Category Archives: Derivatives

Commodities Tank

We’ve been sayin’ the commodities runup and the fixation on inflation looked like a rerun of spring 2008: a liquidity-fueled hunt for inflation hedges when the deflationary undertow was stronger. That observation is now looking to be accurate.

But what may prove different this time is the speed of the reversal. With investors acting as if Uncle Ben would ever and always protect their backs, markets moved into the widely discussed “risk on-risk off” trade, a degree of investment synchronization never before seen. All correlations moving to one historically was the sign of a market downdraft, not speculative froth. And as we are seeing, that means the correlation will likely be similarly high in what would normally be a reversal, and that in turn increases the odds that it can amplify quickly into something more serious.

Why Does Reputation Count for So Little on Wall Street?

There is a very peculiar article by Steven Davidoff up at the New York Times: “As Wall St. Firms Grow, Their Reputations Are Dying.” It asks a good question: why does reputation now matter for so little in the big end of the banking game? As we noted on the blog yesterday, a documentary team was struggling to find anyone who would go on camera and say positive things about Goldman, yet widespread public ire does not seem to have hurt its business an iota.

Some of Davidoff’s observation are useful, but his article goes wide of the mark on much of its analysis of why Wall Street has become an open cesspool of looting and chicanery (as opposed to keeping the true nature of the predatory aspects of the business under wraps as much as possible).

On Economics of Contempt’s Reliance on His Own Brand Fumes

Economics of Contempt is aptly named. While his stand alone pieces on various aspects of regulation are informative, if too often skewed towards officialdom cheerleading (he too often comes off as an unpaid PR service for Geithner), his manner of engaging with third parties leaves a lot be desired. He often resorts to the blogosphere version of a withering look rather than dealing with an argument in a fair minded manner. This then puts the target in a funny position: do you deal with these drive-by shootings which have either not engaged or misrepresented your argument, by cherry picking and selective omission? If you do, you can look overly zealous or argumentative. But if you do nothing, particularly if it’s in an important area of regulatory debate, you’ve let disinformation, at the expense of your reputation, stand.

So How Exactly Does Buffett Get Information Like This?

Reader Hubert soliders on in the lonely task of continued Lehman spadework. He highlighted this section of FCIC testimony from Warren Buffett:

I think that if Lehman had been less leveraged there would have been less problems in the way of problems. And part of that leverage arose from the use of derivatives. And part of the dislocation that took place afterwards arose from that. And there’s some interesting material if you look at, I don’t exactly what Lehman material I was looking at, but they had a netting arrangement with the Bank of America as I remember and, you know, the day before they went broke and these are very, very, very rough ﬁgures from memory, but as I remember the day before they went broke Bank of America was in a minus position of $600 million or something like that they had deposited which I think J.P. Morgan in relation to Lehman and I think that the day they went broke it reversed to a billion and a half in the other direction and those are big numbers.

Hubert muses:

The FDIC’s Rosy, Theoretical, Misleading Lehman Resolution Counterfactual (or Why TBTF is Still TBTF)

The FDIC has released a document that purports to show how it could have successfully resolved Lehman Brothers using its new Title II resolution authority granted under Dodd Frank.

All I can say is that this is an interesting piece of creative writing. The Lehman counterfactual rests on a series of assumptions, which as I will discuss shortly, look pretty questionable. The most charitable assessment one can make comes from a famous exchange between two technologists. Trygve Reenskaug says: “In theory, practice is simple.” Alexandre Boily asks: “But, is it simple to practice theory?”.

But some longstanding Administration cheerleaders have jumped on the bandwagon, arguing that “pundits” have asserted “without evidence or analysis” that the resolution authority can’t work. That’s pretty amusing, given that Shiela Bair herself concedes, per the Financial Times, that the resolution authority will not work on a major international bank with retail and investment banking operations:

Senator Levin Claims Goldman Execs Perjured Themselves Before Congress on Mortgage Testimony

As readers may know, the Senate Permanent Subcommittee on Investigations just issued another report, Wall Street and the Financial Crisis. This is a far more focused and damning document than the Financial Crisis Inquiry Commission report, which was produced at considerably more expense and was undermined by dissent among its commissioners (which in fairness appears to have been by design).

I confess to having only gotten partway through the document and plan to issue a more thorough discussion in the next few days. However, some things are clear at this juncture.

A suspicious sniff at CoCos

Contingent Convertible bonds (“CoCos”) are supposed to address this nonsensical phenomenon: During the financial crisis a number of distressed banks were rescued by the public sector injecting funds in the form of common equity and other forms of Tier 1 capital. While this had the effect of supporting depositors it also meant that Tier 2 capital […]

Rationalization of Biggest Foreign Bank Bailout Misses Regulatory Failure

Some aggressive spinning on the Fed data releases about its lending during the financial crisis has surfaced at Bloomberg (admittedly with some less favorable facts also included). The Friends of the Fed and other Recipients of Largesse are defending the central banks’ panicked and indiscriminate responses to the crisis. These efforts to rationalize emergency responses fail to acknowledge underlying regulatory failings that remain unaddressed.

The PR push surrounds the foreign bank that got the most support during the post-Lehman phase, namely, Dexia.

Magnetar Strikes Again: JP Morgan Negotiating Settlement with SEC on Toxic CDO

As longstanding readers of this blog presumably know, we broke the story of Magnetar, a Chicago-based hedge fund. Magnetar was arguably the biggest player in driving toxic subprime demand through its program of creating hybrid CDOs (largely consisting of credit default swaps, but also including cash bonds by design).

