Interestingly, the BW article that Michael posted makes no mention of the
Russian default that involved the Long-Term Capital Management crash. I
note this after just reading Fictitious Capital, Real Debts: Systemic
Illiquidity in the Financial Crises of the Late 1990s by Anastasia
Nesvetailova in the Winter 2006 Review of Radical Political Economics.
From ANs abstract: This article focuses on the issue of systemic
illiquidity as a key component in the financial crises of the late 1990s.
The article critically revisits Minskys financial fragility hypothesis,
advancing his insights into the analysis of crises in East Asia, Russia and
the United Sates in the late 1990s. Three key factors of these crises are
identified and explored: financial liberalization, progressive illiquidity,
ad the debt burden incurred during the periods of investor euphoria.
Seth
To: [email protected]
Subject: Risk
From: michael perelman < [EMAIL PROTECTED] >
Date: Sun, 11 Jun 2006 17:10:04 -0700
User-agent: Thunderbird 1.5.0.4 (Windows/20060516)
--------------------------------------------------------------------------------
We have been briefly discussing risk. Here is an excellent Business
Week article. Notice the reference to some traders enjoying risk, as
Doug mentioned.
JUNE 12, 2006
COVER STORY
Inside Wall Street's Culture Of Risk
Investment banks are placing bigger bets than ever and beating the odds
-- at least for now
On the 31st floor of a skyscraper overlooking Times Square one recent
spring day, a dozen or so of Lehman Brothers Inc.'s (LEH <javascript:
void showTicker('LEH')> ) top executives filed into a conference room to
run through risks, relive past financial crises, and worry about new
ones. They analyzed how much money the firm might lose if the markets
were buffeted like they were after the terrorist attacks of 2001. They
pored over complicated risk models showing how tens of thousands of
trading positions and financial contracts with clients would fare in the
event of an Avian flu epidemic. They tested all conceivable scenarios
that might put Lehman in harm's way. "We are in the business of risk
management 24/7, 365 days a year," says Chief Administrative Officer
David Goldfarb.
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 they had to reconcile so many bets
made on so many fronts. The conditions have been ripe. Historically low
interest rates and relatively calm markets in the last few years have
allowed a new type of firm to flourish, one that acts primarily as a
trader and only secondarily as a traditional investment bank,
underwriting securities and advising on mergers.
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. The biggest
stunner came in March when Goldman announced that in three months it had
tossed off $2.6 billion in profits -- nearly half as much as it earned
in all of 2005 -- on $10 billion in revenues. Not coincidentally,
Goldman also put a record amount of the firm's capital at risk of
evaporating on any given trading day. Its so-called value at risk jumped
to $92 million, up 135% from $39 million in 2001. "[Goldman is] a horse
of a different color now," says Samuel L. Hayes III, professor emeritus
of investment banking at Harvard Business School.
As Paulson prepares to move to Washington to serve as U.S. Treasury
Secretary, Goldman shows no sign of easing up. Nor do its followers.
This trading boom, fueled by cheap money, is fundamentally different
from the ones of the past. When traders last ruled Wall Street, during
the mid-'90s, few banks put much of their own balance sheets at risk;
most acted mainly as brokers, arranging trades between clients. 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. They're shouldering risks for their clients to an
unprecedented degree. They're dabbling in remote markets from Brasilia
to Jakarta, and in arcane products like credit-default swaps and
catastrophe bonds. Led by Goldman, many investment banks now do more
trading than all but the biggest hedge funds, those lightly regulated
investment pools that almost brought down the financial system in 1998
when one of them, Long-Term Capital Management, blew up.
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. With $25 billion of
capital under management, Goldman's private equity arm itself is one of
the largest buyout firms in the world, according to Thomson Venture
Economics. The moves are not unrelated to trading. In both cases, banks
are flocking to exotic and inaccessible markets where there aren't many
others to fight for profit. Counterintuitively, they're seeking out the
investments that would be the hardest to get rid of in the event of a
disaster. They're betting, in other words, that handsome returns when
times are good will make up for losses when things turn ugly.
THINNER SAFETY CUSHIONS
So far, the rewards are justifying the risks: Big investment banks are
booking record profits, and their stocks have zoomed, up 64% since 2001.
