Economic Rebalancing

The global economy is horribly out of balance, with the United States going deeper into debt each year as a result of a huge trade gap. This blog describes the process of global economic rebalancing. If you have any comments or questions about the posts here, please don't hesitate to use the comments section.

Saturday, July 22, 2006

Wall Street's Risk Game and Rising Volatility

As the global rebalancing process continues, much stress will be put on the American financial system. The great depression began with a major collapse of the banking system, with small depositors losing their life savings and banks losing their ability to lend. While our government has taken measures to protect against the specific problems that arose in 1932, the financial sector has found ways to magnify the total systemic risk manyfold. How the financial system handles a rise in volatility and risk aversion will be well worth watching in the coming months.

Businessweek ran an article last month entitled Inside Wall Street's Culture Of Risk that provides a nice overview of how the big investment banks have shifted their business models toward generating trading profits, while at the same time introducing tremendous systemic risk to the greater economy. As this is a mainstream media article, there is a conscious effort to avoid stating how bad things really are or make accusations as to the hidden motives of the players involved.

For those who don't have the ability to read between the lines, I'm glad to provide my own observations and context. I suggest opening the article in another window and reading the whole thing while following along as I quote from the article in italics and add my own comments:

"Wall Street has always been about taking risk. But never has the "R" word been such an obsession for the men and women who rule the nation's biggest investment banks."

Never have the profits been so large. Never have the government and fed been so thoroughly controlled by Wall Street. Never has it been so easy to transfer the full burden of Wall Street risk taking to Main Street.

"Goldman Sachs' CEO Henry M. Paulson Jr. has led the charge. Major Wall Street firms have watched with envy as Goldman has repeatedly racked up record earnings on the strength of its trading business."

And now he's taken on so much risk at Goldman that he had to take over the reigns himself as chief plunge protection officer. And he traded in 10s of millions in annual compensation for a government salary. Things must indeed be getting interesting on the street.

"Now, virtually all banks are making huge bets with their own assets on many more fronts, and using vast sums of borrowed money to jack up the risk even more."

If it was just their own money it wouldn't be so bad. However, they've created tremendous systemic risk. Everyone they've borrowed from is at risk. All of their counterparties are at risk. Everyone who works for their counterparties is at risk. The whole economy is at risk.

"What's more, banks are jumping into the realm of private equity, spending billions to buy struggling businesses as far afield as China that they hope to turn around and sell at a profit."

Buy the whole business and you can book it almost any way you like. Turn a money losing stock bet into a guaranteed profit overnight... never mind the bloodstains from the red ink.

"If banks succeed, they'll rack up even bigger earnings. But if they borrow too much money for their trades or take on more risk than they can manage, the wreckage could be considerable."

Success on past bets has largely been achieved by taking on ever larger new bets. It's a big ponzi scheme, and the question isn't one of whether it will work, but rather one of how long it will work.

"As the banks trade in ever-more-obscure products with ever-more-opaque clients such as hedge funds, observers worry that they might not be able to settle their trades in the event of a market shock, intensifying the damage."

That's putting it mildly.

"Suspicions are rising that bank traders are acting on nonpublic information gleaned from their clients."

Count the Fed and the Treasury Department among their clients, and that's probably the mildest way that the game's been rigged.

"The Securities & Exchange Commission has "very active examinations and investigations under way," says Lori A. Richards, an agency director."

There you go, Lori. Find us a couple of scapegoats so that we can pretend the rest of the crowd isn't robbing investors blind.

"Yet for all the risks they're taking on, banks insist they're safer than ever. They've hired many of the greatest mathematical minds in the world to create impossibly complex risk models."

It takes a really good theoretical mathematician with no real clue as to how the market works to come up with a model that says everything is OK.

"And traders have been feathering banks' nests for five years."

That's why the next Goldman boss was their most successful trading guy.

"They've produced record earnings and boosted asset bases to unheard of sizes, making even bigger bets possible."

That's not just the model for Wall St. It's the model for the entire US economy: Book false profits... leverage up... book more false profits... leverage up...

"The degree to which risk management has evolved in the past few decades is astonishing, say analysts."

What's astonishing is that the American public has allowed Wall Street to risk their own security.

"Some on the Street argue that such confidence is misplaced, and that the relative stability in the global markets since 2003 has lulled traders into a false sense of security."

That false sense of security is the only reason for having confidence.

"One senior bank executive thinks so. He worries that at any moment volatility could spike to levels never seen before."

Read volatility as a collapse in asset prices and the rapid disappearance of wealth. Why worry? Better just plan for that rise in "volatility."

