Having spent much of the weekend absorbing the European bank stress test results, I’ve got to ask why they bothered.
OK, so it was to get bank share prices up, but the whole thing was just a typical European sham where every country does things in a different way, with the whole thing designed to cover up the real weaknesses in the European banking system.
Bearing in mind that the stress tests were called to shore up confidence in the system due to the concerns in the markets over a sovereign default in Greece or Spain, the fact that the tests left out that particular scenario is ridiculous.
In case you didn’t catch it, the tests looked at a double dip recession and a sovereign debt shock, but purely based upon debt that banks were trading, not debt that banks had in their vaults. Now I blogged a while back about the fact that Europe’s banks held over $1 trillion in debt to just Greece and Spain (double click picture to enlarge):
With sovereign debt trading on the bank's books worth about a tenth of their total exposure, that means that around $900 billion of potential sovereign debt has been ignored. How this can be ignored is beyond me.
Secondly, the tests ignore any liquidity risk issues, and just looked at market and credit risks. Why?This crisis started with liquidity risk when interbank lending dried up, and then exploded when sovereign debt became a major concern. The fact that CEBS left out these two clearly important dimensions just seems silly.But then it is purely a politically motivated exercise to try to stop the haemorrhaging of confidence in the European system.Now, I actually went to the press briefing on Friday night – a time chosen to ensure that markets could not react immediately to this sham – and saw the baying hounds of the media looking totally incredulous as the headlines were announced.“We have seven bank failures that, between them, in the most adverse scenario would need €3.5 billion of new capital.”I’m sorry, but that’s nuts.When the Americans did their stress tests, half their banks failed and they needed $75 billion of new capital. So how come, in the worst of situations, our banks would only need €3.5 billion and fewer than 10% fail?Because it’s a fix.
It’s fixed because each country interpreted the stress test conditions for unemployment and house prices and other economic conditions in their own way.
It's fixed because each regulator and central bank applied the test conditions against their bank's balance sheets in dfferent ways.
And it’s fixed by leaving out the sovereign debt exposures and potential defaults on the bank’s books.
Nevertheless, something useful did come out of it: data.
There's lots of data about the state of the bank's balance sheets released by CEBS that can now be analysed by the markets, rather than the fudge that the regulators applied.
Therefore, with the reservations stated above, I went through the numbers over the weekend and found an interesting result.
First, a little explanation of the numbers.The tests are based upon three scenarios.Scenario 1 is the benchmark, which is based upon the current ECB forecasts for macroeconomic developments across the European Union.Scenario 2 is then based upon a double dip recession, which sees no growth in 2010 and a 0.4% downturn in GDP in the European Union in 2011, versus 1% in 2010 and 1.7% forecasted in the benchmark.
Scenario 3 studies the impact of a sovereign debt shock to the European Union on top of this recession, and is geared towards higher debt losses and impairments in the PIGS – Portugal, Ireland, Italy, Greece and Spain – than in other countries.
This does not assume a sovereign default, just corporate debt and sovereign debt on the trading books of the banks. That’s about 10% of the total exposure for the banks, should a country default.
In the CEBS tests, they looked at Tier 1 Capital Ratio – not core capital, just Tier 1 capital – and said that the ratio should not fall under 6%. Under the EU Capital Requirements Directive, as it stands uncorrected since this crisis hit, the lowest level by law is 4%. Meanwhile, the likelihood is that a minimum 8% Tier 1 Capital will be required in the future and, in this context, is a far better ratio to apply.For example, based upon the CEBS view of the world, using the combined worst case of a double dip recession and a sovereign debt shock, they find seven banks would fall under the 6% Tier 1 Capital Ratio level: five in Spain, one in Germany and one in Greece.
Looking at the numbers using an 8% Tier 1 Capital Levels - a level that is rumoured to be required under revised terms for EU bank trading in the future - 39 banks would fail in the worst case scenario: one in Austria, one in Cyprus, five in Germany, three in Greece, two in Ireland, four in Italy, one in Portugal, one in Slovenia and twenty one in Spain.
Figure 1: 8% Tier 1 Capital Measures Failed by 39 Banks (double click image to enlarge)
Figure 2: Banks that Pass the 8% test (double click image to enlarge)
That would have been a far more realistic number to have announced and, based upon the fragmented application and interpretation of the tests by member states, is probably more likely to be the worst case scenario than the seven bank fails CEBS announced last Friday.
NOTE: failure does not means the banks are insolvent just undercapitalised, and so this would have been a much better way for CEBS, the ECB and the European Commission to have achieved some credibility from this exercise.
And a few of the more interesting tidbits that I picked up when looking at the background to these tests:“According to a survey by Goldman Sachs, 10 of the 91 banks subjected to the stress tests are expected to fail. The poll of 376 respondents, shows that European banks are expected on average to raise £40.6bn in extra capital following the tests.”Money Marketing“Hypo Real Estate’s Tier 1 capital ratio was 7.7 percent at the end of March, according to a presentation on its website dated June 2010. The lender said in May that it holds 72.1 billion euros ($93.4 billion) of debt in Greece, Italy and Spain, among the highest held by a bank in Europe, according to data compiled by Bloomberg ... Germany’s Soffin bank-rescue fund had provided Hypo Real Estate with 7.87 billion euros in funds by the end of March. The bank has said it may require a total of 10 billion euros from the fund. The lender said on July 8 that it received approval to establish a so-called bad bank to transfer as much as 210 billion euros of investments consisting of ‘non-strategic assets and risk positions.’ The amount represents more than half of Hypo Real Estate’s total assets at the end of 2009.” Bloomberg“According to CEBS, the other German lenders tested are Deutsche Bank AG, Commerzbank AG, Deutsche Postbank AG, Landesbank Baden-Wuerttemberg, Bayerische Landesbank, Norddeutsche Landesbank Girozentrale, WestLB AG, HSH Nordbank AG, Landesbank Hessen-Thueringen Girozentrale, Landesbank Berlin AG, DZ Bank AG, WGZ Bank AG and DekaBank Deutsche Girozentrale ... Among the banks on the list above, we note that e.g. Commerzbank has leverage of roughly 150:1 (tangible assets divided by tangible common equity), Landesbank Berlin has leverage of 75:1, WestLB 68:1 and Deutsche Bank 56:1. For the sake of comparison, by the time of its demise, Lehman Brothers is said to have been leveraged about 30:1. How can any of these banks not be de facto insolvent? If they hold any PIIGS bonds at all (and some of them do, in spades – e.g. 468% of Commerzbank's tangible book value was invested in PIIGS bonds as of about six weeks ago), it is a near mathematical certainty that they are.” Pater Tenebrarum
Gawd, I hate acronymns and look at that! Three in one blog entry title!!!
Anyways, for the nerdy-nerd equities guys, this will grab their attention.
It's all to do with trading in European and American stocks and shares using High Frequency Trading (HFT) systems, and the regulations therein with EU MiFID rules applying over here and USA RegNMS rules applying over there.
These rules are going to be overhauled soon thanks to the Flash Crash, that dreaded thing that caused US stock markets to go haywire on May 6th. There has been lots and lots written about the Flash Crash of May 6th, but there’s not been a great deal saying it was a good thing ... until you meet JPMorgan.
In this week’s Eye on the Market, they identify five things they like about the Flash Crash, namely:
[1] Stock-specific circuit breakers. The U.S. has been slow to install circuit breakers on major exchanges, relying instead on “clearly erroneous trade rules” that cancel trades after the fact. In Asia and Europe, circuit-breakers have been around for a while. In Asia, trading is restricted outside of pre-specified daily bands of 5%, 10% and 15% (different by market). In Europe (e.g., Deutsche Bourse), trading is halted for 5 minutes after a 3%-10% move, and then reopened. In the wake of the Flash Crash, 10% circuit breakers are now applied to a few stocks as part of a pilot program (they have already been triggered on Citigroup, Anadarko and the Washington Post Company). If we are going to exist in a world with automated robots doing the lion’s share of daily trading, circuit breakers may be needed to prevent unintended and unmanageable meltdowns.Another topic under discussion by the SEC: prevent HFTs from having “unfiltered, naked access” to the exchanges by requiring them to live by the same pre-trade risk management controls that clearing members do. Why? As noted by the Chicago Fed, “high-frequency trading has the potential to generate errors and losses at a speed and magnitude far greater than that in a floor or screen-based trading environment”.[2] More balance to the HFT discussion. HFT supporters claim they are providers of liquidity to the market, and that HFT makes U.S. markets more efficient than ever. Suggestions to the contrary have been deemed “utterly laughable” by firms defending them. However, the Flash Crash highlights the uncertainties around these assertions.While volumes have tripled in the last few years, there’s a big difference between volume and liquidity (the ability to transact without moving the price). In an industry barometer survey1 conducted by the Tabb Group in May of this year, barely half the participants had a high degree of confidence in the US equity market structure; 73% did not believe the market structure is “orderly”. One of the survey recommendations: HFTs should be required to register as broker-dealers.To be sure, there were weaknesses in the old specialist system as well2. But specialists were required to maintain a fair and orderly market, and post quotes that were part of the National Best Bid and Offer system; their reputations mattered. HFTs have no such requirements (no minimum shares or minimum quote times); one proposal would require quotes to be valid for at least one second. The SEC has broadened the trader reporting system in order to analyze HFT activity more closely.[3] Proposals requiring HFTs to act more like the floor specialists they’re replacing. With the advent of HFTs, cancelled orders have soared. Today’s ratio of 30 cancelled orders for each one executed means that 97% are cancelled.To curb abusive practices, some market participants recommend applying a fee to HFTs for an excessive number of cancelled orders. The increase in cancelled orders is one reason we do not agree that increased order depth on S&P 500 stocks at the NBBO is a clear indication of greater liquidity, as some market research alleges. Quotes pulled within a nano-second of being posted, and which are part of an algorithmic order detection exercise, don’t seem like liquidity in the traditional sense. Ameritrade’s representative on the recent SEC Roundtable referred to this as “opportunistic liquidity”.[4] More discussion around HFT “co-location”. Some HFTs co-locate computer servers inside stock exchanges3 to minimize the milliseconds (or nanoseconds) required to scan existing orders, and have algorithms act on this information. As trading execution and IPO listing fees declined, exchanges have tried to make up the difference by selling access to market data. Some exchanges have products which give clients a faster look at quotes, in exchange for a fee. As a result, some HFTs end up with access to information sooner than institutional or retail investors who rely on more standard venues (such as SIP Quotes).The search for co-location benefits has existed forever (in polite company, “order anticipation strategies”). Broker-dealers in past decades argued that being closer to floor traders on the CBOT was an advantage to their clients. But historical parallels can lose their meaning when the instruments of battle change: one HFT computer can reportedly decode more than 5 million messages per second. The Flash Crash has increased the debate around whether co-location confers advantages to HFTs, and whether there should be obligations and responsibilities that accompany them.[5] Asset managers learn that “cheapest <> best”. After the NYSE moved to decimalization in 2001, bid-offer spreads fell almost in half on S&P 500 stocks (less so for the Russell 2000 stocks, where HFTs are less active). Schwab retail commissions fell from $35 in 2003 to less than $10 in 2009. This trend is confirmed by broader research from the American Association of Individual Investors. So if the prism of success is bid-offer costs and commissions on individual trades, the battle has been won.But is that the right prism to define what makes an optimal marketplace? Part of the HFT industry tracks the order flow of larger investors who leave electronic footprints4. Using algorithms which include spraying the tape with thousands of quotes, the intentions of large investors is ferreted out. This can result in higher trading costs for such investors, and by extension, their clients, who include 401k investors, and pensioners participating in state and corporate plans. Quantitative Services Group computes analyses of HFT impacts on execution costs. They estimate that HFT tracking algorithms can drive execution costs up 1.5 to 3 times, even when institutional investors parcel trades into smaller orders to avoid detection.
There’s lots more of interest in their report, which you can read in full and download if you want:
This means that this area is going to get regulated, and it will mean significant restructuring. For example, back in January, the SEC started a consultation through the Concept Release - a request for public comment on securities issues - on HFT and more.
Key areas under review include:
Market Quality MetricsWhat are the best metrics for assessing market quality for long-term investors and have these metrics improved or worsened in recent years?Fairness of Market StructureIs the current highly automated, high-speed market structure fundamentally fair for investors?High Frequency Trading
What types of strategies are used by the proprietary trading firms loosely referred to as high frequency traders, and are these strategies beneficial or harmful for other investors?
