, mortgage contracts are based on a promise to repay money borrowed. Importantly, there is no provision in the mortgage contract, express or implied, that the lender will restore equity or reduce the repayment amount if the value of the collateral – be it a home, a car or a stock market investment – depreciates. If we re-write the mortgage contract retroactively to restore equity to any mortgage borrower because the value of his or her home declined, what responsible lender will take the equity risk of financing mortgages in the future? What responsible regulator would want lenders to take such risk?
In other words, the same bank (there were, of course, others) whose inability to meet its contractual obligations a few years ago was such that it needed loans from, and preferential swapping of toxic for performing securities with, the Fed, equity support from the Treasury, and a release from the onerous task of marking securities to market, NOW thinks contracts, regulations and agreements are sacrosanct.
I wonder if the issue up for debate was deriviatives regulation or marking toxic assets to market, would any person from a bank end a paragraph with "what responsible regulator would want lenders to take such risks?"
Big School Rules.
In a Jonathon Demme film appropriately (for our purposes) titled "Stop Making Sense", the Talking Heads' David Byrne asked, "Well, how did I get here?"
The Big School took its cue from Kuhn and engaged not in democratic debate, but totalitarian revolt. They appropriated Walter Bagehot's views on the Central Bank's Lender of Last Resort facility in times of crisis but perverted them in the process. Instead of the outline presented in Lombard Street of "very large loans at very high rates" which, in modern times, became, "lend freely at a high rate", the Big School preaches the doctrine of "lending freely (to the banks) at a very low rate" thereby relieving the Central Bank of its responsibility to enforce prudence.
I may, however, be wrong in assuming the Big School appropriated their "lend freely (to the banks) at a very low rate" doctrine from Bagehot (they may simply have thought "lots of free money would sure be nice"), because this implies a reading thereof. If they had read Lombard Street they would have found these lines of concern about big banks, and management practices obscured from review:
The second misgiving, which many calm observers more and more feel as to our largest joint stock banks, fastens itself on their government. Is that government sufficient to lend well and keep safe so many millions?
All that the best board of directors can really accomplish [in the largest joint-stock banks] is to form a good decision on the points which the manager presents to them, and perhaps on a few others which one or two zealous members of their body may select for discussion
There is no more unsafe government for a bank than that of an eager and active manager, subject only to the supervision of a numerous board of directors, even though that board be excellent, for the manager may easily glide into dangerous and insecure transactions, nor can the board effectually check him.
Our great joint stock banks are imprudent in so carefully concealing the details of their government, and in secluding those details from the risk of discussion. The answer, no doubt, will be, “Let well alone; as you have admitted, there hardly ever before was so great a success as these banks of ours; what more do you or can you want?” I can only say that I want further to confirm this great success and to make it secure for the future. At present there is at least the possibility of a great reaction. Supposing that, owing to defects in its government, one even of the greater London joint stock banks failed, there would be an instant suspicion of the whole system. One terra incognita being seen to be faulty, every other terra incognita would be suspected. If the real government of these banks had for years been known, and if the subsisting banks had been known not to be ruled by the bad mode of government which had ruined the bank that had fallen, then the ruin of that bank would not be hurtful. The other banks would be seen to be exempt from the cause which had destroyed it. But at present the ruin of one of these great banks would greatly impair the credit of all. Scarcely any one knows the precise government of any one; in no case has that government been described on authority; and the fall of one by grave misgovernment would be taken to show that the others might as easily be misgoverned also. And a tardy disclosure even of an admirable constitution would not much help the surviving banks: as it was extracted by necessity, it would be received with suspicion. A sceptical world would say, “Of course they say they are all perfect now; it would not do for them to say anything else”.
A read of Lombard Street would not have led to the Big School's conclusion that the Lender of Last Resort should, in times of crisis, lend only to the banks, and even insolvent ones.
Bagehot advised differently: A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to “this man and that man,” whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.
In other words, Bagehot argued the Central Bank's responsibility was to "the market", not the banks.
Further, he argued: the majority to be protected, are the “sound” people, the people who have good security to offer. He also speaks to the issue of unsound people, perhaps using a bit of wishful thinking: No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the “unsound” people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected;
While the fraction of business which is unsound today is likely larger than in Bagehot's England, I suspect most is sound. Unfortunately, the unsound elements, while small in practical classification (derivatives, mortgage backed securities, etc.) are huge in terms of currency relative to the whole economy.
