Bearish on Risk Taking...

...or, "The Socialization of Capitalism, continued."

Anyone who’s ever been quoted by any of what we used to call “the media” quickly learns that the way one's words are perceived is mostly a function of context (or more correctly, the absence or distortion of it), in so many cases.

With a respectful acknowledgement of that fact, I print here a quote from the Bloomberg News website of one Charles Geisst, professor of Finance at Manhattan College. Well, out of deference to context, let me cite a few lines from the article:

The risk-taking culture that Bear Stearns represented is probably now gone for good, said Charles Geisst, a finance professor at Manhattan College in New York and author of ``100 Years on Wall Street.''

"Hopefully the surviving firms will manage their risks better and won't leave it to individual traders," he said. "As they sink into the sunset, as I suspect they will, that model they embody will as well."

Now I’m going to take issue with Mr. Geisst’s sentiments, as I read them in the context of the article (or absence or distortion thereof).

Mr. Geisst doesn’t approve of “the risk-taking culture” of Bear Stearns, which is legendary in the industry. He advocates that firms will eliminate “individual traders” from the risk management process, in favor of some “model” that is unspecified, but is suggested by the context to be a “risk czar” – either human or machine – that holds veto over any trade or position. This is an aggregated, top-down, if you will, socialistic, and flawed model. But it was aggregated risk-management algorithms that were at the very heart of the models of the structured securities that blew up in Bear's face.

As the author of a book entitled “100 Years on Wall Street” (which sounds like a good read), he ought to know that both individuals and risk-taking on Wall Street, are Wall Street. At least, they were, until the cash cow got so big that the institutional, mechanized approach to management began to take over, finally asserting itself into trading rooms.

In the recent Wall Street Journal series about the Bear disintegration (recommended), we read – not surprisingly – that it was three individual traders – including the legendary Wall Street individual trader and risk-taker Mr. Ace Greenberg – who insisted that Bear cut its risk in mortgages by hedging and liquidating prudently.

But it was the bureaucrats – the managers and executives -- who advocated what in hindsight appears to be the classic “don’t do anything until it’s too late” approach; acting like deer in the headlights of a bad trade until someone came along from outside and took control of the situation far too late to be of any benefit whatsoever to the Bear Stearns that was built (into the 5th largest securities firm in the US and an acknowledged innovator) by individuals who were risk takers.

Mr. Geisst's prescription for the aversion of (an isolated episode of) bad risk management is to replace risk-takers with some...entity, the nature of which cannot be reduced to specifics but must certainly be better than 86 years of Bear Stearns' home runs followed by one very mismanaged portfolio event. Manage risk by replacing traders means, not taking risk. A bearish stance on reality, indeed.

I rather hope for the opposite of what Mr. Geisst hopes for, and presumably inculcates into his students: I hope for individuals who know how to take risks – and in case the reader doesn’t know, on Wall Street – the one that was built by individual risk-takers – “taking risk” implies “laying off risk.” Every individual trader who lives long enough to be Mr. Greenberg’s age has learned that lesson at the beginning of his career.

I counter sentiments from the Ivory Tower with observations from the street, in my favorite way, by pointing out what is obvious: it took a trader to see a trade-gone-bad and insist on the risk-managing course of action. Had the Ace trader been closer to the action all along, I'd wager the decline of Bear Stearns would be as nearly unthinkable now as it was a mere week or two before it happened.

The further away the risk manager is from the trade – the further away the trader is from the trade – the less skin he has in the game, the less effective his judgment of the risk will be. Every trader knows that an objective opinion is an edge in risk management. All big-money-machines need to managed. Even Alex Rodriguez – an individual and a risk taker – needs to be managed. But once he starts his swing, it’s his game, not his manager's. Accountability is not being denigrated here. The denigration of individuals, risk-takers, and specifically of individual risk-takers is.