"How the markets will respond to such an event "is up in the air," says Leslie Rahl, president and founder of Capital Market Risk Advisors Inc., a New York-based consultancy. That's because banks are dealing more with unpredictable clients like hedge funds and in less familiar financial products like derivatives of derivatives."

"Up in the air" or "up in smoke?"

"On the very next page of the JPMorgan report, the bank tells investors that losses could have soared to as much as $1.4 billion over, say, a four-week period last year if an abnormal event had occurred."

Not quite what the report actually said. Rather, they said " Based upon the Firm's stress scenarios, the stress test loss (pre-tax) in the IB's trading portfolio ranged from $469 million to $1.4 billion..." Of course JPM designs their own scenarios and I doubt they included the full potential of their derivative hedging bets blowing up on them when "volatility" soars.

"Goldman's Paulson was asked to talk about his readiness for a big blow to the financial system. Paulson issued a litany of warnings. The main risk measure Goldman discloses, VAR, "always assumes that the future is going to be like the past," he said. And even though the bank regularly uses many different models to test its resiliency to various disaster scenarios, no one can correctly predict where the next disaster will come from."

Sounds like Greenspan saying that nobody can correctly predict when a bubble is forming. Why'd you change jobs, then, Hank? Dedication to public service?

"banks' aggressive moves into trading threaten to scare off clients who wonder where they will rank if a panic triggers a sell-off. Will the bank perform its fiduciary responsibility to its client and execute its trades, or will it cover its own hide?"

When the markets are going craziest, it provides the best cover for Wall Street firms to screw their clients.

"Big firms can no longer subsist on underwriting or stock and bond trading as the combination of more rivals and cheap electronic trading drives down profit margins. "Wall Street doesn't get paid to not take risk anymore," says Merrill Lynch & Co. financial-services analyst Guy Moszkowski. The big investment banks add value by "absorbing the risk that their clients are looking to get rid of.""

And risk these days is really just a euphemism for profiting through accounting fraud.

"Businesses that once accounted for most of the profits at investment banks are now viewed more as gateways that lead them into the lucrative land of risk."

The only way to stay in the game is to play along.

"More surprising, banks are also regularly agreeing to buy huge blocks of stock from trading clients even when they know they will likely lose money on the trade. It's a high-risk, low-reward endeavor designed to keep clients coming back to pay for more lucrative business in the future."

It's also a good way to keep the markets propped up and prolong the game a little longer.

"In the bond markets, money managers ring up traders routinely and ask them to bid on messy multibillion-dollar portfolios of bonds and other financial products with expiration dates ranging from 2 to 10 years. "You have a trader committing in one or two minutes to a trade that could lose or make tens of millions of dollars," says Thomas G. Maheras, head of capital markets at Citigroup."

That's an interesting turn of events. It used to be the traders calling the managers and ramming trash down their throats. Now the traders don't mind eating the garbage that the managers are dumping back on them. Heck, it'll all blow up soon anyway. Give me any old trade so I can book a profit, please.

"Risky though the trading may be, it's the forays into private equity that keep many risk managers awake at night. Fully formed companies are the hardest assets for banks to get off their books if things go wrong; just try selling a pipeline in the middle of a financial panic."

Risky in the real world, yes, but easiest to fudge in the fantasy land of financial reports. And that's the world that matters when bonus time comes around at the end of the year.

"Wall Street moves in cycles of excess. Before the current cycle turns, the odds are good that at least one bank will take things too far. That's what happened in the '80s, when banks churned out an array of new products like junk bonds and created whole new markets for them, then abused those markets for their own ends. It happened again in the '90s as bankers cashed in on the Internet bubble. "There's always someone who doesn't see that the turning point has been reached," says Frank Fernandez of the Securities Industry Assn."

Ummm... "one" bank?

One thing the article doesn't mention is how market volatility decreased dramatically from 2002 to 2005. Meanwhile, Wall Street ran up great profits by selling derivative protection against volatility. Fed policy of letting banks create almost unlimited liquidity amidst a backdrop of very slowly rising interest rates has been extremely helpful to the firms absorbing risk through the derivatives markets. Consequently many firms have taken on tremendous amounts of risk, jeopardizing the stability of the entire system.

I don't care for the VIX or other wall street measures of volatility, opting instead to calculate my own measures based on daily highs and lows. Here's a chart giving an indication of what I've seen volatility do in recent years:

Volatility began a significant uptrend about the time Japan began reducing its treasury holdings. The market appears to be getting away from the tight control of the Fed and its main constituents. Volatility will continue to be a major indicator for me of how much trouble is brewing in the financial system.

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