Big School means Big Problems
Why, I wonder, did the other schools of thought so meekly submit to the Big School's totalitarian revolution? Perhaps the question might better be phrased, what problem(s) deemed intractable by most other schools of thought did the Big School solve.
My best guess; one of the problems the Big School solved is Triffin's Dilemma. Alternatively, a previous (temporary) "solution" of Triffin's Dilemma, the London Gold Pool, was brought back to life, a la Frankenstein's monster which begat Big School thinking.
Triffin's Dilemma states that when a national money is used as an international medium of exchange and international reserve there will be trade-offs between the national and global effects of the reserve currency issuer's monetary policy. Moreover, the reserve currency issuer nation would soon find that it had to run increasing current account deficits to provide liquidity to the rest of the world. This, in turn, would erode confidence in reserve currency convertibility, eventually leading to international currency instability and potentially a break down in world trade.
Robert Triffin forecast the breakdown of the Bretton Woods system based on this dilemma. Of late, his work has been cited by the PBOC.
Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries´ demand for reserve currencies. On the one hand,the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities on the other hand,they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists. Zhou Xiaochuan: hairman, Monetary Policy Committee of the People's Bank of China
Triffin, in the late 50s, called for the creation of a new global currency to act as international reserve, along the lines of Keynes' Bancor, or the IMF's SDR (deliberations for the creation of which were informed of his concerns), which, in my view, invites a whole new set of problems, but may still, barring a significantly large, in economic terms, country usurping the US$'s role, e.g. China (which invites similar problems, and leads to the US' loss of the exorbitant privilege), prove the best solution. A "free banking" system of competing moneys is another option.
As the US, not entirely without globally altruistic justification, did not want the Bancor in 1960 any more than it wanted it in 1945, the dilemma of convertibility fears was managed by illusion by way of intervention. The London Gold Pool was established in 1961 to keep the "market price" of Gold at $35 and thus reduce the incentive to demand promised convertibility from the Fed.
This worked until French demands for Gold were not satisfied. The cartel failed to maintain prices within the target and within a few years Nixon's closing of the Gold window ended US$-Gold convertibility.
I'll spare you the details of the 70s inflation and early 80s newfound stability. Suffice it to write that US$ reserves were accepted as semi-convertible- if not to Gold at a fixed price, at least to Gold and a basket of commodities with limited (until recently) fluctuations at new, higher prices.
In one (presumably easily accepted) respect, Big School banks that created and kept markets going in multiple new ($ based) investment vehicles helped sustain the sense of convertibility so long as those markets were trading. Markets to spend one's $s, even if one never shops there, engender a sense of stability.
Also coincident with this new found stability was the beginning of a business deal between J. Aron (purchased by Goldman Sachs in 1981) and Central Banks around the world. As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!" (pg. 258)
The book goes on to detail that J. Aron was actually making 8% on the deal with no money down, "it produced a nearly infinite rate of return." The book suggests they pulled a fast one on the central banks.
What Coyne may not have known was that at least some governments may well have done the deal for nothing. J. Aron offered to do what the London Gold Pool had done, and was willing to take the risk itself- a risk passed on in the merger to GS. An added benefit, assuming the deal worked as described, no gold had to actually be sold on the market, paper gold would suffice.
GS was not alone in this game. By the mid to late 80s when I was at Chase (now JPM), our Gold desk (fortunately positioned right behind the options desk where I worked) was playing the same game. Paper gold flooded the market.
One of the reasons I began working with GATA a decade ago was my observation (shared by them) of Gold's stubborn reluctance to rise in price despite the rapidly increasing external US$ reserves. If Gold was, as Triffin asserted, undervalued in the early 60s, surely, I thought, it was a steal in 2000 at $275.
Global US$ reserves have done nothing but rise since, at an increasing pace.
In 1978, Triffin and Mundell were warning of a sudden collapse of the US$ due to the growth of those reserves. Back then they wrote in astonishment of US$ reserves in the few hundreds of billions. Now, such reserves are measured in the trillions.
Without concrete data I can only speculate as to the extent of Central Bank gold leasing, or its effect on the price. In the past few years, the price of Gold has risen above $1000. Interestingly the price broke above the early 1980s high of $800 when problems began appearing in large US banks. The mid 2008 dollar squeeze in international markets capped its advance at that time, only to bring the US banking system to the brink of disaster.
