Several weeks ago, The Lamb announced that he would be accepting submissions for Guest Posting. Today, we inaugurate this concept with a post from Hank (name changed to protect the camera-shy).  Hank works as a bond trader for a foreign bank on Wall Street.  Below, he comments on the current financial tsunami, how we got here, who’s to blame, and what should be changed.

Without further adieu, The Lamb presents Hank:

I’m asked at times by those outside of the financial business how this mess could have happened. Although my background isn’t in subprime mortgages or CDOs, but in another corner of the credit markets, the attitudes that led to this blow-up and the subsequent bailouts are the same.  The truth is that everyone with any sense at all saw this coming for years, but too much money was being made in the meantime to worry about what might happen when the music eventually stopped.  And stop it did.

Back in the last recession earlier in the decade, credit traders were licking their wounds, like they are now.  The Federal Reserve drove rates to 1% and saved the day.  Soon it became obvious that there was a lot of cheap money sloshing around the system.  The economy was set to boom for some good reasons (tax cuts) and some bad ones (very low interest rates).

With threats of deflation (“We’ll be like Japan!”) still out there, the Fed was in no rush to raise rates after the immediate economic slow-down was past us.  Meanwhile, traders were looking at their daily profit & loss statements and finding that momentum was turning in their favor.  Activity was way up.  Cash kept coming into their markets and increasing the returns of their bond positions while the costs they incurred (the interest they paid for the money borrowed to hold their positions) were staying relatively low.  Seemingly every day that they sat on these high-yielding and out-of-favor credit positions they were making money.

In early 2004, bonuses were being paid again at the banks for traders who made money in 2003.  And you made money in 2003 if you were smart enough to convince your managers to let you hold on to your underwater positions.  Later in 2004, the stock markets began to drift lower as the Fed began to raise interest rates once again, and some were calling for a return to the recent lows in the stock market.  But the smart traders realized that there was just too much cash in the system to let that happen.  Sure, interest rates were moving higher, but the spreads on their bonds (the differences between the cost of owning bonds and the interest rate paid by those bonds) remained very enticing, or at the very least, positive.

By 2005, the markets were briefly smacked down on concern that General Motors would go bust.  It should have, but it didn’t.  And as an aside, if there were worries about automakers at the absolute peak of the availability of consumer credit, these guys don’t have a chance to survive as going concerns now.  But the markets moved past this.

And this is when the real troubles began.  For the next two years, the typical trading desk went from having a split of traders with positive outlooks and negative outlooks to being universally convinced that their best interest was in owning as much credit risk as their banks allowed.  How did this happen?  The traders who were paid bonuses were paid based on their share of their firm’s and their group’s profits.  The ones who weren’t paid were the ones who didn’t own enough risk, who didn’t buy into the new paradigm.  If you made a ton of money in 2004, you were paid.  If you didn’t, you weren’t paid and, even worse, in the eyes of your manager you were wrong.  Traders learned that to keep their jobs, they had to compete for profits and the only way to do that was to take more and more risks.

2005 should have been the end of the bubble, but it took another two years for it to pop.  The Fed should have acknowledged that risk-taking was out of control, but they didn’t.  Congress should have realized that lending standards for mortgages had become non-existent.  They only had to watch the ads that lenders were running to realize it was too good to be true, but the lobbyist cash was too good to pass up.  For those traders who were cautious or prudent with their firm’s capital, it was a nightmare.  You could fight the trend for only so long before losing your job, and many gave in to the momentum of the bull-market hoping that they could get out before it collapsed.

Phrases heard in 2006-2007:

“There’s a wall of money out there!”  This was supposed to mean that there was so much cash out there (sovereign, hedge fund, etc) waiting on the sidelines to buy into the market that to fight against the trend and bet against rising asset prices was basically career suicide.  The reply to that statement, “It’s not cash, it’s leverage… and leverage can unwind quickly,” was dismissed as ridiculous.

“It’s the Rio trade.”  This meant that the trader had built such a huge position (with the firm’s permission, by the way) that she would either get paid massively or she would take her prior earnings (and her severance) and take a year on the beach if it didn’t work out.

“Clients love him.”  This is the answer to the question of why a bank would hire a trader who was just fired from another bank because he blew up and lost a ton of money.  Another answer might be: “He’s comfortable taking risk.”  No kidding!  But he’s bad and reckless at it.  But no matter, it’s a competitive business and every shop wants the best!  As the CEO of Bank of America said last year, roughly, “Making money for four years and then giving it all up in the fifth is not a business model.”