Perhaps Mr. Geisst would prefer that individual batters “sink into the sunset,” as well. The effect on baseball would be about on par with the socialization of capitalism that the removal of individual risk takers will naturally (and has naturally) cause(d) in the marketplace. It will flatten it.

Even as Wall Street is converted into condominiums right before our eyes, as the industry is hard-coded into black boxes and outsourced, I say, "No. Bring back the individual. Bring back the risk taker. Or lose the crowning jewel of America: the heart of capitalism."

It wasn't PsD's that brought down Bear. PhD's, maybe.

Word Association

What do The New York Times, the Apocalypse, Banks, and Starbucks all have in common, besides the fact that they all appear, in unrelated comments, in this post? Probably lots of things, none of them of any concern to me at this moment. All I needed was a way to tie them together in the same paragraph.

I rarely read the Times, for the same reason, I suppose, that I don't read the Enquirer: I don't trust it. But I do concede that the Times has a bunch excellent craftsman churning out really delightful, if dubious, pieces.

However, I spied a headline in the neighbor's Times this morning as it lay on the stoop, and made a mental note to look into it later. The story is about how HSBC took a hugh-mongous beating on its 2002 acquisition of Household Finance and Beneficial, America's big subprime lenders. That's no news flash, but the angle of the piece was that this acquisition was The Deal That Fueled Subprime; and while it may be, the story won't convince you. (I don't know how long that link will be good; you may have to hunt the NYT site if you want to actually read it, in the event it expires.)

It's really "Business Lite," but that's not why I'm writing about it here. I'm doing that because the piece makes the following assertion:

Securitization was based on the fiction that financial engineering could turn risky loans into risk-free securities.

Bosh! This is itself a fiction. I can't recall ever seeing, in any official document or any commentary, the claim that any securitized assets were "risk-free." That's probably because claiming they are would be like claiming cars could be made to run on seawater. All "financial engineering" (a term I've never, ever agreed with, even when I was studying it), did, with the aid of computer power that wasn't available a few short years ago, was allow financial instruments to be created from pools of assets, and enable the clever attribution of the characteristics of such aggregates.

The characteristics of the loans -- their terms, risk profiles and cash flows -- are aggregated (it is a pool, after all) and then re-arranged and divvied-up again in a way that is entirely customizable, within the parameters of the pooled characteristics. Like all things designed to appeal to the "sophisticated," the sliced-up assets were given a french name: "tranche," meaning, of all things, "slice." In this, at least two notable things occured: Wall Street prefigured Starbucks by at least a decade, and a high-water-mark in truth in advertising was reached.

Some of the slices were first in line to receive their prorated cut of the cash flows from the underlying loans. Some were last, and some were in-between. Where the slice fell on this hierarchy determined it riskiness with regard to the rest of the slices, and hence, its debt rating. This isn't engineering so much as it is high-powered, labor intensive accounting. But the computers make the intensiveness of labor a moot point. And computers do things mathematically. And engineers speak "math." So high-powered accounting became known as "financial engineering." This can be likened to the pencil and ledger opening up accounting possibilities that were simply too labor-intensive in a world dominated by the abacus. Nothing new under the sun, indeed.

To some extent, all accounting is "fiction," but it's very useful fiction. The accounting one does doesn't affect reality, it only does bold things to one's perception of it, semantically. The loans that are pooled didn't change, but their characteristics are micro-managed.

Nobody would ever say such pools were "riskless," but the pro's and con's of this micro-management are perhaps both misunderstood and misrepresented, at various times, willfully and not so willfully.

In that environment, with the help of a little grease to the skids, bond insurers found they could do a pretty good business by selling insurance on these asset pools. Insurance is a business of averages -- statistics -- and we all know what they say you can do with statistics. In any event, the purchase of a misguided rating -- Triple-A, for example -- from a government-sanctioned rating agency might go along way to overcoming, in the mind of the manager of large pools of investment capital, any visceral trepidations regarding such newfangled instruments. It might, in other words, fog one's judgment. In any case, a rating ensured that someone was on the hook financially in the event that one of these nifty financial robots went berserk and started killing the pilots of the great spaceship that Wall Street had become.