How causal the coincidence proves to be remains a mystery. What seems certain is that, if Central Bank gold leasing is a policy aimed at extending the life of the US$ as global reserve currency, the banks so engaged cannot be allowed to fail, or the game is over.
Thus, I wonder how much effect, if any, the Gold leasing practices of the big NY banks had on the decision to make them too big to fail.
Have we dodged Triffin's dilemma by trying to maintain the illusion of convertibility only to invite a banking collapse worse than Bagehot's worse nightmare?
How will the US respond if an economy as large as China's needs a boost in international liquidity? How large might an IMF rescue package need to be to keep China from suffering a disastrous contraction? Would the US, as is its wont, allow the current account to widen further to ensure China repaid the IMF?
What if Japan needs IMF support?
How far off might such events be?
Big Questions for the Big School
Saturday, April 03, 2010
GoldiSachs and the TBTF Banks
GoldiSachs and her friend MorganStanley were tired (of worrying about insolvency) so they went upstairs in the Banks' home and found a bed labeled TBTF that was just right. In contrast to the children's story, GoldiSachs and MorganStanley were welcomed into the club.
In March of 2008, years of poor investment decisions finally caught up to Bear Stearns, forcing the firm to accept a $2 per share bid (later revised to $10) from JPMorgan (financed by loans from the NY Fed). A once mighty financial firm which had survived the Great Depression was no more. Adding insult to injury, its final 5 year stock price chart, which depicted a dive from over $150 to the single digits could easily have been mistaken for that of a dead Tech firm which never generated a dime in profits.
Coincidentally, the Federal Reserve announced the creation of the Primary Dealer Credit Facility (PDCF) which allowed any Primary Dealer not already authorized to borrow at the Fed's Discount Window, to, in effect, enjoy the privilege of discounting their securities if they were cash poor.
Despite the new access to Fed liquidity, however, stock prices of Primary Dealers, who, inter alia, sell US government debt, were under assault within 6 months. Lehman Brothers did not survive the assault, declaring bankruptcy on September 15.
Perhaps due to the thinning ranks of Primary Dealers (in the previous 2 years, 5 Banks, ABN AMRO, CIBC, Nomura Securities, Lehman Brothers and the aforementioned Bear Stearns, had left the club or died) or some other reason (more on that in my next post) the Fed and Treasury made the hitherto unsaid policy of Too Big To Fail (TBTF), explicit, and welcomed GS and MS into the club (which, according to Simon Johnson and James Kwak, numbers 13), declaring the new entrants Bank Holding Companies (BHCs), for emphasis.
A recent check of the Fed's NIC (a wonderful resource on BHC data) demonstrates that GS and MS fit into the BHC club about as well as I fit into the crowd on my first visit to Beijing many years ago. Their source and use of funds are quite different as are their arenas of profit. They are investment firms, more closely related to Hedge Funds than banks. I'm all in favor of investment firms, however, I don't agree that, if TBTF is wise policy (which, at this stage, I doubt) they should be included in the protected group.
I still, on the topic of sticking out from the crowd, remember being asked to join a picture of a Chinese family during a visit to the Great Wall, because, I suspect, this rural family rarely saw white people and wanted to show the folks at home their great adventure.
Banks, as I recently argued, always and everywhere earn their money lending. As the table below demonstrates, however, the meaning of the term "bank" is being diluted at roughly the same pace as the US$. Admittedly, the banks themselves, in their desire to be more like Hedge Funds, are helping the dilution of meaning. This makes me wonder if the next GS to join the club will be George Soros. Perhaps if he becomes a primary dealer....
click for larger version
As you can see, GS and MS needed no help in provisioning against bad loans (one argument, with some merit, in favor of TBTF is that the banks provided more mortgage credit than they otherwise would have if the government wasn't promoting home ownership). These investment houses earn money from, inter alia, Investment Banking, Brokerage and Proprietary Trading.
Proprietary Trading is the arena one tends to find "rogue traders" like John Rusnak, Brian Hunter of Amaranth fame and this fellow from France. A policy of TBTF might well bail out a "rogue bank"or the banks' creditors, perhaps it already has. This isn't to suggest I'm against prop trading (it's one way I earn my keep) I just don't see the positives (if any) outweighing the negatives.
A thoughtful reader at Seeking Alpha wanted a more explicit statement of TBTF effects which inspired the use of "scam" in my last post.