Is the overall use of any harmful strategies by proprietary firms sufficiently widespread that the Commission should consider a regulatory initiative in this area?
Co-Location
Do co-location services (which enable exchange customers to potentially route trades faster by placing their computer servers in close proximity to an exchange's computer system) give proprietary trading firms an unfair advantage?
If so, should the proprietary firms that use these services be subject to any specific trading obligations?
Dark Liquidity
Has the trading volume of undisplayed trading centres (such as dark pools) reached a sufficiently significant level that it has detracted from the quality of public price discovery?
If more individual investor orders were routed to public markets, would it promote quote competition in the public markets, lead to narrower spreads, and ultimately improve order execution quality for individual investors beyond current levels?
Are a significant number of individual investor orders executed in dark pools and, if so, what is the execution quality for these orders?
Lots of comments have been received on the Concept Release, and its conclusion cannot be far away.
Now we have a European response to this area with Kay Swinburne, rapporteur to the Economic and Monetary Affairs committee of the Parliament, producing a draft report last week. This report provides indication of much of what might be in the revised MiFID and very little is left untouched.
Jeremy Grant over at the Financial Times, has picked out some of the more interesting nuggets from Kay’s report:
She suggests it may be necessary for “informal market makers” – read: HFTs – to be subject to mandatory liquidity provisions;
Calls for an “ongoing regulatory review” of the algorithms used by HFTs;
Seeks an examination of HFT to determine whether market flow generated automatically is providing “real liquidity” to the market and what the effect of this is on overall price discovery;
Suggests that, “in the interests of equitable treatment”, rules need to be introduced so that MTFs (multilateral trading facilities”, like Chi-X Europe) are subject to the same level of supervision as exchanges, under certain circumstances;
Calls for new provisions under Mifid for “broker crossing networks”, including requirements that they submit to authorities “orders matched in the system”, and “details on access to the system”; and
Suggests a minimum order size for dark pools.
This is pretty dramatic stuff and Jeremy finishes his column by referencing David Doyle, a regular speaker at the FSClub, returning to the London meeting on 12th January 2011 for our annual EU regulatory update.
David presented on the key changes in MiFID at a conference at the London Stock Exchange last week, stressing that “the whole review of MiFID will have as its driving principle investor protection – that is, the interest of the retail investor, not the operators of exchanges, dark pools and HFTs.”
Too true David, too true.If you’re interested in more of what David had to say, here are his slides:
A final posting on bank stats, but this time focused upon capital markets.According to the report from TheCityUK (which I cited a couple of times last week):
Companies raised £83 billion on the London Stock Exchange in 2009, including £5 billion raised on AIM, the market designed specifically for smaller, high growth companies.
An additional £21 million was raised on PLUS, which also caters for smaller high growth companies.
Of the 1,038 UK companies quoted on AIM, 603 are based outside London, as are 42% of the companies on PLUS.
Meanwhile, FX transactions have gone through the roof, ever since they became a tradable instrument on the foreign exchange markets. This BIS chart of the Global FX transactions since 1992 shows the impact this has had:
Of course, this has to be combined with globalisation, so here’s the world’s trade volume growth from 2000 through 2009:
Yet another blog posting on stats, and this one was inspired by Wikipedia of all places. I was looking for some stats on High Frequency (HFT) and Algorithmic trading, and stumbled across a great range of facts and figures.
First, we need to just say that HFT and Algo Trading are different.
Algorithmic trading just refers to all and any form of trading using programmed systems that automate the trade cycle.
HFT is a more specific area, and uses algo tools to move equities fast. In other words, the holding of stock in an HFT strategy might be for seconds or parts of seconds, whilst algo focuses upon those plus holdings for the medium and long term.
So there is a difference.
That’s why, when Wikipedia quotes Aite Group as saying that high frequency trading firms account for 73% of all US equity trading volume in 2009, they’re wrong.
OK, as usual, Wikipedia have got it wrong as, according to Reuters who should know, high-speed trading “accounts for about 60 percent of U.S. equity volume”.Bloomberg agree, quoting TABB Group who state that HFT accounts for 61% of equities volume, up from 35% in 2007.There’s the key point. HFT is big news, especially when it causes trillion dollar rises and falls.This is well illustrated when we think about my old forecast that the markets will be run by a man and his dog: the man’s there to feed the dog and the dog’s there to stop the man touching the keyboard.Don’t think that’s true?Back in 2006, 40% of all orders were entered by algo traders at the London Stock Exchange, rising to 60% in 2007 and now estimates believe that around 80% of trading is automated thanks to so many MTFs. Long live the man and his dog!On that note, I’ve used this analogy for a long while now (see Question 4 of Euromoney’s 2007 Christmas Quiz) but, in researching this stuff again, was surprised to see this conclusion of an interview with yours truly in June 2007:
“As brokers and exchanges scramble to adjust, those who face the biggest risks from algorithmic trading may very possibly be small-scale investors — those most reliant on market stability, good governance and fair access to information and technology.
“‘Many of the algorithmic trading strategies include risk strategies untested by market downturns,’ warns Balatro's Chris Skinner. ‘A lot of the traditional market stabilizers are being taken out’ by the trading speed and fluidity enabled by algorithmic trading, he adds.
“The biggest stabilizer of all, he notes, is perhaps the role of local and national financial regulators.“But in the new era of algorithmic trading, in which trading technologies and strategies are closely-held competitive secrets fiercely protected from scrutiny, Skinner says regulators will have a tough time gaining sufficient information to ‘understand what they are regulating.’ Especially if it's happening in 10 or 20 jurisdictions simultaneously. It all starts to make Enron's famously complex trading strategies look simple, he adds.
“After all, Skinner notes, if major Canadian banks find it necessary to outsource their algorithmic trading expertise because it's too expensive to go it alone, how likely is it that our notoriously parsimonious financial regulators — with their laughably small technology budgets — will be able to ensure the world's increasingly fleet-footed algo-experts always play fair?”
On 6th May, US markets fell into a trillion dollar freefall. Accenture’s shares fell from $41 at 2:30 that afternoon to just one cent each by 2:47 whilst Apple’s shares soared 40,000 per cent to reach $100,000 each during the same twenty minute period. Overall, the US stock market lost 9 per cent of value before rebounding just as fast. The result is that the SEC is bringing in rules that will stop a freefall by freezing any equity whose price moves more than 10 per cent in any five minute period. This may deal with the issue but does it deal with the cause?
For over a decade electronic trading has progressed from simple puts and calls to hugely complex structures. A decade ago, FIX Protocol was designed to streamline connectivity between buy and sell side, whilst today it is designed to allow millions of trade offers of indications of interest and order cancellations to take place in real-time, low latency operations. This point was brought home to me in conversation with Thomson Reuters in the UK, who tell me that, in 2000, they were following 5,000 trading changes per second. This figure had increased to 550,000 changes per second today, and the exchanges expect this to reach over a million by the end of year. In New York, the figures are ten times this level with the US Options Exchange claiming to track four million messages per second across the US trading markets, peaking at ten million per second.Algorithmic black box structures have stretched the point further, by moving from simple trading of stocks to complex trading strategies that seek arbitrage opportunities at every point of the trade lifecycle. For example, these complex layers of trading strategies have allowed the rise of cross-asset class trading, where a simple trade call for Microsoft stock can be hedged with a link to other tech stocks, such as Apple and IBM, mixed with FX pricing movements and the speed of rises and falls on the Dow and S&P 500, all in real-time. This is why we find the interlinkage and complexities of trading created by such technologies are rapidly becoming more precarious.A point that was obvious to me back in August 2007 when Goldman Sachs' systems messed up losing thirty percent of the value, or $1.5 billion, of their flagship global equity funds in a week. Goldmans' CFO David Viniar said that this was because they were "seeing things that were 25-standard deviation events, several days in a row." A 25-standard deviation event is meant to only happen once every 100,000 years.It was obvious that systems seeking arbitrage opportunities could get their models wrong and, since the implosion of liquidity in 2008 when Lehman Brothers failed, we know how fragile these systems can be.It has not stopped the ongoing march of investment innovation however, with the latest sprinkling of low latency for high frequency trading added to the melting pot. For example, the CIO of NYSE Euronext said to me recently that the fastest processing in the investment world processes in about 250 microseconds today, or 0.00025 of a second. In other words, in the time it took you to read the last sentence, about ten seconds, about 40,000 trade movements could have flowed sequentially through the system.And all of those trades movements need to be time stamped, recorded and indexed for client and regulatory reporting purposes, which is why firms ranging from Barclays to Instinet to Credit Suisse have all received fines from the FSA recently for incorrect time reporting of trades.And every nanosecond is the difference between getting the trade executed or losing the trade execution opportunity to a competitor. So this march of high frequency complex arbitrage-based automated trading will continue.Unless regulators stop it that is.The fact is that the SEC and FSA in the USA and UK respectively are really concerned about such developments, particularly with the issues created by ‘flash orders’, where a sell side firm might change prices in real-time between a client’s order and its execution in order to make a buck at their expense.Similarly, regulators are fearful of things they do not understand or hear stories about that sound like in appropriate use of information systems, such as ‘dark pools’. Dark pools, where orders are placed unseen by the lit markets, are actually good for liquidity according to institutional investors and trading institutions, but have an issue just due to their title: ‘dark’.Dark is scary and that’s why rumours of the new European revision of the Markets in Financial Instruments Directive might crack down on dark pool trading structures and worse.All in all, we are living through a moment in time where the steady march of technology to create innovative trading opportunities are likely to be reined in by regulatory authorities who fear irrational and unexpected market movements in real-time.The question is: how much of a brake can they put on such innovation?My answer would be: not much.After all, most regulations result in unexpected consequences, e.g. MiFID moved a third of all European equities trading from traditional exchanges to high frequency automated trading pools. Do they really want to reverse this trend?I don’t think so.So it’s all about checks and balances ... or is that cheques and bank balances?
We are pleased to provide our sixth month of monitoring the MTF
performances in
European Equities trading, in partnership with Thomson Reuters Equity Market Share Reporter (EMSR).
* these figures
reflect auction and non-auction transparent order book
and dark pool trades, but excludes real-time and post-trade on-exchange
reported and off-exchange OTC trades in order to provide a true
comparison between the MTFs impact and the traditional exchanges.
At the conference in Santander, I was particularly taken with a presentation by Jorge Yzaguirre from the Bolsas y Mercados Españoles (BME).
BME is the Spanish company that deals with all of the organisational aspects of the Spanish stock exchanges and financial markets, as well as providing clearing and settlement and technology consulting in 23 countries focused upon trading systems.Jorge presented in Spanish with English slides so I didn’t get much of the words, but the slides speak volumes.The discussion was all about that American flash crash on May 6th.This was the one when Accenture’s share price went from $41 at 2:30 p.m. to just one cent at 2:48 p.m.Tsk, tsk.I’ve read lots of explanations of the crash, and it boils down to bad programming or a virus it seems that caused a glitch in the system.For the best explanation looking at all this stuff, checkout Nanex’s website. The flash crash illustrates the fragility of our markets and how exposed they are to massive data spikes and bursts.What would happen if crossing systems were seriously cross?Well now we know and sure, we’re working on addressing such issues, but what I liked about Jorge’s presentation is that it’s the first time I’ve seen someone present what happened (rather than just reading it). I also like the charts he used, so here’s a wee selection.
The market indices went into a meltdown in the afternoon of May 6th.
With the Volatility Index at the Chicago Board of Exchange zapping skywards.
The brown stuff hits the fan at 2:48, when Accenture’s share price hits rock bottom.
As did Procter & Gamble.
And Exchange Traded Funds (ETFs) such as iShares.
Around the same time, shares such as 3M hit bottom.
As did IBM.
And Intel.
Meanwhile, some equities rocketed, such as the price of Sotheby’s, that auction house.
Going, going, that’s a gonner!
Overall, the volatility was massive as electronic liquidity provider’s black box algorithms traded intermarket sweep orders aggressively between the market makers and taker robots.