A few logical steps to diminish the chance that credit traders blow up banks again:

Investment banks should not be public companies.  They should be partnerships.  This will automatically limit the size of the risks that their underlings put on their books.

Sadly, deposit-taking institutions should not be allowed to position credit risks for trading purposes, outside of generic commercial lending.  Now that the remaining large investment banks have converted to bank holding companies, they should be severely restricted in their risk-taking abilities.  The government can not subsidize glorified hedge funds.

Credit derivatives allow risk-taking at banks without cash being put up at the start of the trade (for now anyway).  There are collateral requirements with counterparties currently, but there should be cash requirements involved in putting these trades on the books comparable to what there are with bonds.  Actual costs that will come out of a trader’s P&L should be levied at the start of any credit derivatives trade.

Revert to the reputed Bear Stearns model of old:  traders will not get paid for any “positive carry.”  Traders should be forced to make their budgets based on their trading skills (turning over positions, buying low and selling high).  “Buy-and-hold” shouldn’t get rewarded.  If a trader puts the firm’s capital on the line and then simply clips coupons on bonds, the firm should not be allowed to reward him for it.  From what I was told years back, this was the policy at the old Bear Stearns of the 1990s.  They should have stuck with it.

More regulation for investment banks is inevitable and justified.  Let’s face it, managers at investment banks are lemmings.  If one ambitious investment bank allows a return to the old rules (allowing carry, etc.), a typical bidding war for talented risk-takers will emerge and all the bad habits will return.

Banks should throw the Value-at-Risk (VAR) models out the window.  These models gauge the riskiness of bonds or other assets basically by looking at their historic volatility (how much their prices bounced around in the past).  Forget that the products themselves only existed for perhaps a few years during an economic upswing and a bull market.  If the notional risks are big compared to the bank’s capital, cut the positions.  This leads to the next point…

Regulate rating agencies.  When accused of negligence or worse, they often fall back on the argument that they should be protected by their “freedom of speech.”  This is absolute rubbish.  They are getting paid for advice on financial products and they should be held accountable.  Of course, it’s an imperfect world and they make judgments that may prove incorrect at times — they should be given some slack.  But the conflicts of interest, sloppiness and laziness in this ratings business is endemic.

Investors need to stop whining.  You lost money in GM?  Why in the world did you own this credit?  They’ve been in decline for decades.  Anyone who didn’t see this coming should be banished from the industry.  Your subprime AAA portfolio was wiped out?  Did you even read the prospectuses or think for a moment that Moody’s might be wrong about their valuations for an essentially new product?  And besides, can you honestly claim to be shocked that there was a housing bubble and that it eventually had to burst?

One-by-one, traders set aside their disbelief over the last five years.  They thought the right thing to do was to buy as much risk as they could.  It’s what their employers wanted them to do and they were to be rewarded for it.  While twenty years ago trading was dominated by skilled market-makers (it really is a talent), over the last five years these dinosaurs disappeared and were replaced by two new types of traders:  the “quants” and the “monkeys.”

The quants are traders who employed models to tell them (statistically) what was a good bet.  This is despite the dearth of statistical data (and its relevance).  After all, financial markets are not driven by natural laws but often by psychology and unpredictable cycles.  The monkeys are traders who only know “buying.”  Buying risk is equal to profits for their banks and for them.  Each of these new class of trader never understood, never paused to think about, and never really cared about the risks that he would be taking on if the music stopped.  And they all blew it.

If we’re lucky, the risk-taking will be left to the professionals (at investment funds that are “disposable” in that they are not too big to be allowed to fail) and the market-makers will return to the banks.These amateurs should go back to studying physics (the quants) or simply kicked out of the business (the monkeys).

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The Lamb is cynical by nature.  He is a paid-up subscriber to the axioms “If it sounds too good to be true, it probably is,” and “Where there’s smoke, there’s arson.”

Recently, a friend of The Lamb, Adam (name changed to protect the imprudent), told him about a new website called OneSeason.com.  Adam is a willing, though very suspicious, participant in the OneSeason market.  Essentially, this site allows “investors” to buy and sell shares in their favorite players and teams from the world of sports.  There are both primary and secondary markets.

In the primary market, OneSeason conducts initial public offerings (IPOs) of shares for both teams and players (with a price set at $5 per share) via an allocation algorithm.  These shares are then traded in the secondary market, splitting if/when the price reaches $20 per share.  The company makes money by charging commissions of 5% on IPOs and 1% on secondary trades.  Presumably, fixed and variable costs are de minimus. 