TBTF direct effects include, as he noted, creditors avoiding "haircuts" (reduction or total loss of investment), and, as I added, employees and owners equally avoiding "haircuts" (reduction in compensation and loss of investment).
I used the term "scam" in reference to the latter two effects. Reductions in compensation and dividend outflow would go right to the bottom line, mitigating the need for equity and liquidity support.
TBTF rewards failure, which creates its own ill effects, and it will impose financial costs on families across the US as the effects of the changes in the Fed's System Open Market Account (latest data seen below) and growth in US Federal Debt manifest. Further, supporting firms which failed to see the collapse coming, or minimally to adjust their exposure accordingly, removes from the list of positives the one social virtue of trading I needed to know to become licensed as a securities' dealer- price discovery.
While I agree with the reader that US financial authorities had trade-offs in mind (I didn't use "total" in my original title) when TBTF became explicit (some going beyond finance, as I'll discuss in my next post) some are taking advantage or "scamming" the public in the lax environment.
Take a good look at aggregated employee compensation in the first table.
The ultimate question of TBTF is not "if" it will end. It will. Such arrangements always end. The Medici were known as God's Bankers, under the protection of the Vatican- the best shield going at the time- and they went under. Money, like water, eventually finds a way to flow around (or through) constraints.
The question is, will we end TBTF or will it end us, in our current form?
In March of 2008, years of poor investment decisions finally caught up to Bear Stearns, forcing the firm to accept a $2 per share bid (later revised to $10) from JPMorgan (financed by loans from the NY Fed). A once mighty financial firm which had survived the Great Depression was no more. Adding insult to injury, its final 5 year stock price chart, which depicted a dive from over $150 to the single digits could easily have been mistaken for that of a dead Tech firm which never generated a dime in profits.
Coincidentally, the Federal Reserve announced the creation of the Primary Dealer Credit Facility (PDCF) which allowed any Primary Dealer not already authorized to borrow at the Fed's Discount Window, to, in effect, enjoy the privilege of discounting their securities if they were cash poor.
Despite the new access to Fed liquidity, however, stock prices of Primary Dealers, who, inter alia, sell US government debt, were under assault within 6 months. Lehman Brothers did not survive the assault, declaring bankruptcy on September 15.
Perhaps due to the thinning ranks of Primary Dealers (in the previous 2 years, 5 Banks, ABN AMRO, CIBC, Nomura Securities, Lehman Brothers and the aforementioned Bear Stearns, had left the club or died) or some other reason (more on that in my next post) the Fed and Treasury made the hitherto unsaid policy of Too Big To Fail (TBTF), explicit, and welcomed GS and MS into the club (which, according to Simon Johnson and James Kwak, numbers 13), declaring the new entrants Bank Holding Companies (BHCs), for emphasis.
A recent check of the Fed's NIC (a wonderful resource on BHC data) demonstrates that GS and MS fit into the BHC club about as well as I fit into the crowd on my first visit to Beijing many years ago. Their source and use of funds are quite different as are their arenas of profit. They are investment firms, more closely related to Hedge Funds than banks. I'm all in favor of investment firms, however, I don't agree that, if TBTF is wise policy (which, at this stage, I doubt) they should be included in the protected group.
I still, on the topic of sticking out from the crowd, remember being asked to join a picture of a Chinese family during a visit to the Great Wall, because, I suspect, this rural family rarely saw white people and wanted to show the folks at home their great adventure.
Banks, as I recently argued, always and everywhere earn their money lending. As the table below demonstrates, however, the meaning of the term "bank" is being diluted at roughly the same pace as the US$. Admittedly, the banks themselves, in their desire to be more like Hedge Funds, are helping the dilution of meaning. This makes me wonder if the next GS to join the club will be George Soros. Perhaps if he becomes a primary dealer....
As you can see, GS and MS needed no help in provisioning against bad loans (one argument, with some merit, in favor of TBTF is that the banks provided more mortgage credit than they otherwise would have if the government wasn't promoting home ownership). These investment houses earn money from, inter alia, Investment Banking, Brokerage and Proprietary Trading.
Proprietary Trading is the arena one tends to find "rogue traders" like John Rusnak, Brian Hunter of Amaranth fame and this fellow from France. A policy of TBTF might well bail out a "rogue bank"or the banks' creditors, perhaps it already has. This isn't to suggest I'm against prop trading (it's one way I earn my keep) I just don't see the positives (if any) outweighing the negatives.