Which is why daily liquidity replenishment points –
a NYSE volatility control
built that automatically converts the markets' to “slow”
or Auction Market only mode temporarily, allowing specialists, floor brokers and
customers to supplement liquidity and respond to the stock’s volatility (see comments) – went through the roof.
So there you have it.
Jorge did put a load of other slides up there, but I think this collection gives you a good flavour of what happened.Now you may think this is a one-off, but our globally interlinked trading systems often spike and move in rapid cycles.
Just take a look at this chart which illustrates the ups and downs of the markets over the last five years, and take particular note of September 2008 when Lehman Brothers collapsed.
No wonder the non-rocket scientists, general investor, market participants and now legislators all fear High Frequency Trading (HFT) systems ... and why the ruling now is that any move in a stock price by more than 10% of its value in either direction in a five minute trading period, will result in a stop trading break of five minutes to ensure it's not some gaming going on.
Oh and yes, the whole thing was Apple's fault anyway.
French and German banks have almost $1 trillion exposure to Southern European economies according to a Bank of International Settlements (BIS) report released last Monday (Download BIS report).
“Exposures” include loans, loan commitments, and derivatives contracts, and represent the cost to the banks if there were a default.All in all, Europe's banks have almost $1.6 trillion exposure to the four countries most susceptible to default in the Eurozone: Portugal, Ireland, Greece and Spain. $727 billion of exposures to Spain, $402 billion to Ireland, $244 billion to Portugal, and $206 billion to Greece.This builds on the chart I posted at the end of last month, but provides a more in depth view of the goings on.This is why the EU changed the rules last week for the way it looks at breaches of their rules on debt and deficits, by introducing a “dynamic debt” policy. This policy is based upon debt being allowable above the previous limits, as long as that debt is going down. So that’s alright then.Except that the level of debt is meant to be under 60% of GDP and yet, according to the latest economic forecasts by the European Commission, the average level of debt is going to reach 88.5% of overall Eurozone GDP in 2011 and 83.8% for the EU as a whole, Eurostat figures published in April (12-page PDF) reveal that the highest debt-to-GDP ratios are 115.8% in Italy, 115.1% in Greece, 96.7% in Belgium, 78.3% in Hungary, 77.6% in France, 76.8% in Portugal and 73.2% in Germany. Malta (69.1%), the UK (68.1%), Austria (66.5%), Ireland (64.0%) and the Netherlands (60.9%) came next.Mind you, this measures only public debt to GDP ratios, e.g. the government’s exposures, and many EU countries are arguing it should cover aggregate debt which would include the private sector borrowing levels. If this were taken into account, then the UK would lead the pack of debtors.Expect this all to be reviewed and redeveloped under new EU rules announced on 30th June.What fun!
Could we have forecast the credit crisis? Yes. Lots of thoughts on this, including last week's comment, but here's some more new stuff.
Ten years ago in the US of A, Sandy Weill put great pressure on Bill Clinton's office to repeal the Glass-Steagall Act with some success. This was because Sandy had a vision for Citigroup, which had grown from a retail bank to an integrated bank and insurer thanks to the merger with Travellers.
Sandy now wanted to create a global universal bank, integrating insurance, securities and retail banking, with Citibank, Travellers and Salamon Smith Barney at the forefront.
Trouble was that his plans were being thwarted by regulations, as Glass-Steagall prohibited any one institution from acting as
a combination of investment bank, commercial bank and insurance company. This ruling was made after the 1929 Great Depression and stock market crash.
After years of lobbying, Weill was successful, and the Glass-Steagall Act was repealed and Gramm-Leach-Bliley (GLB) came into force. The Gramm-Leach-Bliley Act allowed commercial banks, investment
banks, securities firms and insurance companies to consolidate, and therefore created the legal platform for Citigroup to emerge.
At the time, we thought the revolutionary model the act would allow was bancassurance, where more banks would offer full service in-house insurance. Instead, it allowed the riskier activities of the investment markets to infect the rest of the financial ops.
These risky activities would infect the rest of the financial ops regardless - just look at Long Term Capital Management - as the markets are like a house of cards. However, it did create a significant step towards the crash situation we are dealing with today.
Did no-one object?
Sure, a few did and, today, the US Senator Byron Dorgan is being accredited as the visionary. Here's what he had to say back in 1999:
I spoke earlier today about this legislation, which is called the Financial Services Modernization Act of 1999, and said then that I am probably part of a very small minority in this Chamber, but I feel very strongly that this is exactly the wrong bill at exactly the wrong time. It misses all the lessons of the past and, in my judgment, it creates definitions and moves in directions that will be counterproductive to our financial future.
What does this bill do? It would permit common ownership of banks, insurance, and securities companies, and to a significant degree commercial firms as well. It will permit bank holding companies, affiliates, and bank subsidiaries to engage in a smorgasbord of expanded financial activities, including insurance and securities underwriting, and merchant banking all under the same roof.
This bill will also, in my judgment, raise the likelihood of future massive taxpayer bailouts. It will fuel the consolidation and mergers in the banking and financial services industry at the expense of customers, farm businesses, family farmers, and others, and in some instances I think it inappropriately limits the ability of the banking and thrift institution regulators from monitoring activities between such institutions and their insurance or securities affiliates and subsidiaries raising significant safety and soundness consumer protection concerns.
CONGRESS PASSES WIDE-RANGING BILL EASING BANK LAWS By STEPHEN LABATON November 5, 1999
WASHINGTON, Nov. 4— Congress approved landmark legislation today that opens the door for a new era on Wall Street in which commercial banks, securities houses and insurers will find it easier and cheaper to enter one another's businesses.
The measure, considered by many the most important banking legislation in 66 years, was approved in the Senate by a vote of 90 to 8 and in the House tonight by 362 to 57. The bill will now be sent to the president, who is expected to sign it, aides said. It would become one of the most significant achievements this year by the White House and the Republicans leading the 106th Congress.
''Today Congress voted to update the rules that have governed financial services since the Great Depression and replace them with a system for the 21st century,'' Treasury Secretary Lawrence H. Summers said. ''This historic legislation will better enable American companies to compete in the new economy.''
The decision to repeal the Glass-Steagall Act of 1933 provoked dire warnings from a handful of dissenters that the deregulation of Wall Street would someday wreak havoc on the nation's financial system. The original idea behind Glass-Steagall was that separation between bankers and brokers would reduce the potential conflicts of interest that were thought to have contributed to the speculative stock frenzy before the Depression.
Today's action followed a rich Congressional debate about the history of finance in America in this century, the causes of the banking crisis of the 1930's, the globalization of banking and the future of the nation's economy.
Administration officials and many Republicans and Democrats said the measure would save consumers billions of dollars and was necessary to keep up with trends in both domestic and international banking. Some institutions, like Citigroup, already have banking, insurance and securities arms but could have been forced to divest their insurance underwriting under existing law. Many foreign banks already enjoy the ability to enter the securities and insurance industries.
''The world changes, and we have to change with it,'' said Senator Phil Gramm of Texas, who wrote the law that will bear his name along with the two other main Republican sponsors, Representative Jim Leach of Iowa and Representative Thomas J. Bliley Jr. of Virginia. ''We have a new century coming, and we have an opportunity to dominate that century the same way we dominated this century. Glass-Steagall, in the midst of the Great Depression, came at a time when the thinking was that the government was the answer. In this era of economic prosperity, we have decided that freedom is the answer.''
In the House debate, Mr. Leach said, ''This is a historic day. The landscape for delivery of financial services will now surely shift.''
But consumer groups and civil rights advocates criticized the legislation for being a sop to the nation's biggest financial institutions. They say that it fails to protect the privacy interests of consumers and community lending standards for the disadvantaged and that it will create more problems than it solves.
The opponents of the measure gloomily predicted that by unshackling banks and enabling them to move more freely into new kinds of financial activities, the new law could lead to an economic crisis down the road when the marketplace is no longer growing briskly.
''I think we will look back in 10 years' time and say we should not have done this but we did because we forgot the lessons of the past, and that that which is true in the 1930's is true in 2010,'' said Senator Byron L. Dorgan, Democrat of North Dakota. ''I wasn't around during the 1930's or the debate over Glass-Steagall. But I was here in the early 1980's when it was decided to allow the expansion of savings and loans. We have now decided in the name of modernization to forget the lessons of the past, of safety and of soundness.''
Senator Paul Wellstone, Democrat of Minnesota, said that Congress had ''seemed determined to unlearn the lessons from our past mistakes.''
''Scores of banks failed in the Great Depression as a result of unsound banking practices, and their failure only deepened the crisis,'' Mr. Wellstone said. ''Glass-Steagall was intended to protect our financial system by insulating commercial banking from other forms of risk. It was one of several stabilizers designed to keep a similar tragedy from recurring. Now Congress is about to repeal that economic stabilizer without putting any comparable safeguard in its place.''
Supporters of the legislation rejected those arguments. They responded that historians and economists have concluded that the Glass-Steagall Act was not the correct response to the banking crisis because it was the failure of the Federal Reserve in carrying out monetary policy, not speculation in the stock market, that caused the collapse of 11,000 banks. If anything, the supporters said, the new law will give financial companies the ability to diversify and therefore reduce their risks. The new law, they said, will also give regulators new tools to supervise shaky institutions.
''The concerns that we will have a meltdown like 1929 are dramatically overblown,'' said Senator Bob Kerrey, Democrat of Nebraska.
Others said the legislation was essential for the future leadership of the American banking system.
''If we don't pass this bill, we could find London or Frankfurt or years down the road Shanghai becoming the financial capital of the world,'' said Senator Charles E. Schumer, Democrat of New York. ''There are many reasons for this bill, but first and foremost is to ensure that U.S. financial firms remain competitive.''
But other lawmakers criticized the provisions of the legislation aimed at discouraging community groups from pressing banks to make more loans to the disadvantaged. Representative Maxine Waters, Democrat of California, said during the House debate that the legislation was ''mean-spirited in the way it had tried to undermine the Community Reinvestment Act.'' And Representative Barney Frank, Democrat of Massachusetts, said it was ironic that while the legislation was deregulating financial services, it had begun a new system of onerous regulation on community advocates.
Many experts predict that, even though the legislation has been trailing market trends that have begun to see the cross-ownership of banks, securities firms and insurers, the new law is certain to lead to a wave of large financial mergers.
The White House has estimated the legislation could save consumers as much as $18 billion a year as new financial conglomerates gain economies of scale and cut costs.
Other experts have disputed those estimates as overly optimistic, and said that the bulk of any profits seen from the deregulation of financial services would be returned not to customers but to shareholders.
These are some of the key provisions of the legislation:
Banks will be able to affiliate with insurance companies and securities concerns with far fewer restrictions than in the past.
The legislation preserves the regulatory structure in Washington and gives the Federal Reserve and the Office of Comptroller of the Currency roles in regulating new financial conglomerates. The Securities and Exchange Commission will oversee securities operations at any bank, and the states will continue to regulate insurance.
It will be more difficult for industrial companies to control a bank. The measure closes a loophole that had permitted a number of commercial enterprises to open savings associations known as unitary thrifts.
One Republican Senator, Richard C. Shelby of Alabama, voted against the legislation. He was joined by seven Democrats: Barbara Boxer of California, Richard H. Bryan of Nevada, Russell D. Feingold of Wisconsin, Tom Harkin of Iowa, Barbara A. Mikulski of Maryland, Mr. Dorgan and Mr. Wellstone.
In the House, 155 Democrats and 207 Republicans voted for the measure, while 51 Democrats, 5 Republicans and 1 independent opposed it. Fifteen members did not vote.
Tucked away in the legislation is a provision that some experts today warned could cost insurance policyholders as much as $50 billion. The provision would allow mutual insurance companies to move to other states to avoid payments they would otherwise owe policyholders as they reorganize their corporate structure. Many states, including New York and New Jersey, do not allow such relocations without the consent of the insurer's domicile state. But the legislation before Congress would pre-empt the states.
Both the Metropolitan Life Insurance Company and the Prudential Life Insurance Company are in the midst of reorganizing into stock-based corporations that are requiring them to pay billions of dollars to policyholders from years of accumulated surplus. In exchange, the policyholders give up their ownership in the mutual insurance company.
The legislation would permit any mutual insurance company to avoid making surplus payments to policyholders by simply moving to states with more permissive laws and setting up a hybrid corporate structure known as a mutual holding company.