Now for the fun part.  Unlike traditional shares of company stock which entitle the holder to a fractional ownership of that company’s net profits, holders of OneSeason shares simply own the bragging rights to a given player or team.  Unfortunately, bragging rights, much like gold and vacant land, are not positive carry investments.  Then again, land and gold are both tangible assets and offer at least the potential of capital appreciation.

Of course, OneSeason shares can go up in value.  An investor simply has to find someone to pay a higher price than he paid — the so-called “greater fool theory.”  The Lamb certainly feels that OneSeason participants are entitled to purchase shares as they wish – (The Lamb’s Rule #5 — “You pay your money, you take your choice.”)  However, he feels that OneSeason has essentially created a somewhat mitigated pyramid scheme.  This “venture” differs only slightly from the early 20th century Ponzi Scheme. 

Charles Ponzi's Mugshot

The product (service?) OneSeason sells has no intrinsic value save for the aforementioned bragging rights of player/team cyber-ownership.  This may be a good time for potential OneSeason participants to repeat to themselves The Lamb’s Rule #2 — “Know and understand what you own.”

One may ask how this is any different from owning a baseball card or even a work of art.  The difference is that in owning one of these two types of positional goods, an investor has possession of a tangible item, and more importantly, one which is of finite supply– 

Pablo Picasso is not going to be composing many more paintings, and the American Tobacco Company threw away the mold for the T206 Honus Wagner baseball card nearly a century ago.

As amazing as it seems to The Lamb that this market exists, more incredible still is that it has actually spawned websites for OneSeason investors (again, the term “investors” is used extremely loosely here) to exchange opinions and information about share prices of players and teams, much like websites devoted to fantasy football/baseball enthusiasts.  Sites like OneSeasonNation.com and OneSeasonTrader.com garner far more hits than does your editor’s humble corner of the blogosphere.

Trade shares at OneSeason.com if you wish.  But keep The Lamb’s Rule #4 (An asset is only worth what someone else is ready, willing, and able to pay for it) safely in the front of your mind. 

Right now, Adam is wishing he had remembered it…

General Motors is an iconic American company.  Unfortunately, the time has come to put this company out of its misery.  We must page that infamous doctor from GM’s home state of Michigan, Dr. Jack Kevorkian, and have him euthanize this patient in order to end its suffering.

GM is currently trading at its lowest level since around World War II.  It has lost over 86% of its value in just the past six months.  According to Bloomberg.com, “GM has not posted an annual profit since 2004, and sales in the U.S., its largest market, have declined every year since 1999.”  Analyst Rod Lache of Deutsche Bank yesterday cut his 12-month price target on the stock to zero.  ZERO! 

Via Barrons.com:

On Friday, GM announced a loss of $2.5 Billion, over $4 per share.  This is greater than its current share price of barely over $3!  And according to Barrons.com, “excluding a $4.9 billion gain on union cost-savings and other extraordinary items, GM lost $4.2 billion, or $7.35 a share.”

But don’t take Wall Street’s word on it.  Ask GM itself.  In a regulatory filing yesterday, it said:

Based on our estimated cash requirements through December 31, 2009, we do not expect our operations to generate sufficient cash flow to fund our obligations as they come due, and we do not currently have other traditional sources of liquidity available to fund these obligations.

But valuation is the least of our problems.  Our problems?  Yes.  GM has traveled hat in hand to Washington begging for financial assistance.  Along with Ford and Chrysler, the Big Three have asked for up to $50 billion (so far) in government money (which, lest we forget, is our money) claiming that the automobile industry in integral to the American economy.  They have apparently already found a sympathetic ear in President-Elect Obama. 

From Bloomberg.com:

“Rahm Emanuel, chief of staff to President-elect Barack Obama, said the U.S. auto industry is “essential” to the economy.” 

“Essential” is debatable.  But The Lamb would say that there is certainly no systemic risk to the economy in allowing GM to fail, as was the reason given for bailouts of AIG, Fannie Mae, Freddie Mac, etc.

Would a GM bankruptcy be painful to many people?  Absolutely.  From The New York Times:

About three million American jobs are directly tied to the Detroit automakers, said David Cole, chairman of the Center for Automotive Research in Ann Arbor, Mich.

The handwriting has been on the wall for years.  GM is now burning through over $76 million per day!  Surely, that money can be put to better use.  With automobile sales and the general economy trending downward, giving money to the auto industry now is tantamount to throwing it away by prolonging the inevitable. 