And, of course, the transformation of a pool of loans into a synthetic "bond" can, by commoditization, encourage a new flow of capital to wash into the asset class (which it did, even if it can be argued by supply-side logic that the availability of all that capital spawned the creation of something else for it to flow into, after all known rivers and tributaries had been submerged); and it did replace bankers with pensioners as risk takers on ever-more ill-conceived mortgages. The move of a giant like HSBC into that market would certainly increase the volume of such transactions. This much of what the article floats makes some sense.

The term "riskless" is a theoretical, financial-math term (referring to government agency debt issues) that is roughly analogous to the term "frictionless" in physics. In high-school you learn that "frictionless" is a convenient myth, that it's factually, but not relatively, untrue. Nobody builds buildings by making any assumptions about frictionlessness being a fact. And nobody -- n.o.b.o.d.y, especially Wall Street sharpies -- takes the term "riskless" literally.

Now, about this Times piece. Admittedly, there's a great deal of misconception (willful and otherwise) surrounding all things finance, and the volume of misconception is proportional, surely, to the area of newsprint (or airtime, or book titles, or Internet links, etc) that is devoted to any particular topic. Considering how many column-inches have been spent on reporting the "financial crisis," this indicates the presence of a great deal of misconception, indeed.

We humbly admit to a small amount of this here. The comments on how CDS's sink protection-sellers still need some fleshing-out. But the operative word here is "admit," and, by the way, in case you haven't noticed, this is not the New York Times. I don't get paid six figures for writing this, I don't get invited to posh parties in Manhattan, and I don't have a cool business card. The upside of this is at least twofold: I can maintain a clean conscience when I write and nobody will ever call this blog the "Gray Lady."

Mojo Nixon wasn't a fan of banks. And I'm not a fan of Mojo Nixon or banks, but I'm glad he wrote a song called "I Hate Banks." Parenthetically, I wonder what it says about us culturally that it takes (what used to be) a character from the outer fringes of the edges of mainstream to say what we all feel: banks are probably really just fronts for little satanic outposts.

I say this as one who has worked for, interestingly, a bank that was concurrently the world's largest (by assets) and its smallest (by market capitalization). Continuing the theme of opposites, banks have been, for most of my lifetime, places of arrogance (on their part) and humiliation (on the customer's part). How many times has the teller smirked at you while refusing to cash the check you brought in, because you don't look like the person on your license, or some such inanity? Banks are the roach-motels of finance: money comes in, but it doesn't go out.

How many times have you been late making a deposit (even if you weren't stalling) and gone to the ATM to get a few bucks for a date and found out that you bounced twenty checks and are now in the hole $510 ($500 in NSF fees, and ten bucks for the lousy check you wrote at the grocery store). Chastened, you enter the bank on Monday, to find the manager has installed a limbo-pole in his office that he expects you to grovel under, while the staff watches with glee, doing shots of tequila and placing bets on "how low you can go."

Yeah, banks are not often associated with happy memories for most of us. Yet I've discovered something so rare -- a bank lobby that has really nice people working there -- that I had to comment on it. Sure, it's Wachovia, the same bank that surprised (and temporarily bankrupted) an acquaintance by illegally seizing and freezing his account, just because some bill-collecting lawyer sent an official looking (and fraudulent) fax to them. But when the pickings are slim, you take the bad with the good. It's Wachovia on 42nd and 1st, and the usual lobby staff is beyond stellar. They act like real people. Not all of them, of course, but enough, and often enough, that it's noteworthy.

If you had to start the apocalypse, how would you do it? Here's one suggestion: start refashioning your administration, if you're president of the United States, as anti-Israel. It's that simple. You don't come out and say that, of course, but if you start appointing in strategic roles the sorts of people who espouse that particular insanity that expresses itself as an irrational hatred of Israel, you'll get the ball rolling. Because what that does is it shows all those countries that have institutionalized the hatred of Israel into law and policy that the US is no longer going to stand behind the tiny, eternal hotspot at all costs, like a great, big brother staring down bullies.