The provision was inserted by Representative Bliley at the urging of a trade association. It attracted little opposition because it was attached to a provision that forbids insurers from discriminating against domestic-violence victims.
In a letter sent to Congress this week, Mr. Summers said that the provision ''could allow insurance companies to avoid state law protecting policyholders, enriching insiders at the expense of consumers.''
In an impressive speech back in 1963, a week before JFK was assassinated, Benjamin Graham – the first proponent of value investing – gave a speech in San Francisco.
In the first half of the speech (to page 9) he outlines the challenges of market fluctuations and puts forward the approach of holding a mix of interest-bearing instruments and equities, and the fact that people are irrational, e.g. buying shares in good times and then claiming the same shares are bad in poor times.In the second part, bearing in mind that markets are irrational, he delves deep into investment policies. His words are worth reposting fifty years later, as it’s still as true today as it was in 1963.
“Let me come to part two: what investment policy to follow under the conditions discussed?
“My views thereon are definite and strong. In my nearly fifty years of experience in Wall Street I’ve found that I know less and less about what the stock market is going to do, but I know more and more about what investors ought to do; and that’s a pretty vital change in attitude.
“The first point is that the investor is required by the very insecurity ruling in the world of today, to maintain at all times some division of his funds between bonds and stocks. My suggestion is that the minimum position of this portfolio held in common stocks should be 25% and the maximum should be 75%. Consequently the maximum holding of bonds would be 75% and the minimum 25% - the figures being reversed.
“Any variations made in his portfolio mix should be held within these 25% and 75% figures. Any such variations should be clearly based on value considerations, which would lead him to own more common stocks when the market seems low in relation to value, and less common stocks when the market seems high in relation to value.
“Now, whiles this is the classic langue of investment authorities, it is amazing how many people think in exactly opposite terms. That was brought home to me when a savings and loan representative came to me with questions. The first question he asked me was: ‘Don’t you think that common stocks are now less safe because of the decline in the market?’
“That hit me between the eyes.
“Here were financial people who could seriously consider that stocks less sage because they have declined in price than they were after they had advanced in price. The policy I propose to have more common stocks when the market seems to be low and less when it seems to be high, by value standards, is obviously opposed to the psychology of investors generally and to that of speculators always.”
Mr. Graham continues to then outline how you should hedge your portfolio based upon its value in a proportionate way between bonds and stocks, with a focus upon taking profits out of stocks and into bonds during bull times and into stocks and out of bonds during bear times. Equally, he focuses upon the simple view that the best stocks are those that are undervalued for investment.
In fact, when talking about which stocks to choose, he puts forward the view that “the investor choose either his own list of, say, 20 or 30 representative and leading companies, or else put his money in several of the well-established mutual funds.
“Many investors would think my prescription too simple. If they can get a result equal to the average in this easy way, why shouldn’t they try to get a substantially higher return by careful and competently advised selection? My short answer has already been given: if the investment funds as a whole can’t beat the averages, even pretty clever investors as a whole can’t do it either.”
So he recommends investing in stocks that are not overpriced (“growth stocks”) or new stock offerings with “absurdly high price-earnings ratios”, and concludes with a three pronged approach to investing:
“First, select stocks of important companies which sell on a no glamour basis. Some extraordinary results could have been obtained each year by buying the shares of the six companies in the Dow Jones Industrial Average which sold at the lowest multiplier of their recent earnings.
“Second, buy definitely ‘bargain issues’. Typically these would be shares that sold for less their value in working capital alone, with nothing paid for fixed assets and goodwill.
“Third, there is the wide field of ‘special situations’ – reorganisations, mergers, take-overs, liquidations, etc. This is a professional area, but it is not impossible for intelligent investors to profit handsomely form it if they approach security operations as they would a commercial business.”
It’s an excellent speech for those trying to work out their investment approach, and some sound advice in there too.Mind you, if you want some further advice on investing, then you could do no harm in meeting Felicity Foresight. Felicity Foresight is a fictitious lady invested by the Economist at the end of the last century (link to pdf of article):
“When Ms Foresight was born in America, on January 1st 1900, her parents invested $1 on her behalf (the equivalent of $22 in today’s prices) in a broad basket of American shares, to provide a little something for when she grew up. If the $1 had then simply been left there, with the dividends reinvested, that nest egg would now be worth almost $15,000. Enough for a splendid 100th birthday party perhaps. However, Felicity—a rather precocious child—reckoned she could do much better. Discovering at an early age that she possessed perfect foresight about the performance of financial markets, her parents encouraged her to adopt a more active investment strategy, moving her funds every year.
“At the start of each year, Ms Foresight would predict which asset and which market around the world—shares, bonds, cash, property, precious metal, etc—would experience the highest total dollar return (income plus capital gain) over the following 12 months. Then, ignoring all the usual rules about risk diversification, she would invest all her wealth in that single asset and not touch it for a year. This she has done on the first trading day of each year throughout this century, allowing all dividend and interest income to be reinvested. The lucky lady thereby enjoyed large gains, but never suffered any losses, such as the 89% plunge in American share prices in the three years after the 1929 crash.
“Chart 1 lists all her investment choices, year by year.
“Felicity not only has perfect foresight, she has also been canny enough to dodge taxes. And, living frugally, she has not spent a cent of her wealth. So how much is her initial $1 stake worth today? If Ms Foresight had succeeded in picking the best performing asset each year (of those assets for which we could find historical data on total returns), she would now be worth an incredible $9,607,190,781,673,150,000 or $9.6 quintillion—some 110m times richer than Mr Gates who has a mere $85 billion. It took 55 years to become a millionaire, but only another 31 years for her to make a trillion dollars, in 1985.”
I wish I had perfect foresight ... but, in the meantime, I’ll stick with Mr. Graham’s advice – don’t speculate, accumulate.
This one intrigued me however, as it was written way back in February 2006, eighteen months before the August 2007 run on Northern Rock and two and a half years before the September 2008 implosion of Lehman Brothers.So Nassim Taleb talks about a Black Swan crisis ... this one wasn’t. This crisis was thoroughly predictable, as Traders, Guns and Money makes clear.Rather than writing a review here, as I haven’t read it yet, I thought that Shocked Investor’s blog entry would provide a good backgrounder on this.However, I have dived straight in to the last chapter on Credit Default Swaps (CDS) and Collateralised Debt Obligations (CDO), one of my favourite subjects.There’s a good note in there on page 295 about these suckers. Here’s a shortened version of that note:
“CDO logic is perverse. You buy loans and other credit risk from the market, then you cut it and dice it and sell it to investors. It should be impossible to make money. Then why are CDOs so profitable?
“In the credit trading age, dealers were taking massive ‘model risk’ to provide investors with higher returns. It was the geeks and their masters who were writing the cheques; they had placed their faith in the credit models; they had started to believe in their lies. Perversely, they were showing massive profits. That’s the beauty of mark-to-model. If the model fails, the profit will disappear like a chimera.
“In 2002 and 2003, benign conditions in the credit market prevailed. Few companies defaulted; people became foolish or brave and lent to companies at ever lower returns; the credit spread on junk bonds reached record lows. Credit standards declined.
“In 2004, one bank suffered a loss of around $50 million in a single day on its credit dealt books. Nobody really knew why: it was the first tremor.”
You get the idea.This book explained all the background to why we would see a subprime explosion and liquidity crisis ... back in February 2006, charting events going back to 2004 and before.The book cites a court case from 2004 for example, where Barclays Capital were sued by German investment fund, HSH, for ‘misrepresentation’ after BarCap lost $151 million on one of their CDOs:“HSH claims it was mis-sold the products, known as collateralised debt obligations (CDOs), and that Barclays then mismanaged its portfolio of CDOs in a way which further damaged the interests of investors. Barclays also stands accused of "short-selling" the CDOs for its own commercial benefit.”Barclays argued that the losses were just due to the ‘unexpected’ downturn in the credit markets, and that HSH was a sophisticated investor and aware of the risks.Doesn’t this sound like Goldman Sachs today?“The risk associated with the securities was known to these investors, who were among the most sophisticated mortgage investors in the world.” — Goldman Sachs April 16th press release, in response to the SEC’s accusations It’s a standard defence, as was BarCap’s response that it would ‘vigorously defend’ the action as they were ‘comfortable that these investments were not mis-sold’.In 2004, Barclays settled the case with HSH a few weeks before it came to trail as they wanted to avoid the headlines.A similar case was brought against Barclays and Bank of America at this time by the Italian Banca Popolare di Intra. Again, it was settled out of court.
If you’re interested in this stuff, there’s a really good presentation on CDO litigation from Jones Day, a law firm, at a London conference in March 2008.
Here’s a few of the slides:What triggers litigation?
Unexpected and large potential losses
Tripping of over-collateralization or similar tests
Disagreement over appropriate priority of payments
Liquidation of portfolio assets
Collateral calls
Poor documentation where ambiguity = opportunity
An unwillingness to compromise or inability to do so due to an encumbered balance sheet
What are the claims?America’s claims are based upon:
Sales Practices:
Misrepresentations and omissions
Collateral contracts/promissory estoppel
Suitability
Federal securities fraud claims
Mismanagement; Breach of fiduciary duty
Breach of contract
Contract interpretation
Third party beneficiary standing
Aiding and abetting breach of fiduciary duty/fraud
Civil conspiracy
Class actions?
UK claims are based upon:
Deceit
Misrepresentation (if contract) based upon being innocent/negligent/fraudulent
Breach of contract: contract term/implied term (reasonable skill and care in management of funds)
Negligent mis-statement (if no contract)
Breach of a duty of good faith/duty to inform
Who brings the claims?
CDO investors
Senior Note holders vs. Income Note holders
Institutional vs. individual investors
Hedge funds/ fund investors.
Liquidators and trustees of insolvent CDOs
Swap counterparties
Mono-line insurers
Warehouse agents
Who gets sued?
Placement agents\underwriter
Portfolio managers
Financial advisors
Administrative agents
CDO directors and officers
Rating agencies
Mono-line insurers
Accountants
Other professionals? Law firms?
Interesting and I’ll bet this rumbles on for years to com.
Meanwhile, if all this was rumbling along back in 2004 such that a book could be written about it in February 2006, how come no-one – including yours truly – knew what was really happening until the poop hit the fan?
We are pleased to provide our fifth month of monitoring the MTF
performances in
European Equities trading, in partnership with Thomson Reuters Equity Market Share Reporter (EMSR).
* these figures
reflect auction and non-auction transparent order book
and dark pool trades, but excludes real-time and post-trade on-exchange
reported and off-exchange OTC trades in order to provide a true
comparison between the MTFs impact and the traditional exchanges.
WARNING: THIS BLOG ENTRY WILL NOT CHEER YOU UP [sorry]
I spent the morning with a group of futurists debating the long-term outlook for financial markets and am never sure about the usefulness of such debates, although there is definitely something of use in creating scenario plans for the future which is where we were focused.
The key question I kept asking myself during the conversation is: when will the next financial crisis take place, what will cause it and is it predictable?
To answer the first part of that question, we only need to look back in history.
If we take the first financial crisis as the fall of the Roman Empire then it was about 1,000 years until the second financial crisis occurred, with the collapse of the Medici banks of Renaissance Italy. Four centuries later, the South Sea Bubble and Great Tulip Collapse took place. 250 years after that, we hit the Great Depression; and 80 years after that we imploded in the Subprime Crisis and Global Credit Crunch.