The situation reminds The Lamb of a scene from one of his favorite movies, Rounders.  In it, Mike (played by Matt Damon) asks Joey Knish (John Turturro) for a loan (paraphrased to avoid profanity):

Mike:  [I don't need a lesson from you right now.]  What I need from you is money.  I need whatever money you can give me.

Knish:  See that’s the thing.  This time, there is no money.  If I give you [some], what’s that buy you?  A day?  Nah, if I give it to you, I’m wasting it.

Mike:  (Sarcastically) That’s [just] great.

Knish:  You did it to yourself.

If we simply must give money to the Big Three, how about earmarking it for job training so that workers in the auto industry can learn new job skills and continue to contribute productively to the American economy?  $50 billion for 3 million workers equates to over $16,000 each.  Why do we continue to treat the auto industry as some sacred cow that must not be slaughtered?  Let’s help workers in this industry learn new skills and embark on new careers that will have long-term benefits for them and for the rest of the country.

Today, General Motors is simply a large health-care conglomerate masquerading as a car company.  Its employees, thanks in no small part to the efforts of the United Auto Workers Union, enjoy some of the finest health benefits on the planet.  This unsustainable cost structure is not something that has occurred overnight.  It has been going on for years, with everyone hoping and praying that it would somehow change.  But it hasn’t.  It has grown worse.  Much worse.

In 1952, during his Senate confirmation hearing to be President Eisenhower’s Secretary of Defense, Charles E. Wilson, former head of General Motors, famously stated, “What’s good for General Motors is good for the country.”  This may have been true more than fifty years ago, but it sure as heck ain’t true today.

Note:  This post is in no way meant to endorse, oppose, compliment, or impugn any person or political party.

Monday, January 28th, 2013

President Palin sat alone in the Oval Office wondering if the plan she had developed with her financial S.W.A.T. Team would be enough to extricate the country from its latest economic crisis.  She was barely one week into her first 100 days in office, and things were going from bad to worse.  She thought back to her predecessor and the challenges he faced during his four years in her position.

It was late summer 2009 and the previous year’s credit crisis already seemed like a distant memory.  The 0.125% federal funds rate and enormous federal bailout programs appeared to have stabilized the financial markets.  The Dow had clawed and scratched its way back above the 11,000 mark and there had been a nearly one year absence of major corporate failures. 

However, the easy monetary policy masked a deeper dilemma.  With memories of 2008 still fresh in their minds, financial institutions remained fearful of committing capital for longer-term projects.  As many banks began facing maturities on their debt, rollovers became a looming problem.  The 2008 guarantee of bank debt issuance had failed to lower term funding costs significantly as investors had grown leery of just what that U.S. government guarantee was really worth.

With small and large banks alike experiencing growing funding difficulties, President Obama called on Treasury Secretary Lawrence Summers to find a solution.  Working with Fed Chairman Robert Rubin, who had reluctantly assumed his position after Ben Bernanke had been “asked” to leave by the President, Summers embarked on a bold solution. 

Loathe to face the specter of another large bank failure, the duo ordered (the official stance was “strongly encouraged”) the marriages of the country’s few remaining “super” banks.  Goldman Sachs was sent kicking and screaming into the arms of Citigroup, and Morgan Stanley was reunited with its ex-spouse JP Morgan.  The restriction on any institution holding more than 10% of total U.S. deposits was conveniently repealed.

Unfortunately, this failed to stem the rising tide of consumer bankruptcies.  Credit card debt was now crippling the country.  By late 2010, credit card debt in the United States had skyrocketed from $27 billion in 2007, past the 2009 level of $96 billion (estimated by NBC News), to a staggering $200 billion, as households tapped any possible source to pay for day-to-day living expenses.

Faced with a public outcry and using the 2008 bank bailout as precedent, President Obama ordered Secretary Summers and Chairman Rubin to enact a freeze on all credit card interest charges effective as of December 1st, 2010.  To mollify the credit card companies, the Treasury would begin making the interest payments on all balances as of this date, though at a rate of just 9%.  Though this was below what they were currently slated to earn from consumer balances, the credit card companies acceded to the plan as it dramatically reduced their allowances for bad debts and strengthened their deteriorating balance sheets.