The deterrent to bullies, once removed, invites all manner of mischief. Bullies push, and test, and torment, and they never stop, until and unless they're stopped. And if the bullies have stated perennially, repeatedly, and unequivocally, their longing for the complete and utter destruction of your little sibling, there's no reason to expect them to stop, until....

If you're Israel, a) you're not stupid and b) you're not weak and c) you're gonna prepare to kick some serious ass because your tormentors are emboldened by the absence of meaningful reality-checks to their insanity.

Now, if you manage to do this in a time when one particularly loony regime is known to have the ability to make nuclear weapons, you just might get your Apocalypse.

It's easy, really.

Finally, in solidarity with the multitudes who have recently "downsized" their lives (especially myself) I have not only moved to more reasonably priced digs, but I didn't bother to subscribe to an Internet provider there. Sure, my inner sloth reasoned that I'd find a wireless network in the building that wasn't password-protected (it was wrong; they're getting harder to find than solid-silver quarters); but the better part of me relished the idea of having to discipline and organize my Internet access, planning for outings to some public access point.

As it turns out, there's a Starbucks right around the corner, and since I was recently gifted with a Starbucks gift card, the decision about where and how to do things online was pretty much made for me.

I'm a Dunkin' Donuts man all the way, at least pre-corporate Dunkin' Donuts. But I'm also open to having my horizons expanded, and accordingly I've actually imbibed in that caustic brew known as Starbucks coffee. One mid-morning I went crazy and had a refill, and I did not get to sleep that night. They do, however, sell a great Plain bagel.

I may say more on the Starbucks culture, later, but just now I'm overdosing on the caffeine. I would like to observe, in closing, that the place is frequently jammed with online jobseekers, and that can't be bad for coffee sales.

I guess that's a good thing for all those poor farmers in Brazil, eh?

[this piece is a work in progress, which means I'm my own editor. This ain't the Times, remember?]

Frankenstein at College

The enduring name “Frankenstein” must surely be some indication of how indelibly effective the half-man half-machine hybrid creature is as a horror story device. There is an analogous creature in economics, and it is all the more scary because it’s not a work of fiction: you cannot walk out of the theater and make it go away. It is the species known as government-sponsored enterprise. Its kind are known by quaint sounding monikers like “Fannie-Mae” or “Freddie-Mac.” While these are names that make you think of your cousins down South, don’t be fooled by them. The damage these creatures can inflict is real. The half-man part of the GSE acts like a regular private enterprise. It enters into a market and competes with regular private enterprises. However, because of the half-machine part – the “government sponsorship” – it has competition-devastating advantages of cost and scale that can enable it quickly to dominate the market, driving out genuine private enterprises. Now Frankenstein has access to the marketplace but is immune to its main guidance system: competition, and thus the monster may undertake an unrestrained haywire binge.

GSE’s don’t have to make money. It would be nice if they did, but it isn’t essential for their survival. Thus this frightening Frankenstein has, unluckily, a power-supply that is as close to a perpetual-motion machine as is known to man: a taxpayer subsidy. Eek. This horror can destroy the market and taxpayer wealth virtually indefinitely, leaving in its wake all the evils associated with “bad money:” a schizophrenic, distorted market, deprived of the healthy competition which regulates prices and forces a measure of quality; a legacy of bad management decisions that includes unwise investments; a financial black-hole which sucks up money and sends it who-knows-where.