Sure there were plenty of hiccoughs along the way - LTCM, Asia, Russia and Latin American implosions in the late 1990s for example - but global crashes have been notable. Loosely speaking, global crisis are now occuring twice as fast as the previous ones:
1,000 years – the Roman Empire to the Medicis
400 years – the Medicis to the South Sea Bubble
250 years – the South Sea Bubble to the Great Depression
80 years – the Great Depression to the Subprime Crisis
On that basis, you could bet on the next crisis being anything between thirty and fifty years from now.2040 to 2060.So what would cause the next financial crisis? After all, we’re only just trying to get through this one. Surely we can regulate to avoid another one?Maybe not.Here’s a view you could take of the factors that contribute to the next financial collapse. I should say that it doesn’t make for fun reading, but the logic could have some grain of accuracy.2011Banks globally are heavily regulated, taxed and governed to avoid another subprime crisis. The focus is on derivatives, liquidity, capital and governance.2012The European Union struggles through a fragile and fallow period of financial and political instability with Portugal, Italy, Greece and Spain managing to just about maintain Eurozone requirements. Unfortunately, it is at the expense of citizens and governments in many of these nations. In fact, the cuts and tight budgets in these Southern member states creates a major movement of economic migrants from Southern Europe into Northern Europe, with the associated tensions and fissures appearing between Northern Europe and Southern Europe as a result. The outcome is that Europe never quite achieves the competitive economic zone it dreamed of becoming.2016China opens its markets to full financial servicing, with a rocking stock exchange in Shanghai that becomes the world’s second major investment banking city by volume and value by 2020, just behind New York This is combined with a revaluation of the Remnimbi (RMB) that satisfies their critics but worries some, particularly the USA, as the Chinese currency is looked towards by the investment community as a possible alternative reserve currency.2019Rather than creating a reserve currency for the world, the investment community creates a basket of currencies to avoid too much exposure to risk in one economy – after all, they don’t want a repeat of the 2008 crisis. The basket includes Euro, RMB and Dollar, along with Gold and other commodities. Nevertheless, the decision to place a weighting towards RMB rather than the Dollar creates issues for the USA, which has spent most of the 2010s in stagnation.2022The Middle East enters a major crisis, as oil becomes less needed as a commodity due to the rise of alternative energy sources and conversion of many motorised vehicles to electricity. Iran and Israel go to War and there is a huge effort by the United Nations to bring stability to the region. Eventually, Sovereign Wealth from the GCC outflows towards new and rising economies, such as Africa, and tensions continue to rage across the region on an ongoing basis.2025Africa’s economy is raging onwards and upwards. Like the BRICs of the 2000s, Goldman Sachs creates a new investment portfolio known as CAGES – Congo, Angola, Guinea, Ethiopia and Sudan – where natural resources of platinum, cobolt, gold, diamonds, manganese, uranium, chromium and tantalite are abundant. Johannesburg is rising fast as one of the largest world financial centres.China is now the largest trading partner and region with Africa, thank to their investments at the turn of the century. America finds this to be particularly challenging, as their view of Africa had been one of occupation and charity, rather than investment and growth, during this period. But China doesn’t care too much, as China has now become the world’s largest economy.2028American and European investment firms decide to make RMB the reserve currency of the world, and drop the concept of the basket of currencies.2032The quiet rise of India as the world’s second largest economy had largely gone unnoticed but, in 2032, for the first time China’s economy had less than 3% growth. This was put down to the lack of skills in the country where skills were needed, and is a reflection of the aging population in China and lack of new blood. China’s one-child policy of the previous century, and a distinct lack of female population for the overly male populated society that resulted, means that 2 in every 5 citizens has reached or is near retirement age. This, combined with strict immigration controls, places a strain on continued growth and industry.2039India’s continually booming economy has created frictions between their Chinese border rivals, and a Cold War commences between the two nations. Like the Cold War of the previous century, no arms are traded or battles take place, but the economic controls freeze out much of China from India’s trading partners and vice versa. The result is an economic climate where India’s investment community trade with India and China’s with China.There are ripples through the Shanghai and Mumbai stock exchanges as a result.2044India continues to see success as a stable and harmonised country. China appears to be becoming more unstable as the government struggles to maintain investment and trading, and avoid the inflationary pressures created by their exposure to investments in Africa for future commodities that can no longer be utilised.The economy fails to achieve growth rates above 1% for three quarters, and the government determines that the Remnimbi needs devaluation. This angers the USA and Europe, who have major investments in Chinese land and other illiquid stocks, along with major reserves of Chinese currency. The decisions taken by the Chinese government force them to look towards India and Africa.2050The outflow of investment by American and European investment houses from China results in aggressive currency arbitrage between the Chinese RMB and the Indian Rupee, with the latter winning as the RMB’s reserve currency status ends. The resultant big time betting against the continued stability of China causes the Cold War between India and China to spill over into skirmishes. The world sees a period of major instability ensue and the China Crisis is put down to currency speculation amongst the world’s capital markets created by complex foreign exchange instruments intertwined between the major economies.
Nothing to do with housing this time.
Jeez, that was a depressing vision and I told you this conversation wouldn't cheer you up.Thank goodness it’s just fiction.
However, if you like this sort of future conjecture and dialogue, you are welcome to join us for two more optimistic discussions (hopefully) at the FSClub in June:Monday, 07 June 2010 The Long Now of Finance A panel discussion with Professor Michael Mainelli and guestsThis evening is dedicated to a panel discussion focusing upon: "The Long Now of Finance - a Framework for the next 10,000 years". Many financiers and academics are beginning to focus upon how to invest in long-term projects that secure the planet for our children and grand children and great grandchildren. Short-term thinking is killing the planet. So how do we think long term: the Long Now, and how do we fund it: Long Finance?Long Finance is an initiative begun in 2007 by Z/Yen Group in conjunction with Gresham College, to establish a World Centre of thinking on Long-Term Finance. The initiative began with a conundrum – “when would we know our financial system is working?” and has worked on a variety of projects, including the signature program focused upon an Eternal Currency.This debate will be chaired by Professor Michael Mainelli, a cofounder of Long Finance and Executive Chairman, Z/Yen Group.Monday, 14 June 2010 The Future of Banking, a discussion with Professor Ray Barrell, Professor David De-Meza and Professor Donald MacKenzie of the Economic and Social Research Council, chaired by Brian Caplen, editor of the Banker Magazine.
The Economic and Social Research Council (ESRC) is the UK's leading agency for research funding and training in economic and social sciences.
Established in 1965 as the Social Science Research Council, under a Royal Charter, the ESRC covers a wide range of disciplines, ranging from anthropology to statistics with a budget that has grown from £73 million in 2001-02 to £204 million in 2009-10. Financial services are a key sector for the Council's business engagement strategy. The ESRC is partnering with the Technology Strategy Board on the new Financial Services Knowledge Transfer Network.
This evening the ESRC has kindly agreed to host a discussion focused upon the Future of Banking featuring three very distinguished scholars.
Professor David De-Meza is with the London School of Economics and has published many papers on banks policies in a wide range of journals. He is the on the Council of the Royal Economic Society and the Institute of Economic Affairs; Associate Editor of the Journal of Industrial Economics and Joint Managing Editor of the Economic Journal.
Professor Donald MacKenzie is a Professor of Sociology at the University of Edinburgh, with work that has constituted a crucial contribution to the field of Social Studies of Finance. He has also undertaken widely-cited work on the history of statistics, eugenics, nuclear weapons, computing and finance, and was awarded the Chancellor's Award from HRH Prince Philip, Duke of Edinburgh and Chancellor of the University of Edinburgh, in August 2006 for his contributions to the field of Science and Technology Studies.
Professor Ray Barrell is a visiting professor at Brunel University, Director of Macroeconomic research and Forecasting for the UK and World Economies, and Senior Research Fellow at the National Institute of Economic and Social Research. Previously, he has been a visiting Professor of Economics, Imperial College, London from 1996 to 2004, and was a part-time professor at the European University Institute, Florence, 1998-1999. He is on the editorial boards of Economic Modelling and was on the board of the Journal of Common Market Studies until 2007.
There’s the classic old joke about the European dream being a place where the police are English, the chefs are Italian, the car mechanics are German, the lovers are French and the bankers are all Swiss. The nightmare is that it is a place where the police are German, the chefs are English, the car mechanics are French, the lovers are Swiss and the bankers are Italians.
It seems that the nightmare is coming true, although the basket case is Greece and the bankers are German.Last week’s surprising comments from German Chancellor Angela Merkel that “the euro is in danger” and “if the euro fails, Europe fails” sent shudders across the world’s markets, and probably made Brussels shake with rage.But the Germans are shaking with rage. After Nicolas Sarkozy was rumoured to threaten Merkel with France’s withdrawal from the euro if she didn’t step up to the plate and support a Greek bailout, Germany’s citizens have been demonstrating their rage by printing deutsche marks whilst the national newspaper, Bild, is stirring anger towards the EU and the Greeks in particular with headlines such as:
"How much more do we have to pump into this country?" April 26th
"Why are we paying the luxury pensions of the Greeks?" April 27th
"Greeks ready to cut back? They would rather strike!" April 28th
As I talk to German colleagues, they refer to Greece as the Golden Fleece and that they aren’t paying bills in Greek restaurants because they’ve prepaid to 2020.All of this puts a huge strain on the European Union, in its fragile 53rd year of unity, particularly as Spain, Italy and Portugal are considered to be on a par with Greece by many, forming a Southern European Union called the PIGS [Portugal, Italy, Greece and Spain].
It raises a key question in my mind, and I’m sure all of the bankers I deal with: if the euro fails, what happens to the monetary union of banks, the Financial Services Action Plan and all those bank and insurance directives like Solvency II, MiFID and the PSD?
What happens to Chi-X, SEPA, the EBA and the rest?
In order to answer this question, you have to look at two key areas. First, is the economic and monetary union (EMU) broken? Second, if it is, do we throw away the eighteen years of change introduced by the agreement to launch the euro when the Maastricht Treaty was signed in February 1992?Let’s take the first question: is the EMU broken?We asked this question in 2005, when the French and Dutch threw out the EU Treaty. Answer: it is political union that they were rejecting, not economic union. Note: even with their rejection, and the Irish no vote, the Treaty became the Lisbon Treaty in 2010 regardless of such resistance. In other words, in the interests of the long-term vision of Europe, Europe wins.
Equally, America has taken years to gain its United status, starting with a nation of disparate states that had far less history than those of Europe. Their Union was easier in comparison, and that still took years, so Europe’s union will take time and will face many more tests.
But this is the greatest test so far.
The size of this test should not be underestimated as it is the first time that we are seeing an economic union, resulting in a cascading effect upon money and politics. Historically, the tests for Europe have been mainly about how much power is ceded to Brussels. This test is showing the inter-relationship between economies and Germany’s anguish is that if they are to keep the vision of Europe in harmony, then they have to pay for it.
Therefore, returning to the rejection of the European constitution, that was a political rejection and when a country has an economic crisis, the monetary union means that other nations pay and, as a result, that political will is tested when one nation's tax dollars are taken to pay for another nation's debts.
That is why this challenge is so much greater than any before, because it is testing the political will of citizens, not just their ability to trade and compete.
The core issue though, is that it is not just the Greek economy and Greece that would leave the Union if they were allowed to fail. It is the Union.
Should the Greek economy fail to honour their government bonds due to being economically bankrupt, the ratings agencies and banks would downgrade Spain, Portugal and Italy, and there would be a spiral effect. This means the European Union breaks apart.
That is why the Greek failure option is unpalatable ... but is the alternative palatable?
Why do we need a European Union?
Answer: Europe needs to be a Union to maintain its drive to be a regional superpower, and competitive commercially and economically with China and America. There’s the rub. If Europe fails, then the UK, Germany and France fail, as parity to compete internationally and intraregion becomes far more difficult.
This is why Greece needs the bailout and why Germans are paying.It does not help Angela Merkel maintain her status or power hold in Germany – her popularity is sinking faster than the Titanic – but if Greece fails, it is felt that Europe may fail too. And that is not an option seen to be agreeable today.Also, nations have been bailed out already.Two years ago, Spanish banks received over €50 billion worth of ‘aid’, in the form of mortgage-backed securities with the European Central Bank (ECB), when they faced a property meltdown. Did the Germans wail out about that bail out? No. Why?Because it wasn’t on the front page of the Bild. That bail out was smaller and less obvious, so no-one really noticed.The Greek bailout is a bit bigger – €110 billion – admittedly, but it is supported by the IMF and is necessary for Europe’s future. ‘nuff said, although if you want to know more, Robert J Samuelson in the Washington Post provides a particularly good overview of why Europe needs to support Greece.My summation is that Europe will survive this crisis, the euro will stay and the currently ridiculous pricing of US$1.24 to the euro will reverse within the next month or so, as forecasted by most economists.
But let’s look at the worst case scenario: what do we do if the euro does fail? Does it mean we unravel all we’ve done to date?