Financial blows continued to batter the global economy.  South American nations, borrowing more and more money in an effort to grow their own economies out of the three year recession, faced spiraling inflation.  Playing their trump card, they threatened an oil embargo against the U.S.  With oil already having soared above $350 per barrel after the June 2011 Israel-Iran War and the American public demanding a reprieve from crippling gas prices, the United States approved low-interest loans to Brazil, Venezuela, and Argentina in exchange for their promise to maintain the flow of oil.

The dire financial straits of consumers and declining property values culminated in much lower tax receipts for municipalities, just when this money was most badly needed.  California, already buckling under huge fiscal strains and unwilling/unable to repeal Proposition 13, in early 2012 became the largest municipal bankruptcy on record, easily eclipsing Orange County in 1994, Alabama’s Jefferson County in 2009, and even the 2011 State of Arizona filing.

In an effort to forestall cascading municipal failures which threatened to paralyze essential state and local services from education to police and fire departments, in the summer of 2012 Congress passed the Municipal Assistance Rescue Program (MARP).  The MARP allowed state and local governments to borrow money interest free from Uncle Sam for up to three years.

However, as the conga line of municipalities lining up to take MARP funds grew, the national debt soared, as did interest rates on everything from U.S. Treasury securities to home mortgages.  Inflation, that scourge not seen since the late 1970s, skyrocketed past 12% and the U.S. Dollar, already battered by the proliferation of government bailouts the past four years, sank like a stone. 

Many banks were now unwilling to make loans in dollars, fearful of the currency’s continued depreciation and unable to effectively hedge themselves in the increasingly illiquid foreign exchange markets.

As summer turned to fall with the economic and financial landscape looking increasingly bleak, the nation elected its first female president — Senator Sarah Palin of Texas.

Sitting in the Oval Office, President Palin greeted newly appointed Fed Chairman Timothy Geithner.  The President wanted reassurance that her campaign pledge of lowering inflation and crippling interest rates could be accomplished.  The Chairman, taking a page from one of his predecessors, Paul Volcker (who had raised the federal funds rate to as high as 20%), reiterated faith in their plan to raise the funds rate from the current 10% all the way to 18%.

In response to the President’s hesitancy to increase rates, Chairman Geithner explained its necessity in wringing inflation out of the system.  The Chairman admitted that he had learned his lessons from the ill-planned bailout binge that he had helped orchestrate and sustain as President of the Federal Reserve Bank of New York during the presidencies of George Bush and Barack Obama.  He said that the country now needed to take its financial medicine, no matter how bad the taste, in order to cure the disease of inflation.

Besides, he elaborated, raising short-term rates might be enough to reverse the outflow of foreign capital that had been occurring for most of the past year.  China and Japan, for example, had sold nearly $1.5 trillion of dollar-denominated debt, mostly U.S. Treasury and Agency securities.  America’s runaway inflation had shaken their faith in its ability to service its debt, now owned predominantly by foreign governments.

If this did not work, Geithner worried, the country might be forced to return to some version of the gold standard, not seen in the United States since President Nixon abandoned it in 1971.

As February turned to March and March to April, the economic climate began to improve.  Data showed that foreign capital was returning to the U.S., taking advantage of higher short-term yields.  As inflation fears abated, fixed-rate mortgage rates dropped precipitously, falling below the psychologically important 10% level.  Even the Dow had closed above the 5,000 mark for the first time since late 2011.

The country was learning (forced?) to live within its means after an arduous period of stagflation.  Long-gone were the days of easy credit and government safety nets.  But a more disciplined and realistic debtor-creditor relationship had emerged, one which held the promise of stable prices and moderate long-term growth.

When the United States was in its infancy (actually all the way through puberty), everyone had the right to vote.  Everyone, that is, who was a white Anglo-Saxon Protestant adult male who legally owned property.

Today, November 4, 2008, you need only be a (registered) adult citizen in order to have a say, albeit indirectly, in how your country functions.  You have the right, The Lamb would say the obligation, to have your opinion count in determining the laws, rules, and regulations that will govern you.

You will undoubtedly disagree with at least some of the results in today’s myriad elections.  Good.  Continue to work to change things which you believe are unfair, which you know are wrong.  Fight (nonviolently) for your voice to be heard. 

Today, take the first step in making this country as close to your ideal as possible.  You will never completely succeed, but making your opinion known is just as important.

“Always vote for principle, though you may vote alone, and you may cherish the sweetest reflection that your vote is never lost.”  — John Quincy Adams

“Individual rights are not subject to a public vote; a majority has no right to vote away the rights of a minority; the political function of rights is precisely to protect minorities from oppression by majorities.” — Ayn Rand