Today we consider for a moment a recent story about kissing-cousin Sallie Mae – the Student Loan Marketing Corporation. Her job is to subsidize student loans. If you’ve noticed that “higher education” just isn’t what it used to be, she just might be the main reason why. Like a tramp at the prom, her virtues are illusory. Her image of sanctity – that pesky government sponsorship – makes her appear to be as safe as a US Treasury bond to the capital markets, so she was -- until the credit markets began reevaluating the depths of taxpayer pockets -- able to borrow all she wanted without having to pay the risk premium that a real private enterprise would have to pay. Amassing mountains of cheap money (aka “bad money”), her job is to entice higher people to finance higher education by borrowing from her at below-market rates (the competition-killer) and to entice education institutions to enroll students to loan that money to. This they are glad to do, because they are in business, it appears, to do just that: manufacture degrees, and the more the merrier. No less eager are the young, apprently, to hang out on college campuses being cool thanks to easy-to-obtain-deferred-repayment-low-cost-loans.

Mass production is rarely associated with the highest quality, and never was it more rarely associated with it than in the mass production of college graduates. Mass production is instead a useful way to stamp out countless identical components to be assembled into roughly identical products. The defective gizmo in the process is the one that isn’t like its millions of peers. It’s the outlier, the non-conformist, the part whose dimensions aren’t so much like all the others as to be indistinguishable from them. The application of such standards of conformity might be a laudable in the production of blenders or automobiles or cans of cat food, but when applied to people it’s called “mediocrity.” Its long term effects on a society remain to be seen, but the early indications are frightening.

But we digress. The inspiration for this little yarn was the article in Bloomberg about Sallie Mae’s efforts to refinance $11 billion in bonds coming due in the next year. It seems that they have recently lured buyers for $1.5 billion at 8.25%. Marvelous. Or not so. After all, the Fed Funds rate at this writing is 0.18%. Sallie is paying nearly double what you’d pay to finance a home for 30 years on a fixed-rate basis. This isn’t as sweet a deal as a GSE might have demanded in happier times; it appears, however, to be very sweet for the buyers of the debt. A bailout by any other name is still a bailout, even if it's for bondholders. The market seems to be assessing a risk premium after all, despite the taxpayer backstop.

Another annoying detail is that the interest that Sallie receives on her student loans – her bread-and-butter -- is fixed at 5.6%, a guaranteed loss of 2.65% for Sallie – well, actually, for Sallie’s “government sponsor”, that is, we the taxpayers. If they make such arrangements with the remaining $9.5 billion coming due, the loss will be $291,500,000.00 over the term of the notes (that's almost a third of a billion dollars). Do you see what we mean by “bad management decisions?” Bear in mind that this deficit will itself have to be financed, likely at higher rates. You might want to scratch second homes, luxury cars, vacations, and other non-essentials (like a college degree?) off your budget for the remainder of your lifetime.

In the article in question, some “expert” is quoted as saying that Sallie Mae “is in a virtuous cycle right now.” If a guaranteed 3% loss on $11 billion is virtuous, I’d hate to see what Sallie’s like when she’s wanton. This does raise questions for us: what with the multi-trillion-dollar deficits that have become so fashionable so fast these days, might there be some future scramble to raise cash when said deficits just as suddenly go out of fashion? What lengths will Frankenstein go to in order to make up for that $333,000,000.00 loss? What claim will it lay upon futures recipients of those mass market degrees? And where did that expert get his degree, at Sears and Roebuck?

Sallie is only half-machine. She’s also half-man – that is, she acts like a genuine private enterprise, and has enjoyed the benefits of the private enterprise system with none of the responsibilities. But when her borrowing costs arise, she might find it more difficult to mint taxpayer losses under some future, more responsible administration. This would remove her luster of irresistibility: her cost advantage. She would definitely be less attractive to would-be borrowers under such circumstances. She would have seen better days, like the harlot who becomes an old maid. Her doom was inevitable, and obvious to anyone paying attention.

It’s an ugly prospect. The world will be better off without her, but it would have been better if she’d never shown up to begin with.

Lagarde Proposes, Bernanke Disposes

We briefly recap, for your convenience:

Item: Dominique Strauss-Kahn is temporarily and falsely accused of sexually assaulting a hotel "maid" in New York City. "DSK" is eventually released, but not before being summarily removed as head of the International Monetary Fund.