This is the second and, in some ways, more important question: is there a backup plan?OK, if the Eurozone breaks apart, then it matters ... but it will not throw away all that has been built to date.The banks will still want to use cross-border instruments that work. They will just bring back a margin to represent those cross-border movements whilst maintaining the efficiency of the infrastructure that has been built.As Werner Steinmuller, Head of Global Transaction Services of Deutsche Bank, stated when we researched the Payment Services Directive (PSD) and the Single Euro Payments Area (SEPA) last year: Deutsche Bank is in a comfortable situation. We spent quite a sizable amount on SEPA infrastructure and have a brand new system that is extremely capable of doing this that is also highly scalable. Others have not made this investment so this gives us a price advantage. We have built some conversion solutions for handling old volumes and now can run both old instruments and the new SEPA instruments so, if SEPA is coming, we are extremely well positioned. If SEPA fails, I can write off the investments and still win. In other words, the SEPA process has forced the banks to build new infrastructure, new systems and new efficiencies in transaction processing. That will stay. It does not go away if the euro goes away, as the new infrastructure is designed to handle efficient transactions, not euro payments. So if we look at SEPA Credit Transfers and Direct Debits, the Euro Banking Association (EBA) and STEP2 ... it will all stay. The EBA will be a private consortium to operate efficient systems, rather than a government initiative to create efficiency, and it will stay. There will be a charge for this, and a charge that could provide a substantial return to the banks that created this infrastructure, but it will not go away.The same will be true for Chi-X, and the capabilities electronic trading platforms have introduced into the European equities markets. Sure, some countries may want to block and reverse policies in these areas – Spain? – but the process of regional investing is unstoppable now. Goldmans, Merrill, BarCap and co, won’t want to see this go away, so it will remain.Bottom-line: the efficiency of European payments and investing is in the interest of banks, corporates and institutions today, not just governments and policymakers.So, if the euro fails, my answer is that the all the investment made by the financial markets in efficient systems will stay. It will just be at a profit rather than a regulation.
Some years ago, I delivered a presentation as a keynote with the title: “All Bankers are Criminals”.
I actually didn’t mean “all”.
The chicken feed, battery farmed, commercial, transactional and retail bankers are pin-stripe suited, humble pie, nice guys.
I was talking about the evil animals of Wall Street and the City.
These jungle animals hunt you down, rip out your wallet and tear your money apart note-by-note.
OK, I exaggerate a little, but you get the idea.
The first time I gave this presentation was back in Summer 2005 at a European Conference, and repeated it again in Spring 2006, as an Associate Director of TowerGroup.
The theme of the presentation mainly came from Frank Partnoy’s excellent book Infectious Greed, which traces the growth of weapons of financial destruction: derivatives, as named by Warren Buffett in his 2002 shareholder letter.
It is quite clear from this book that unchecked investment markets will run free of scruples and morals. This is what happened with Frank Quattrone of Credit Suisse and the dotcom boom and bust, along with many other examples through history.
It is not necessarily as true when we talk about arbitrage strategies and the John Meriwether’s of this world. However, these people are far more dangerous because they create financial markets systemic risk that can bring down companies and countries.
For example, in case you are wondering who John Meriwether is, he was one of the first arbitrage players and built Salomon Brothers into the big swinging dick master of the universe world so brilliantly depicted in Michael Lewis’s book Liar’s Poker.
With his colleagues, the use of arbitrage instruments led to the downfall of Salomon Brothers – they were subsequently merged into Citigroup – and Meriwether went on to create Long Term Capital Management (LTCM).
In 1998 LTCM lost $4.6 billion in less than four months and became the leading case study for how systemic risk created by derivatives products, combined with massive leverage
and arbitrage risk-models, creates a financial deck of cards. A deck that can rise and fall in the blink of an eye, with the latter potentially ruining companies, markets, countries and governments, as happened in the most recent crisis.
Anyways, not to be dissuaded from his cause, Meriwether went on to found JWM Partners, another highly leveraged "relative value arbitrage" firm. Yet again, he built leverage through this hedge fund from its opening with $250 million under management in 1999 to a massive $3 billion firm by 2007. Of course, it was all just on paper as the latest crisis battered the fund, losing almost half of its value between September 2007 and February 2009. The deck of cards strikes again. It closed in late 2009 and guess what? Meriwether’s about to launch yet another hedge fund, based upon just the same concepts.To me, this is the criminality of the financial system in action. Firms that build highly leveraged derivatives instruments for short-term arbitrage, with unproven skills and massive risk.Not that I’m calling Meriwether a criminal, as it’s all perfectly legitimate under SEC and FSA Rules.Or it was.It may be that the Goldman Sachs furore will change all this.You see, Goldman Sachs, like Meriwether, is very good at taking leverage and risk and managing the markets to gain short-term profit. Like Meriwether, Goldman Sachs succeeded in using these tools and instruments to generate massive profits. They achieved a record 131 trading days last year, in which the bank made at least $100 million net trading revenue each day.
Unlike Meriwether, Goldman Sachs managed to offload and hedge their risks back to others, such as AIG and IKB, such that when the markets collapsed their clients, suppliers and partners got burnt, but not them.Nothing wrong with that, as it’s all perfectly legitimate under SEC and FSA Rules. Unless the SEC and FSA find Goldman Sachs guilty of fraud.But how can they be guilty of a crime that was not a crime at the time it was committed?There’s the rub.I’m sure the SEC will aim to build a bulletproof case, and their cause is a worthy one: clean up the financial system. Is it worthy to do this so publicly?Not sure.Is it worthy to name the defendant up front, when the burden of proof has yet to be proven?Not sure.The Goldman Sachs case is actually more like watching a rape trial in action, where the defendant is a shifty looking guy who probably seems guilty whether guilty or not.For example, if you name someone like Jack Tweed in the UK, you might still associate him with being a rapist even though he was found not guilty.The guilt sits there, and that’s what will happen with Goldman Sachs.Whether guilty or not – and they’ve hired the best team possible to defend themselves, including “Master of Disaster” Mark Fabiani – we will always associate Goldman Sachs with something smelly for the foreseeable years to come.Ho-hum.At least all of this seems to inspire some humour. For example, in an April episode of hit comedy US TV series This American Life (TAL), they tell the story of a hedge fund that comes up with an elaborate plan to make money. It sponsors the creation of complicated and ultimately toxic financial securities while, at the same time, betting against the very securities it helped create. TAL commissioned a Broadway song to go along with the story:
The only thing that really gets me, in finishing this blog entry, is Warren Buffett.The Sage of Omaha has made his billions through prudent focus upon ‘value investing’. That means investing in strong and robust businesses like Coca-Cola, American Express, Gillette and the Washington Post. So when he referred to derivatives as ‘weapons of financial destruction’ in his shareholder letter of 2002, I respected the man and his integrity of thought.Now, having found Goldman Sachs under attack, he has stepped up to their defence, and I wondered why.Warren Buffett is an intriguing character, as we all know. The friend of kings and kingmakers, he walks a path separate to most.He knows the dangers of arbitrage, derivatives and leverage, because he had to step into Salomon Brothers in 1991 to clean up Meriwether and his colleagues mess.An extract from Carol Loomis’s in-depth review of Buffett’s experience at Salomon’s:
“You may reasonably ask what was going on in Salomon's stock while all of this was transpiring. It was emphatically down, from above $36 per share on Friday to under $27 on Thursday, when the second press release rocked the market. But the stock was only the facade for a much graver matter, a corporate financial structure that by Thursday was beginning to crack because confidence in Salomon was eroding. It is not good for any securities firm to lose the world's confidence. But if the firm is "credit dependent," as Salomon was to an extreme, it cannot tolerate a negative change in perceptions. Buffett likens Salomon's need for confidence to a mortal's need for air: When the required good is present, it's never noticed. When it's missing, that's all that's noticed.
“Unfortunately, the erosion of confidence was occurring in a company grown enormous. Salomon in August of 1991 had bulged up to $150 billion in assets (not counting, of course, huge off-balance-sheet items) and was among the five largest financial institutions in the U.S. Propping the company on the right-hand side of the balance sheet was--are you ready?--only $4 billion in equity capital, and above that was about $16 billion in medium-term notes, bank debt, and commercial paper. This total of about $20 billion was the capital base that supported the remaining $130 billion in liabilities, most of these short-term, due to run off in one day to six months.”
The result meant that Warren Buffett had to actually take over physically as manager of Salomon Brothers for a nine-month period, and it was emotionally exhausting for him.
Switch to 2010.
Warren Buffett invested heavily in Goldman Sachs in September 2008 – when Lehman Brothers, Merrill Lynch and Morgan Stanley were all imploding – buying $5 billion of preferred stock at a 10 percent dividend. These investments earn him $950 a minute, or $500 million a year today. No wonder he claims to be in love with that investment.
Trouble is that the alleged fraud at Goldman Sachs has really hit their share price. For example, Standard & Poor's downgraded Goldman
shares to "Sell" and lowered their target price by $40 to
$140 the other day.
Thinking back to Salomon's - if the firm is "credit dependent," as Salomon was to an extreme,
it cannot tolerate a negative change in perceptions - Buffett must be seriously worried about Goldman Sachs losing its credit worthiness, especially as it depends on good credit.
Oh yes, and having called derivatives ‘weapons of financial destruction’, guess what? Berkshire Hathway, Warren Buffett’s investment firm, has a massive portfolio of derivatives investments. From the Wall Street Journal last week: “Democrats took a step toward their goal of overhauling financial regulation, reaching a tentative deal to set restrictions on trading in exotic financial instruments known as derivatives. Among the considerations still in the balance: A big provision being sought by Warren Buffett in recent weeks ... the provision, sought by Berkshire and pushed by Nebraska Senator Ben Nelson in the Senate Agriculture Committee, would largely exempt existing derivatives contracts from the proposed rules. Previously, the legislation could have allowed regulators to require that companies such as Nebraska-based Berkshire put aside large sums to cover potential losses. The change thus would aid Berkshire, which has a $63 billion derivatives portfolio, according to Barclays Capital.”
Hmmm ... maybe that greed is infectious, although Morningstar Analyst Bill Bergman supports Mr. Buffett's exemption by stating that: "claiming Berkshire poses a risk to the financial system is a difficult
case to make."
Either way, the US movement towards an approval of a Financial Reform Bill to handle the issues of banks that are 'too big to fail' yesterday, takes it one step nearer to the American system taking a lead role towards a new financial architecture.
Derivatives are next ... and Warren Buffett, like Lloyd Blankfiend at Goldman Sachs and all of those current and former bankers and brokers who dealt in toxic derivatives across the world, must be worried.
Postnote: here is Berkshire Hathaway’s full commentary on derivatives from that shareholder letter back in 2002:
Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.Having delivered that thought, which I’ll get back to, let me retreat to explaining derivatives, though the explanation must be general because the word covers an extraordinarily wide range of financial contracts.Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values. If, for example, you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction – with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration (running sometimes to 20 or more years) and their value is often tied to several variables.Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands.The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem – at a price, you will easily find an obliging counterparty.When we purchased Gen Re, it came with General Re Securities, a derivatives dealer that Charlie and I didn’t want, judging it to be dangerous. We failed in our attempts to sell the operation, however, and are now terminating it.But closing down a derivatives business is easier said than done. It will be a great many years before we are totally out of this operation (though we reduce our exposure daily). In fact, the reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit. In either industry, once you write a contract – which may require a large payment decades later – you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability.Another commonality of reinsurance and derivatives is that both generate reported earnings that are often wildly overstated. That’s true because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them.Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions. In the twins scenario, for example, the two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.Of course, both internal and outside auditors review the numbers, but that’s no easy job. For example, General Re Securities at yearend (after ten months of winding down its operation) had 14,384 contracts outstanding, involving 672 counterparties around the world. Each contract had a plus or minus value derived from one or more reference items, including some of mind-boggling complexity. Valuing a portfolio like that, expert auditors could easily and honestly have widely varying opinions.The valuation problem is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.”I can assure you that the marking errors in the derivatives business have not been symmetrical.Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we’ve been in a liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind. That’s how we conduct our reinsurance business, and it’s one reason we are exiting derivatives.Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-TermCapital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM – a firm unknown to the general public and employing only a few hundred people – could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for weeks, was far from a worst-case scenario.One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes.Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.
Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
We had a fun meeting of the financial services club this week, looking at the implications of MiFID, the Markets in Financial Instruments Directive, and the outlook for MiFID II, or MiFID2 if you prefer.