A thoughtful reader at Seeking Alpha wanted a more explicit statement of TBTF effects which inspired the use of "scam" in my last post.
TBTF direct effects include, as he noted, creditors avoiding "haircuts" (reduction or total loss of investment), and, as I added, employees and owners equally avoiding "haircuts" (reduction in compensation and loss of investment).
I used the term "scam" in reference to the latter two effects. Reductions in compensation and dividend outflow would go right to the bottom line, mitigating the need for equity and liquidity support.
TBTF rewards failure, which creates its own ill effects, and it will impose financial costs on families across the US as the effects of the changes in the Fed's System Open Market Account (latest data seen below) and growth in US Federal Debt manifest. Further, supporting firms which failed to see the collapse coming, or minimally to adjust their exposure accordingly, removes from the list of positives the one social virtue of trading I needed to know to become licensed as a securities' dealer- price discovery.
While I agree with the reader that US financial authorities had trade-offs in mind (I didn't use "total" in my original title) when TBTF became explicit (some going beyond finance, as I'll discuss in my next post) some are taking advantage or "scamming" the public in the lax environment.
Take a good look at aggregated employee compensation in the first table.
The ultimate question of TBTF is not "if" it will end. It will. Such arrangements always end. The Medici were known as God's Bankers, under the protection of the Vatican- the best shield going at the time- and they went under. Money, like water, eventually finds a way to flow around (or through) constraints.
The question is, will we end TBTF or will it end us, in our current form?
Thursday, October 01, 2009
From Black Scholes to Black Holes (part 4- Finance)
Were a modern-day financial Rip Van Winkle to awake today having slumbered for the past 20 years, he would observe a capital market vastly different from the one he knew. Introduction: From Black Scholes to Black Holes
It's been 16 years since the above noted book-a collection of essays explainging how one models the risks associated with certain derivative securities- was published and the introductory statement is more true now than then. In 1992, the notional amount of interest rate derivative exposure in US banks was about 77% of GDP. The graph below shows the growth since.
I begin this 4th look at the US economy from a flow of funds perspective with derivatives to "cut to the chase." This isn't to diminish the still currently intractable problems of mortgage finance, but that topic has been ably covered by many others. Further, as hard as it may be to believe, the problems associated with mortgage finance pale in comparison to those associated with derivatives. Warren Buffett famously called these securities financial weapons of mass destruction, but I think he understated the problem. These securities are far worse- a Ponzi scheme even Carlo wouldn't have dreamed of. We can choose to fire a WMD, but these securities have taken on a life of their own and they will, in my view, drag everything financially tied to them into oblivion- into a black hole.
The intent of the book From Black Scholes to Black Holes, to cloak these securities in an aura of cool, is quite ironic in its, apparently unintended, prescience. Black Holes are singularities in Einstein's space-time continuum which swallow, for want of a better term, everything that comes near. They are the Charybdis-es of space. Derivatives are the Charybdis-es of finance. They are creating their own ever stronger gravitational field that has already swallowed 3 of the 8 major US players since 1998. The 5 banks which remain are increasingly linked together.
Last night, after perusing the derivatives data from the BIS and Office of the Comptroller of the Currency (OCC), I was wondering what the end game would be, happened to glance at my book shelf and the book title jumped out at me. "It's a Black Hole," I realized. In the end the remaining banks will merge into one and money, instead of light, would never be able to escape as the fallacy of netting benefits- the assumption that they are all similarly valued- is exposed.
In the OCC Report on Derivatives, the benefits of netting are explained: For a portfolio of contracts with a single counterparty where the bank has a legally enforceable bilateral netting agreement, contracts with negative values may be used to offset contracts with positive values. This process generates a “net” current credit exposure (NCCE)
I had some experience with this fallacy of netting when I was trading FX derivatives for Chase. When Drexel Burnham collapsed I had to "net out" - put on the opposite trade with the same counterparty- the exposure of my option portfolios with Drexel's. While this seems easy to describe there was a problem. They didn't value their options at the same values we did. In some cases I was short low delta (far out of the money) options I had marked to the (lower) at-the-money value. Who should take that revaluation loss? In other cases, I might have to net out a position I needed only to find that replacing it was far more expensive than our agreed upon price.