Magnetar constructed a strategy that was a trader’s wet dream, enabling it to show a thin profit even as it amassed ever larger short bets (the cost of maintaining the position was a vexing problem for all the other shorts, from John Paulson on down) and profit impressively when the market finally imploded. Both market participant estimates and repeated, conservative analyses indicate that Magnetar’s CDO program drove the demand for between 35% and 60% of toxic subprime bond demand. And this trade was lauded and copied by proprietary trading desks in 2006.

As a source who worked in the structured credit area of a firm that did Magnetar trades explained in ECONNED:

OMG, Greenspan Claims Financial Rent Seeking Promotes Prosperity!

I was already mundo unhappy with an Alan Greenspan op-ed in the Financial Times, which takes issue with Dodd Frank for ultimately one and only one disingenuous and boneheaded reason: interfering with the rent seeking of the financial sector is a Bad Idea. It might lead those wonderful financial firms to go overseas! US companies and investors might not be able to get their debt fix as regularly or in an many convenient colors and flavors as they’ve become accustomed to! But the Maestro managed to outdo himself in the category of tarting up the destructive behaviors of our new financial overlords.

What about those regulators? Never never can they keep up with those clever bankers. Greenspan airbrushes out the fact that he is the single person most responsible for the need for massive catch-up. Not only due was he actively hostile to supervision (and if you breed for incompetence, you are certain to get it), but he also gave banks a green light to go hog wild in derivatives land. And on top of that, he allowed banks to develop their own risk models and metrics, which also insured the regulators would not be able to oversee effectively (there would be a completely different attitude and level of understanding if the regulators had adopted the posture that they weren’t going to approve new products unless they understood them and could also model the exposures).

And the most important omission is that the we just had a global economic near-death experience thanks to the recklessness of the financial best and brightest.

Complexity and War or How Financial Firms Wreck Economies for Fun and Profit

There’s a great post up, “Human Complexity: The Strategic Game of ? and ?,” by Richard Bookstaber, former risk manager, author of the book A Demon of Our Own Design and currently an advisor to the Financial Stability Oversight Council. As insightful as it is, Bookstaber does not draw out some obvious implications, perhaps because they might not be well received by his current clients: that the current preferred profit path for the major capital markets firms is inherently destructive.

I suggest you read the post in its entirety. Bookstaber sets out to define what sort of complexity is relevant in financial markets:

The measurement of complexity in physics, engineering, and computer science falls into one of three camps: The amount of information content, the effect of non-linearity, and the connectedness of components.

Information theory takes the concept of “entropy” as a starting point…

Satyajit Das: Controlling Sovereign CDS Trading – The Dysfunctional Debate

By Satyajit Das, author of Extreme Money: The Masters of the Universe and the Cult of Risk (Forthcoming September 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

In an opinion piece entitled “Hedging bans risk pushing up debt costs” published on 9 March 2011 in the Financial Times, Conrad Voldstad, the chief executive of the International Swaps and Derivatives Association (“ISDA”) and formerly a senior derivatives banker with JP Morgan and Merrill Lynch, made the case against the EU ban on “naked” credit default swap (“CDS”) contracts on sovereigns.

Just as “patriotism is the last refuge of a scoundrel”, arguments citing market efficiency and the benefits of speculation seem to be the first resort of dealers.

Quelle Surprise! Geithner Gutting Dodd Frank via Intent to Exempt Foreign Exchange

I have mixed feelings about an article by Robert Kuttner, “Blowing a Hole in Dodd-Frank.” On the one hand, he’s found an important example of the Administration’s lack of interest in meaningful financial reforms, which is its intent to exempt foreign exchange derivatives from the implementation of Dodd-Frank. But his discussion of what this matters at critical junctures confuses foreign exchange cash market trading with derivatives and thus leaves the piece open to criticism.

Kuttner warns that Geithner has signaled strongly his preference to exempt foreign exchange from Dodd Frank implementation:

Treasury Secretary Timothy Geithner is close to a decision to exempt the $4 trillion-a-day foreign-currency market from key provisions of the Dodd-Frank Act requiring greater transparency in the trading of derivatives. In the horse-trading over the final conference version of that legislation last year, both Geithner and financial-industry executives lobbied extensively to give the Treasury secretary the right to create this loophole.

A New “Whocoulddanode” Defense, This Time of Coddling Banksters in the Crisis

I hate shooting the messenger even when he lets us know that he is a tad invested in the information he is conveying, but sometimes it is warranted. Floyd Norris now tells us that maybe it wasn’t such a good idea to have been so generous to the banks during the crisis. He cites the usual reasons: the recovery is shallow, the officialdom missed the opportunity created by the crisis to restructure the financial system, sparing bondholders created moral hazard, and we are now stuck with banks in the driver’s seat. His lament, as the headline accurately summarizes, is “Crisis Is Over, But Where’s The Fix?”

The problem is that his account is larded with a rationalization of the decisions made at the time to treat major financial firms with soft gloves:

At the time, rescuing seemed more important than reforming. The world economy was breaking down because of a lack of financing. Trade flows collapsed, and companies and individuals stopped spending. It seemed clear that halting the slide was critical…

A surprising citadel of that second-guessing is at the International Monetary Fund, where researchers this week concluded that the rescues “only treated the symptoms of the global financial meltdown.”

“Second guessing” is simply misleading.

Shades of 2007: Synthetic Junk Bonds

Aha, the level of financial innovation spurred by super low interest rates is starting to have that “I love the smell of napalm in the morning” feel to it.

The Financial Times reports that there is a frenzy to create synthetic junk bonds, ostensibly to satisfy the desire of yield-hungry investors. Any time you see a lot of long money flowing into synthetic assets rather than real economy uses, it’s a sign that Keynes’ casino is open for business (“When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”)

The author compare this development to that of the asset backed securities CDO market, one of our betes noirs which blew up spectacularly in the crisis. There are some similarities and differences.