I’ve referenced the revision of MiFID before and included a great white paper by Philippe Guillot of CA Cheuvreux for reference.
Equally, we now see more developments taking place, including investigations by CESR – the Committee of European Securities Regulators – that will conclude at the end of May, and covers 107 questions across a broad spectrum of issues:
Investor protection and intermediaries
Telephone recording
Execution data quality
Instrument complexity
Personal recommendations
Supervision of tied agents
Options and discretions
Equity markets
Pre-trade regime for RM/MTFs
Definition of Sis
Post trade transparency regime
Extended scope of transparency
Regulatory framework for consolidation and cost of market data
RM and MTF alignment and crossing networks
Eliminating options and discretions
Transaction reporting
New trading capacity (riskless principal)
Counterparty and client identifiers
User guidelines (how to fill in the reports)
There are also bigger issues, such as the post-trade clearing environment and its challenges. For some time, there has been reference to a Clearing & Settlement Directive for example, and MiFID2 is meant to address this.
It is also meant to address the fragmentation of trade reporting and the price tape.
It may also pop a whack at ‘dark pools’ and high frequency trading.
For all we know, it could even re-regulate the new electronic trading platforms – most of which are yet to wipe their face with a profit – and make them completely unworkable by introducing reporting rules and overheads that are as onerous as the ones that traditional stock exchanges have to work with.
Now, to be clear, we don’t know what’s in MiFID2 right now – we won’t really know until 2012 or after when the new regulation is drafted – but there are some pretty good guesses and so, in order to find out what those guess would be, we gathered an expert panel on star wars day (May 4th):
Andrew Allwright, Business Manager, MiFID Solutions, Thomson Reuters
Andrew Bowley, Head of Electronic Trading Product Management, Nomura
Hirander Misra, CEO of Algo Technologies Ltd and former COO, Chi-X
Philippe Guillot, Global Head of Trading and Execution, CA Cheuvreux
Willy Van Stappen, COO, Equiduct
to debate and discuss. Here is the outline of the evening:
For full access to this knowledge, join the Financial Services Club.
Meanwhile, there are some rapid fire changes ahead with key dates this year including:
April The FSA formed a MiFID working party and trade associations, such as FIX Protocol, ISITC, FISD and RDUG all have meetings looking at the implications of MiFID 2.
May CESR hearings on key questions and issues around MiFID2 and closure of consultation at end of month.
June
The MiFID JWG, Joint Working Group, reforms on 9th June in a meeting at Thomson Reuters.
If you're wondering what is in the document before downloading, here's the executive summary on the main answers to CESR's Call for Evidence:
I. HIGH FREQUENCY TRADING (HFT)3. What are the key drivers of HFT, and (if any) limitations to the growth of HFT?
The key drivers of HFT are all linked to the reduction of frictional costs:
Optimal latency reduces the implementation risk;
Market and settlement fees (optimisation of a maker/taker model);
Tick size.
Any change in the frictional costs of the order book has a direct impact on HFT.
4. In your view, what is the impact of high frequency trading on the market?
HFT increases the number of orders and trades being carried out on the market, decreasing the average trade size (ATS). HFT increases the trading cost for almost all players, from brokers to exchanges via the increase of complexity and memory needed to trade. HFT has no positive impact on volatility.
5. What are the key benefits of HFT? Do these benefits exist for all HFT strategies?
The benefits of HFT must be weighed against the value extracted from the markets and the extra collective costs it generates. Given that high frequency traders constantly extract value from the markets, and that activity on MTFs (mainly guided by HFT) decreases when volatility increases, it appears that when the market needs liquidity most, the HFT activity does not provide it, as it provides liquidity when it is least needed (during the market outages of November 2009, no price formation process occurred on MTFs when primary markets were closed, which means that HFT cannot be considered reliable liquidity providers). There is a disproportion between the costs supported by the markets and the supposed benefits of HFT.
6. Do you consider that HFT poses a risk to markets (e.g. from an operational or systemic perspective)? In your view, are these risks adequately mitigated?
The HFT activity raises the collective costs of trading by increasing the need for technology, anti gaming and surveillance investments. There is also no reward in terms of decreased volatility. Thus far, there is no evidence of the purported benefits of the decrease in the bid-ask spread, while the implementation costs linked to market impact have risen.
9. Do you consider that additional regulation may be desirable in relation to HF trading/ traders? If so, what kind of regulation would be suitable to address which risks?
Any increase in frictional costs is a smooth way to control the expansion of HFT. Any frictional cost components can be used to achieve this aim: increased tick sizes, minimum duration of orders, avoiding co-location, increasing market surveillance procedures that will at least increase the latency of orders.
IV. FEE STRUCTURE
Large liquidity-providing orders and small liquidity-consuming orders should pay lower fees than small liquidity providing ones (as the latter blur pre-trade information) and large consuming ones (as these create market impact and uncertainty, i.e. volatility).
1. Please describe the key developments in fee structures used by trading platforms in Europe.
Most European MTFs have adopted a maker/taker fee schedule to attract liquidity. Like other changes (tick size, co-location), fee schedules have naturally been designed to attract liquidity rather than to improve the efficiency of the Price Formation Process (PFP).
2. What are the benefits of any fee structures that you are aware of?
For investors, only the net sum of the fees is relevant. As the technological investments required to access the numerous venues available are larger than the resulting reduction in fees, no immediate benefit can be associated with the maker/taker fee schedule.
3. Are there any downsides to current fee structures and the maker/taker fee structure in particular? If yes, please describe them.
Current fee structures have a great impact on the rewards of any HF trading activity. But without regulatory constraints, their evolution is guided by the fact that they can be used to attract liquidity in one a pool vs. another one.
4. What are the impacts of current fee structures on trading platforms, participants, their trading strategies and the wider market and its efficiency?
The specificities of the maker/taker fee structure can also affect the net sum paid by investors who need to buy or sell at some point, because they have a view on the fair price of an asset (and they will have to act as liquidity consumers at some point), vs. HF traders that wait for an opportunity to arise. It is the regulator’s duty to ensure that a level playing field is maintained among the various members of an exchange or an MTF, by ensuring that proprietary orders not linked to binding market-maker activities do not receive more favourable treatment than agency orders.
V. TICK SIZE7. What principles should determine optimal tick sizes?
At present, tick size is based only on the stock price, whereas other factors such as liquidity and volatility should also be considered. Thus far, there has been no satisfactory study of optimal tick size and the constraints that tick size should place on the order book and the PFP. We urge the regulator to take measures so that tick size cannot be used as a weapon in market share battles, and to utilise it as the main lever for adjusting the order book.
For
example, Chi-X talk about High Frequency Trading (HFT) as "a means of execution that can be applied across a range of trading strategies referring to an automated trading process generated by mathematical algorithms rather than being a strategy in itself".
I suppose they would, as all their clients strategically use their automated trading process to generate arbitrage alpha through HFT.
Similarly, in response to the question: "Do you consider that additional regulation may be desirable in relation to HF trading/
traders? If so, what kind of regulation would be suitable to address which risks?"
NYSE Euronext state that the company: "strongly feels that HFT provides value to
the market by systematically capturing the short-term alpha".
Hmmmm ... nothing like short selling alpha is there?
They go on to say: "Harmonising at European level and upgrading regulators’ surveillance systems may require
changes in how regulators are funded, with a more even distribution of the burden across all
trading platforms, be they exchanges or MTFs."
In other words, harmonise the regulators structures and funding, but don't enforce stronger regulation.
Interesting.
Finally, a former speaker at the FSClub - Anthony Hilton, City Editor at
the
Evening Standard - wrote an excellent piece last week in said publication:
Much is written about how the monopoly of the
Stock Exchange has been broken since the implementation of the European
directive MiFID, which encouraged the arrival of electronic trading
platforms where customers can buy and sell shares more cheaply. What
is less commented upon is that the success of the new arrivals in
grabbing market share does not mean they are making any money ...
We are pleased to provide our fourth month of monitoring the MTF performances in
European Equities trading, in partnership with Thomson Reuters Equity Market Share Reporter (EMSR). This month is particularly interesting with the demise of NASDAQ OMX Europe - rumours are that Equiduct are interested in buying their business - and a meeting at the FSClub tonight on MiFID Wave 2 (more on this later).
* these figures
reflect auction and non-auction transparent order book
and dark pool trades, but excludes real-time and post-trade on-exchange
reported and off-exchange OTC trades in order to provide a true
comparison between the MTFs impact and the traditional exchanges.
We had a great session at the FSClub the other day, discussing the views of the corporate client and their relationship with the bank. The panel consisted of a representative for corporate treasurers; a former head of treasury ops for a major technology vendor; and the head of epayments for a large, global bank.
The corporate treasury representative kicked off the evening by discussing the key challenges for a treasurer. These are roughly summarised by:
Access to credit: the relationship between the corporate borrower and their bank has fundamentally changed as the bank now looks very carefully at who is asking for how much and what they are going to use it for;
Regulations: as the uncertainty over Basel III and OTC derivatives regulations are in flux and this could clearly change a treasurer’s portfolio of investments;
Pensions: where the resources, management and overall structure of the portfolio is being challenged, and the trustees are nervous of reactions of the fund;
Value-add: both of the treasurer and the treasurer’s bank – the corporation is looking for value-add from treasury functions and this means a clear focus upon processes, technology, employees and customer relationships
He summed up all of the above by making it clear that treasury and treasurers have a real issue right now, which is that they cannot see the lay of the land for the future. I asked him if the issue of access to credit was down to the banks tightening up so much that they wouldn’t lend, or if businesses just don’t want loans, which is what quite a few banks claim.His view was that it’s ok if you’re a FTSE100 firm and need to borrow, as the banks don’t want to upset those relationships, but that it’s far harder if you’re outside the FTSE100. Sounded like the old adage of those who owe the bank £1,000 have a problem but those who owe the bank £1 million mean the bank has the problem.The banker followed by stating that this is the ‘year of disruption’ as focus moves from Western economies to Eastern economies, and that the corporate supply chain would be radically altered as firms re-engineer for dealings with Asian economies, and China in particular.For these reasons, risk is becoming increasingly important as a factor and this is why firms are moving away from the open account style of trading popularised in the early 2000s to refocus around bank licensed relationships and letters of credit.He also felt that regulators have a real challenge here as “generals fight the war they fought before”. In other words, regulators have zero foresight, only hindsight, and that is their dilemma.
The banker went on to talk about SWIFT and the fact that the level playing field has also been disrupted.
In this context, it related to SWIFT’s post-9/11 subpoena by the US authorities to disclose any messages that might relate to terrorism. How is SWIFT meant to delineate between those that might relate to terrorism and those that do not? It’s impossible. But this means that the EU cannot agree with the USA on the information sharing rights and access to SWIFT messaging. As a result, SWIFT has to take an increasingly regionally focused approach to financial markets, rather than a global approach.
It made me wonder whether this meant that SWIFT’s role is diminished.
Strangely enough, maybe not, as the banker went on to discuss the increasingly internationalised way of doing business and the fact that the internet and, more importantly, mobile internet is making this even more the case.
Mobile internet banking is enabling many new international organisations to launch so that the old days may have been one of an Asian cash business, a European cash business and an American cash business, but it’s now a Global cash business.
Corporates are expanding globally but, in many cases, they are not big enough to split the world up into the regional structures required and expect the bank to do that for them. This means that there is an increasing focus upon the quality of bank’s service and client engagement.
The former treasury head then had their chance to respond, and said that the top of mind matters for treasury varied by company size and region; whether they were cash rich or exposed to net debt; how they fitted into the supply chain; and whether they were a retailer, manufacturer or producer.The core question for all of them however is: can I access credit, liquidity, capital, etc. For these reasons, all of them need a good sight of their cash positions and a good feeling about the strength of their banking partner(s).Her view is that it is still very difficult for a global corporate to find a single global bank relationship for these reasons, as no single bank has a global position or platform that is adequate in every geography. The question however is how many relationships do you therefore have to have: ten, twenty, thirty...She believes that treasurers will have as many relationships as required to be effective but will then use technology for virtual consolidation to provide that cash positioning dashboard on a globalised basis. In this context, being bank agnostic is the key. She also believes that the move towards open account trading is inevitable, unlike the banker, and that the procure2pay process will be reengineered to reflect this.The question then is what are the right timings for netting, pooling and positioning: end-of-day, intraday or real time?Of course, I would say real-time.The evening then went into an open Q&A, with a wide range of topics covered from the role of technology to the future of SWIFT; supply chain processes to working capital reengineered; the role of social media to the role of the EACT and EU; the bank relationship and standards to the corporate relationships and TWIST; and more.All great stuff that could form a blog entry of several thousand words but, at just over a thousand, this will doodle-do.All in all, an event that looks like it will become a stable Club meeting for years to come.Oh yes, and what’s on a treasurer’s mind?