Item: Christine Lagarde, top Chicago labor/antitrust lawyer, finds herself in charge of the global monetary authority.

Item: DSK is on record against using the IMF "as a fist" to bully nations (such as Iceland or perhaps Germany) into making loan guarantees. Lagarde gives no indications of suffering any such scruples.

Item: At the annual Jackson Hole Fed Economic Summit, Lagarde announces that the scheduled IMF speaker has "graciously" given her his slot at the podium (in addition to having been removed from his job). From that podium comes what we have named the Lagarde Dictum: after stating, with her global authority, that said globe was about to enter a "downward spiral", Lagarde instructs "the US and Europe to abandon fiscal austerity and switch to stimulus measures" .

Item: As if on cue, the US and ECB central banks echo her. First, Chicago Fed president Evans:

"the central bank should move 'aggressively' to reduce unemployment, even at the cost of temporarily pushing inflation higher."

Next, ECB head Jean Claude Trichet:

...threats to the euro region have worsened and inflation risks have eased, giving officials the option to take further action should the debt crisis worsen...

And finally yesterday, Fed Chairman Ben Bernanke, in his own passive-aggressive voice, at a speech in Minneapolis:

...A substantial fiscal consolidation in the shorter term could add to the headwinds facing economic growth and hiring...[in Lagarde's terms, "abandon austerity"]...prepared to employ these tools as appropriate...[in Lagarde's terms, "switch to stimulus measures"]...[oh, yeah]...we see little indication that the higher rate of inflation experienced so far this year has become ingrained in the economy...[we see inflation but it's not "ingrained."]

It is doubtful that anyone believes that the Fed or the ECB can do anything now to "stimulate economic growth." Certainly this is Mohamed El Arian's opinion, which we find ourselves in agreement with:

Pacific Investment Management Co.’s Mohamed El-Erian said the U.S. faces “serious” economic challenges, including lagging housing and labor markets, that will prove resistant to Federal Reserve stimulus efforts.

According to Bloomberg, he continued:

The world is undergoing a “historical” realignment akin to “tectonic plates shifting,” which is focused on balance sheets, growth dynamics among different countries, and policies or politics, he said.

“The key issue any risk manager faces today is that too many parameters have become variables,” El-Erian said. “A cyclical mindset is not sufficient given the world we live in,” he said. “ You need to think structurally.”

Mohamed must read this blog, for just yesterday we postulated:

you can bet on more "stimulus measures." "Aggressive" ones, to be sure, but we look for novel ones, desperate ones, unheard of ones (we've speculated on some here).

We're certain Christine Lagarde and the rest of the Chicago Gang that seems to be everywhere at once these days is "thinking structurally."

El Arian Smells the Coffee

Bloomberg headline: Europe Close to Banking Crisis: El-Erian. Close? Europe is "close to a banking crisis?" Where has this guy been for the last month?

One need look no further than the first paragraph of the piece to see what's on El Arian's mind: he's just another mouthpiece for IMF head Christine Lagarde:

Pacific Investment Management Co.’s Mohamed A. El-Erian said organizations such as the International Monetary Fund need to act with European banks at risk of being engulfed in the region’s sovereign-debt crisis.

The bottom line on all this is that "cooperation" of the "greater","more aggressive" and "broader" variety, with copious amounts of Geithner's "political will" is to be encouraged, persuaded, and eventually enforced to make it look as though everyone's debt is no longer going to swallow all the wealth the human race has ever and will ever create. As Geithner intimated, the "rich nations" are going to have to bail out "the weak ones." We're talking, for the record, about unified, global socialism, full-blown and out of the closet, as if that needed to be pointed out.

We foresee things getting messy, ugly, confusing, and nonetheless resulting in such "cooperation" and "unity" and a new financial order as described elsewhere in this venue.