But once-calm global markets are getting rocky as interest rates rise,
choking off the easy money. Fears of more rate hikes to come have
triggered sell-offs in stocks, bonds, and currencies around the world
since early May.
That's raising the stakes for arguably the biggest game of risk ever to
play out on Wall Street. 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. "A
world where huge amounts of leverage have been brought into the system
is a dangerous world," Berkshire Hathaway Inc.'s CEO Warren Buffett
observed at his most recent annual meeting. And "as interest rates
rise...people will stretch even further and take greater risks," warns
John H. Gutfreund, senior adviser at the investment bank C.E. Unterberg,
Towbin and former CEO of Salomon Bros. Andy M. Brooks, head of equity
trading at investment manager T. Rowe Price Group Inc. (TROW
<javascript: void showTicker('TROW')> ), puts it more bluntly: "If
people step out too much, they're going to get whacked."
Just as investment banks are taking more risks, so are millions of
individuals. They've bid up prices and accepted thinner safety cushions
in the past few years on commodities, international stocks, and shares
of the riskiest U.S. companies. Penny-stock trading has soared, up 640%
from three years ago. Gambling and casino stocks have risen sharply in
recent years. And home buyers have leveraged up, buying more expensive
houses with more complex mortgages. "Investors seem to be displaying
signs of pure fearlessness," James Montier, global equity strategist at
Dresdner Kleinwort Wasserstein, summed up recently. Says James Grant,
editor of /Grant's Interest Rate Observer/ and a financial market
historian: "The world is stretching for return." The last time investors
stretched so far, during the dot-com boom of the late '90s, the results
were disastrous.
But the biggest danger may be on Wall Street. 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. "The
heartburn," says Robert Fuller, the principal and founder of Hopewell
(N.J.)-based financial adviser Capital Markets Management, "could be
anywhere from something you can cure with a Tums to death by trauma."
It might not take a major meltdown to send bank profits tumbling:
Scandals might get them first. Suspicions are rising that bank traders
are acting on nonpublic information gleaned from their clients.
So-called front-running is nothing new to Wall Street watchers, but with
so many different kinds of financial products being traded today, and so
many parties involved, the temptations are unprecedented. The Securities
& Exchange Commission has "very active examinations and investigations
under way," says Lori A. Richards, an agency director.
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. They deal in so many markets
that the chances of all of them going haywire simultaneously appear
minuscule. And traders have been feathering banks' nests for five years.
They've produced record earnings and boosted asset bases to unheard of
sizes, making even bigger bets possible. Although the scale of trading
activity has soared, risk now accounts for about the same percentage of
brokers' total equity as it did in the 1990s, notes Tom Foley,
financial-services credit analyst at Standard & Poor's, like
/BusinessWeek/ a unit of The McGraw-Hill Companies.
The arguments have been good enough for investors, who have been
cheering banks on to raise their risk profiles even more. If you thought
the recent volatility in the emerging markets would have discouraged
them, think again. Even though such jitters have knocked Goldman's stock
price down 9% since May 9, wiping out $6.8 billion in market value,
analysts from UBS, Merrill Lynch, and Punk Ziegel & Co. have either
upgraded or reiterated their support for the stock. They expect that any
rise in volatility will create even more trading opportunities. The
question is, how far will Goldman and the others go?
From the looks of it, pretty far. All of them are ramping up teams of
so-called proprietary traders who play with the banks' own money.
Merrill Lynch is expanding a "strategic risk" team for a wide variety of
equity securities. More than 100 UBS (UBS <javascript: void
showTicker('UBS')> ) traders have migrated to a hedge fund the bank has
seeded and is marketing to outside investors. The appetite for
proprietary traders is growing "exponentially," says Richard Stein of
executive recruiting firm Korn Ferry International. Banks are paying up,
offering some traders $10 million to $20 million a year, he says.