Fortunately, markets I was trading at that time were not excessively volatile, which would have made the procedure even more difficult. Even more fortunately, the notional amounts were orders of magnitude less than currently carried by US banks.
50 basis points (a fairly trivial change in an option value, or, if you prefer, an aggressive post Volcker Fed tightening) on $100M (roughly the size of trade back then) is $500K. 50 basis points on $7Tln (or 1/5th (5 banks left) of the notional exposure in interest rate derivatives with maturities between 1-5 years) is $35B (7 times the total net income for JPM in 2008).
Why has interest rate derivative exposure grown so much over the past few years? The search for profits in an ultra low interest rate environment seems, in part, a good answer as the graph below depicts.
The other answer is that, as I discovered, the easiest way to make money from a derivatives portfolio is to grow it. Increasing risk in the far dates that is mispriced in your favor can cover many sins as derivatives mature.
Warren Buffett describes the pain of going in reverse on (winding down) such portfolios: When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: “I liked you better before I got to know you so well.” General Re's derivatives exposure was orders of magnitude less than that of GS, C, or JPM.
The OCC seeks to assure us that they have things under control: While market or product concentrations are normally a concern for bank supervisors, there are three important mitigating factors with respect to derivatives activities. First, there are a number of other providers of derivatives products whose activity is not reflected in the data in this report. Second, because the highly specialized business of structuring, trading, and managing derivatives transactions requires sophisticated tools and expertise, derivatives activity is concentrated in those institutions that have the resources needed to be able to operate this business in a safe and sound manner. Third, the OCC and other supervisors have examiners on-site at the largest banks to continuously evaluate the credit, market, operation, reputation, and compliance risks of derivatives.
In addition to the assumed virtues of netting, the OCC seeks to calm you with VaR (value at risk analysis) analysis (about the shortcomings of which, more here). The average VaR in 2008 relative to 2008 net income according to 10K and 10Q SEC reports is roughly 3% for JPM, C, and BoA and higher for GS. In the event revenues from interest rate derivative trading for Q1 2009 was $9B. Those tails sure seem to be fatter than assumed. If you can make it, as all traders eventually learn, you can certainly lose it.
Perhaps now we can see why the Fed is being so tentative with talk of removing stimulus and raising rates. 50 basis points can wipe out a bank. Imagine if the Fed is faced with the situation of a full blown currency crisis- the Scylla near the Charybdis- and needs to lift the Fed Funds rate 200, 300 or 500 basis points swiftly- a policy response chosen by the Fed in the late 70s/early 80s and many other Central Banks since.
In that event, the black hole becomes operative and another type of derivative, the credit default swap starts sucking the financial life out of the remaining big banks.
Since Q3 2007, credit default derivatives have generated $28B in losses. As of Q2 2009 there were still some $13.44Tln in notional exposure or 95% of GDP. What happens if only 1 bank is left? even if that bank has successfully bet on the collapse of the other 4? Who pays?
From Black Scholes to Black Holes indeed. In my view, the sooner, the better. If Warren Buffet's experience is any guide, an implosion of the 5 biggest banks seems a better alternative to an attempt to wind down these portfolios.
It's been 16 years since the above noted book-a collection of essays explainging how one models the risks associated with certain derivative securities- was published and the introductory statement is more true now than then. In 1992, the notional amount of interest rate derivative exposure in US banks was about 77% of GDP. The graph below shows the growth since.
I begin this 4th look at the US economy from a flow of funds perspective with derivatives to "cut to the chase." This isn't to diminish the still currently intractable problems of mortgage finance, but that topic has been ably covered by many others. Further, as hard as it may be to believe, the problems associated with mortgage finance pale in comparison to those associated with derivatives. Warren Buffett famously called these securities financial weapons of mass destruction, but I think he understated the problem. These securities are far worse- a Ponzi scheme even Carlo wouldn't have dreamed of. We can choose to fire a WMD, but these securities have taken on a life of their own and they will, in my view, drag everything financially tied to them into oblivion- into a black hole.
The intent of the book From Black Scholes to Black Holes, to cloak these securities in an aura of cool, is quite ironic in its, apparently unintended, prescience. Black Holes are singularities in Einstein's space-time continuum which swallow, for want of a better term, everything that comes near. They are the Charybdis-es of space. Derivatives are the Charybdis-es of finance. They are creating their own ever stronger gravitational field that has already swallowed 3 of the 8 major US players since 1998. The 5 banks which remain are increasingly linked together.