There are so many articles and analysis into Goldman Sachs practices at the moment ...
... that I’m not going to write a lengthy analysis to add to all of these, but have picked a few of the best articles at the end of this blog entry.
What I would like to say is that the Goldman Sachs area of this blog shows that the SEC’s actions announced last Friday could be easily anticipated. From their near admittance of market manipulation in July 2009, followed in August 2009 of talk about the SEC looking at their flash trading practices; to the comments I made in January about the fine line “between making markets and moving markets that Goldman walk. It will be interesting to see how Goldman and company make markets in the future, between the Obama tax and the new regulatory regime.”This was followed by the way they had to defend themselves recently, as evidenced by Chief Executive Lloyd Blankfiend’s letter to shareholders earlier this month.
Now the USA’s SEC has announced their formal investigation of Goldman Sachs, followed by the UK FSA's agreement to coordinate this investigation across borders.
There has to be a concern about their future.
Here’s my take on it.The case for Goldman Sachs
They are the world’s most successful investment bank
They are able to create incredible profits from complex instruments
They are the preferred choice of most clients for investment advice for these reasons, and this is why they maintain their success
The case against Goldman Sachs
They are the world’s most successful investment bank ... and most of their brethren – Bear Stearns, Lehman Brothers, Merrill Lynch have imploded through this crisis
They are purely driven by greed and pay massive bonuses
They manipulate markets in their own favour
Sure the list could be longer, and sure we can argue the toss over some of these points, but overall there could be a case of saying the investigations into the bank are all driven by schadenfreude and political motivations. For example, Barack Obama presents his financial reform bill to the Senate this week, so what better timing.Nevertheless, for the SEC to have “Pit Bull” Richard (Rick) Simpson in there litigating against the bank, means that there has to something in this and that must be a worry for them. Equally with the share price dropping 13 percent on Friday and further again today, even with their stunning results of $3.6 billion profits and $5.5 billion in bonuses for the last quarter, the reputation of the bank is taking a battering.The core of this debate is the question: does Goldman Sachs make stunning profits – over $100 million every day for 131 trading days last year – by betting against clients?If the answer is yes, then it’s more a case of Sack Goldmans rather than Goldman Sachs.Best of the media coverage from The Week, via the NY Times, Reuters, Naked CapitalismWhy the SEC is going after the Wall Street powerhouse, and what it means for the financial industryThe Securities and Exchange Commission took on Wall Street titan Goldman Sachs on Friday, filing a potentially explosive civil lawsuit accusing the investment bank and one of its mortgage traders, Fabrice Tourre, of fraud. (Watch a CBS report explaining the SEC's charges.) Here's a brief rundown of the charges, and what they could mean for Goldman, Wall Street, and financial reform legislation:
What is Goldman accused of?
The SEC says that Goldman created and sold a package of mortgage-backed securities to investors in 2007 without telling them that the person who picked or approved the securities, hedge fund manager John Paulson of Paulson & Co., was betting heavily that they would fail. Goldman brought in independent fund manager ACA Management to help pick the portfolio, allegedly to make the deal seem more trustworthy. But the SEC says Goldman misled ACA, too, not disclosing that deal "sponsor" Paulson was betting against, not on, the investments. Paulson's role was withheld from investors, too.
What's Goldman's defense?
That the investors who bought the securities were given "extensive information" about the securities they were investing in, and were "sophisticated" enough to know that somebody was going to take the opposite side of their bet. Also, Goldman says that while it earned $15 million in fees, it lost $90 million in the deal, although it didn't explain how.
Who else lost, and made, money on the deal?
The investors collectively lost $1 billion, with the primary losers being ACA Capital and German bank IKB. Paulson & Co. earned almost $1 billion in profit.
Is Paulson being charged?
No. Legal scholar Alan Dershowitz thinks that was a somewhat arbitrary choice by the SEC, though, saying in The Daily Beast that Paulson "could easily have been charged with conspiracy to defraud."
How damaging is this for Goldman?
Analysts say the hit to Goldman's "seemingly invincible" reputation could be much worse than any punitive damages. Given how important trust is on Wall Street, "it's very bad for business" if your clients think "you are doing shady things," says NYU law professor Marcel Kahan. And while any SEC fine would be "really small potatoes" for the firm, Goldman's stock price tumbled 13 percent on the news Friday, erasing more than $10 billion in market capitalization. Also, Britain and Germany are mulling their own investigations, based on the SEC allegations.
Are other Wall Street banks facing similar SEC charges?
It's certainly possible. SEC enforcement chief Robert Khuzami says the agency is stepping up its anti-fraud actions, and specifically looking at "similar deals" involving other Wall Street firms. Until Friday, Goldman employees were able to "sleep soundly after collecting their huge bonuses," says The New York Times in an editorial. Since Goldman wasn't the only bank betting against its own mortgage products, "others on Wall Street may have a harder time sleeping" now, too.
What are the politics of this case?
The SEC is an independent agency, but political strategists and banking lobbyists say the Goldman fraud allegations could help the Democrats pass a financial reform bill. The House passed its version last year, and the Senate finance committee recently sent its version to the full Senate (on a party-line vote) for debate this week. Some Republicans and TV pundits suggest that the announcement was timed to help secure the bill's passage. Business Insider's Henry Blodget says the SEC also might have rushed out the lawsuit to divert attention from a damning internal review of the agency's enforcement over the past few years.
After the long analysis of Jamie Dimon’s 36-page shareholder letter, we now have an 8-page shareholder letter from Goldman Sachs.
I cannot remember such letters being of such interest in the past, and wonder if the let’s tell-all letter writing from Bank CEOs is the new fashion for the teens (or 2010s if you prefer).
Alternatively, Goldmans just don’t like being called names, since this is their longest shareholder letter ever. If anything, it appears to be a direct response to the accusation of being a Vampire Squidlobbed at them last year by Rolling Stone’s Matt Taibbi (who I’m sure will have something to say about this letter).
Mind you, if I had just dished out $16 billion in bonuses for last year, for an average pay of $500k per staffer, you could call me anything you want.
It’s noteworthy that the letter refers to ‘clients’ on at least 56 occasions. A good example being: “We are responding to our clients’ desire either to establish, or to increase or decrease, their exposure to a position on their own investment views. We are not ‘betting against’ them.”
Yea, right.
That’s why Goldman Sachs managed to generate over $100 million in pure profit every day for over 131 days of trading last year I guess, a new record.
It also defends the bank’s controversial employee bonuses, relationship with AIG and role in short-selling the mortgage market.
Here’s a summary of the really juicy bits (the last three pages):
“In July 2007, as the market deteriorated, we began to significantly mark down the value of our super-senior CDO positions.
The letter refers to Collateralized Debt Obligations – click here to find out background on this stuff.
July 2007 was a key point as Goldmans had just lost billions on their Alpha Fund, due to their algorithmic systems messing up.
“Our rigorous commitment to fair value accounting, coupled with our daily transactions as a market maker in these securities, prompted us to reduce our valuations on a real-time basis which we believe we did earlier than other institutions.
They would do this on a real-time basis because their systems are controlling ahead of the markets.
“This resulted in collateral disputes with AIG. We believe that subsequent events in the housing market proved our marks to be correct — they reflected the realistic values markets were placing on these securities.
“Over the ensuing weeks and months, we continued to make collateral calls, which were based on market values, consistent with our agreements with AIG. While we collected collateral, there still remained gaps between what we received and what we believed we were owed. These gaps were hedged in full by the purchase of CDS and other risk mitigants from third parties, such that we had no material residual risk if AIG defaulted on its obligations to us.”
What this implies is that, acting as an intermediary in the markets and as a market maker, Goldman Sachs could see the ensuing implosion in the housing markets and specifically in Credit Default Swaps (CDS) and CDOs, in real-time.
These complex derivatives were integral to their trading strategies for hedging purposes, as well as being a prime broker of these risk instruments at the same time. Therefore, they were using these hedging strategies to cash-in their insurances with AIG to get out of any risk positions early.
This is why: “In mid-September 2008, prior to the government’s action to save AIG, a majority of Goldman Sachs’ exposure to AIG was collateralized and the rest was covered through various risk mitigants. Our total exposure on the securities on which we bought protection was roughly $10 billion. Against this, we held roughly $7.5 billion in collateral. The remainder was fully covered through hedges we purchased, primarily through CDS for which we received collateral from our market counterparties. Thus, if AIG had failed, we would have had the collateral from AIG and the proceeds from the CDS protection we purchased and, therefore, would not have incurred any material economic loss.”
So they aren’t saying they screwed AIG, but they legitimately ensured they weren’t screwed by insuring someone else was. All perfectly legal and above board. Only the fittest and strongest survive and all that.
The letter then goes on to talk more generally about their involvement in the mortgage securitisation market.
“The markets for residential mortgage-related products, and subprime mortgage securities in particular, were volatile and unpredictable in the first half of 2007 (which is why they unravelled their position with AIG). Investors in these markets held very different views of the future direction of the U.S. housing market based on their outlook on factors that were equally available to all market participants, including housing prices, interest rates and personal income and indebtedness data. Some investors developed aggressively negative views on the residential mortgage market. Others believed that any weakness in the residential housing markets would be relatively mild and temporary. Investors with both sets of views came to Goldman Sachs and other financial intermediaries to establish long and short exposures to the residential housing market through RMBS, CDOs, CDS and other types of instruments or transactions.
“The investors who transacted with Goldman Sachs in CDOs in 2007, as in prior years, were primarily large, global financial institutions, insurance companies and hedge funds (no pension funds invested in these products, with one exception: a corporate-related pension fund that had long been active in this area made a purchase of less than $5 million). These investors had significant resources, relationships with multiple financial intermediaries and access to extensive information and research flow, performed their own analysis of the data, formed their own views about trends, and many actively negotiated at arm’s length the structure and terms of transactions. We certainly did not know the future of the residential housing market in the first half of 2007 any more than we can predict the future of markets today. We also did not know whether the value of the instruments we sold would increase or decrease. It was well known that housing prices were weakening in early 2007, but no one — including Goldman Sachs — knew whether they would continue to fall or to stabilize at levels where purchasers of residential mortgage related securities would have received their full interest and principal payments.
“Although Goldman Sachs held various positions in residential mortgage-related products in 2007, our short positions were not a ‘bet against our clients’. Rather, they served to offset our long positions. Our goal was, and is, to be in a position to make markets for our clients while managing our risk within prescribed limits.”
In other words, Goldman Sachs puts everything down to prudent accounting and intelligent risk management.
Maybe ... but the fact that both clients selling and buying mortgage products and complex instruments (which no-one understood except Goldmans traders and a few others, such as JPMorgan Chase, creators of Credit Default Swaps) came to Goldmans, meant that they could see very early on that more people were getting out of the housing and mortgage markets than getting in.
Why are they coming to Goldmans?
Because Goldmans market manipulating systems for high frequency trading give them the best price. This resulted in Goldmans getting out of the mire before everyone else got into it, and is why they cashed in their positions with AIG before everyone else.
They were almost acting as a primary market in and of themselves and, as a market, therefore had much greater knowledge of what was being bought and sold.
Then, as not just the market but also an investor, they invested when everyone was getting out (buy low) and were selling when everyone was getting in (sell high).
The only difference with this market being that it just happened to be the whole US housing market, based upon leverage and funding fuelled by AIG's insurances and complex hedging instruments.
The result is that Goldmans is the nimblest firm at avoiding bubbles bursting and bandwagons rolling.
It’s not illegal of course. It just means they’re far more likely to be onto a sure thing than anyone else.
So, Matt Taibbi’s claim that Goldman Sachs is “a great vampire squid wrapped around the face of humanity” is obviously wrong, and their bonuses are fully justified.
Recent Comments