Banks are building out their infrastructures, too. UBS already boasts
the largest trading floor in the world in Stamford, Conn., where more
than 1,000 traders inhabit a 103,000-square-foot space that was last
updated in 2002. It is no longer big enough. "We're expanding," says
Mark E. Bridges, a senior executive. The Swiss bank is so eager to keep
its employees focused on the task at hand that it has sprinkled six
concession stands that sell Starbucks (SBUX <javascript: void
showTicker('SBUX')> ) coffee around the trading floor. Across the
street, the Royal Bank of Scotland expects to start construction of a
95,000-sq.-ft. space this summer. Citigroup (C <javascript: void
showTicker('C')> ), meanwhile, is focusing on squeezing more bodies onto
its three main trading floors. Right now there are twice as many
technologists crunching analytics and market data as there are traders
on the floors. By 2008, the ratio could be 1 to 1. They're needed:
Transactions have become so complex that some traders have eight
computer screens at their desk.
Wall Street's exuberance is palpable as the pain of big blowups of the
past recedes from memory. John Meriwether, the former head of Long-Term
Capital Management, is now considered a hero to some. On June 28 the
industry newsletter /Alternative Investment News/ will give Meriwether a
lifetime achievement award for pioneering alternative investment
strategies. (Meriwether, who now runs a fund called JWM Partners,
doesn't plan to attend the event.)
"THE MACHINE WORKS"
To some extent, the jubilation is understandable. Banks in recent years
have been remarkably successful in shrugging off crises, from the
downgrading of General Motors Corp.'s (GM <javascript: void
showTicker('GM')> ) credit to junk status last spring to the destruction
of New Orleans, that could have triggered meltdowns. "Right now
everything on my screen is flashing red," said Michael Alix, chief risk
officer at Bear, Stearns & Co. (BSC <javascript: void showTicker('BSC')>
), on May 11, the day after Federal Reserve Chairman Ben S. Bernanke
raised interest rates, sending the market gauges he was looking at
tumbling. But "that doesn't make me nervous," says Alix. The bank has
built such powerful computing systems that Alix can reevaluate every day
the risks of thousands of positions across the firm's trading businesses
under various stressful scenarios to be sure the firm doesn't hold too
much of any risky investment at any one time. That type of analysis used
to take a week to complete. "The machine works," he says. The degree to
which risk management has evolved in the past few decades is
astonishing, say analysts.
As is the development of trading itself. Morgan Stanley's (MS
<javascript: void showTicker('MS')> ) John Shapiro, who runs one of the
world's most profitable energy and commodities trading operations,
joined the firm two decades ago. Back then his group traded mostly
metals and crude oil futures. Now it trades a long list of energy
products and owns several power plants. Those hard assets have been
hugely advantageous, throwing off revenues in their own right and giving
Shapiro's traders a much better sense of the overall market than the
grinders in the futures pits have. "It's not that I'm looking to take on
extra risk," says Shapiro. "But if opportunities we come across require
us to do it...I will not hesitate to ask for more."
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. So much speculation has crept into
commodities markets, for example, that in April they were trading at
prices 50% higher than they would have been based only on fundamentals,
estimated Merrill Lynch. A sharp sell-off followed in May. Are bank
traders and hedge funds living on borrowed time? One senior bank
executive thinks so. He worries that at any moment volatility could
spike to levels never seen before.
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. They also use any number of
risk models whose predictions vary wildly depending on the assumptions.
For example, JPMorgan Chase & Co. (JPM <javascript: void
showTicker('JPM')> ) estimates on page 76 of its annual report that in
2005 its trading portfolios were at risk of losing $88 million on any
given day, a pittance compared with its annual profit of $8.5 billion.
The figure it cited is called value at risk, or VAR, which describes the
total losses across all positions, from pork bellies to Iraqi bonds,
that could be sustained in any single day under normal trading
conditions. On average, major investment banks report VAR of $56 million.
But such backward-looking estimates don't capture the extent of the
banks' risks. 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. That figure was based on a "stress test" it performed on its
books, another kind of risk-modeling technique.
The good news? At least banks are reporting their VAR numbers; they
didn't before the late 1990s. The bad news is that JPMorgan is one of
only a few banks to divulge results of a stress test or any other
measure of unusual risk. Investors, guided mostly by VAR amounts, have
no idea what might happen in an abnormal event. "Banks are treating
exceptions [to the norm] as adjunct risk," says Nassim N. Taleb, a
professor at the University of Massachusetts Amherst and former
proprietary trader at UBS and Credit Suisse First Boston (CSR
<javascript: void showTicker('CSR')> ) who has written extensively about
the limits of VAR. "But when you ride a plane, you don't worry about
your coffee being cold. What you worry about is the risk that your plane
will crash."