Last night, after perusing the derivatives data from the BIS and Office of the Comptroller of the Currency (OCC), I was wondering what the end game would be, happened to glance at my book shelf and the book title jumped out at me. "It's a Black Hole," I realized. In the end the remaining banks will merge into one and money, instead of light, would never be able to escape as the fallacy of netting benefits- the assumption that they are all similarly valued- is exposed.
In the OCC Report on Derivatives, the benefits of netting are explained: For a portfolio of contracts with a single counterparty where the bank has a legally enforceable bilateral netting agreement, contracts with negative values may be used to offset contracts with positive values. This process generates a “net” current credit exposure (NCCE)
I had some experience with this fallacy of netting when I was trading FX derivatives for Chase. When Drexel Burnham collapsed I had to "net out" - put on the opposite trade with the same counterparty- the exposure of my option portfolios with Drexel's. While this seems easy to describe there was a problem. They didn't value their options at the same values we did. In some cases I was short low delta (far out of the money) options I had marked to the (lower) at-the-money value. Who should take that revaluation loss? In other cases, I might have to net out a position I needed only to find that replacing it was far more expensive than our agreed upon price.
Fortunately, markets I was trading at that time were not excessively volatile, which would have made the procedure even more difficult. Even more fortunately, the notional amounts were orders of magnitude less than currently carried by US banks.
50 basis points (a fairly trivial change in an option value, or, if you prefer, an aggressive post Volcker Fed tightening) on $100M (roughly the size of trade back then) is $500K. 50 basis points on $7Tln (or 1/5th (5 banks left) of the notional exposure in interest rate derivatives with maturities between 1-5 years) is $35B (7 times the total net income for JPM in 2008).
Why has interest rate derivative exposure grown so much over the past few years? The search for profits in an ultra low interest rate environment seems, in part, a good answer as the graph below depicts.
The other answer is that, as I discovered, the easiest way to make money from a derivatives portfolio is to grow it. Increasing risk in the far dates that is mispriced in your favor can cover many sins as derivatives mature.
Warren Buffett describes the pain of going in reverse on (winding down) such portfolios: When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: “I liked you better before I got to know you so well.” General Re's derivatives exposure was orders of magnitude less than that of GS, C, or JPM.
The OCC seeks to assure us that they have things under control: While market or product concentrations are normally a concern for bank supervisors, there are three important mitigating factors with respect to derivatives activities. First, there are a number of other providers of derivatives products whose activity is not reflected in the data in this report. Second, because the highly specialized business of structuring, trading, and managing derivatives transactions requires sophisticated tools and expertise, derivatives activity is concentrated in those institutions that have the resources needed to be able to operate this business in a safe and sound manner. Third, the OCC and other supervisors have examiners on-site at the largest banks to continuously evaluate the credit, market, operation, reputation, and compliance risks of derivatives.
In addition to the assumed virtues of netting, the OCC seeks to calm you with VaR (value at risk analysis) analysis (about the shortcomings of which, more here). The average VaR in 2008 relative to 2008 net income according to 10K and 10Q SEC reports is roughly 3% for JPM, C, and BoA and higher for GS. In the event revenues from interest rate derivative trading for Q1 2009 was $9B. Those tails sure seem to be fatter than assumed. If you can make it, as all traders eventually learn, you can certainly lose it.
Perhaps now we can see why the Fed is being so tentative with talk of removing stimulus and raising rates. 50 basis points can wipe out a bank. Imagine if the Fed is faced with the situation of a full blown currency crisis- the Scylla near the Charybdis- and needs to lift the Fed Funds rate 200, 300 or 500 basis points swiftly- a policy response chosen by the Fed in the late 70s/early 80s and many other Central Banks since.
In that event, the black hole becomes operative and another type of derivative, the credit default swap starts sucking the financial life out of the remaining big banks.
Since Q3 2007, credit default derivatives have generated $28B in losses. As of Q2 2009 there were still some $13.44Tln in notional exposure or 95% of GDP. What happens if only 1 bank is left? even if that bank has successfully bet on the collapse of the other 4? Who pays?
From Black Scholes to Black Holes indeed. In my view, the sooner, the better. If Warren Buffet's experience is any guide, an implosion of the 5 biggest banks seems a better alternative to an attempt to wind down these portfolios.
Subscribe to:
Posts (Atom)