Wall Street chiefs are aware of risk models' limitations. During an
investor conference last November, 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. "The one thing we do
know," Paulson explained, "is [that] if and when there is another shock,
things you hope wouldn't correlate [or trade in tandem] are going to
correlate." Seemingly unrelated assets like, say, silver and options on
Japanese commercial mortgages could all go into free fall.
Yet, even if the financial markets don't crash, 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?
If banks are seen misusing client information to gain a trading edge,
they could find themselves right back in the regulatory quagmire that
followed the scandals of the '90s, when they were accused of pushing
lousy stocks on unsuspecting investors to win what were then lucrative
underwriting deals. Those abuses cost Wall Street more than $1.4 billion
in fines. There's no telling what this cycle's price tag could be if the
banks mismanage relationships in new ways. The New York Stock Exchange
is investigating a major investment bank to see if it's giving a hedge
fund it runs preferential treatment. And the SEC is examining whether
banks have sufficient controls to prevent information about customer
positions from being passed on to traders. Fines aside, the hit to banks
resulting from the loss of their reputations could be far bigger this
time. It's one thing for them to burn individual investors in order to
serve big clients; it's another for the banks to burn big clients to
serve themselves.
So why, then, are banks racing ahead to build bigger, more complicated
trading operations, risking huge losses and long-term damage to their
credibility if things go wrong? For one, the banks think they can handle
the risks. For another, their shareholders and clients are demanding it.
Consider what happened at Morgan Stanley. Its stock price trailed many
of its rivals for four years in large part because the bank wouldn't
take on more risk. As it remained cautious, the gap between its bond-,
currency-, and commodities-trading revenues and those of Goldman
ballooned to $1.7 billion in 2005, up from less than $500 million in
2001. Some say that's one reason why former CEO Philip J. Purcell lost
his job. (Purcell did not return calls seeking comment.)
When current CEO John J. Mack accepted the post in July, 2005, he made
it his mission to bolster areas Purcell thought risky, including
mortgages, equity derivatives, and junk bonds. In April, he created a
new group that trades residential loans and other securities. He has
also increased the private equity capital pool by $1 billion, to $2.5
billion. The result: Morgan Stanley's VAR is 61% greater than it was in
2003, and the bank is closing the revenue gap with Goldman.
Investors argue that trading is booming now while most traditional
banking businesses are languishing. 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.
(MER <javascript: void showTicker('MER')> ) financial-services analyst
Guy Moszkowski. The big investment banks add value by "absorbing the
risk that their clients are looking to get rid of."
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. Even mergers and acquisitions, an area that's doing well
now, is serving a larger goal. Say a private equity firm acquires a
struggling foreign company but worries about currency and electricity
price fluctuations. In the past a big bank advising on the deal might
have tossed in a currency trade to relieve the firm of some of that
risk. Now, it will take on virtually any risk the client wants to hedge,
from jumps in electricity prices to hurricanes. And it might also go in
on the acquisition itself with its private equity arm, taking on far
more risk. Bankers call this a triple play: M&A, trading, and private
equity all in one deal. The only sure money is the M&A advisory fee, a
pittance compared with the potential private equity gains down the road.
FAT TAILS
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. Some executives estimate the dollar volume of such transactions
has doubled in the past few years. Yet banks have barely broken even on
about 30% of their big block trades this year, according to Thomson
Financial (TOC <javascript: void showTicker('TOC')> ). That's because
the share prices often fall during the time they hold the securities on
their books. Even so, "banks are falling all over themselves to bid on
blocks," says T. Rowe Price's Brooks. "It's not for the faint of heart."
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.
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. Private
assets are also difficult to value on a daily basis and don't fit neatly
into risk managers' models. Against this backdrop, VAR numbers seem
utterly inadequate.
What risk managers particularly fear are "fat tails." The term comes
from the shape of a bell curve of probabilities, in which the long, thin
tails on both ends represent extremely rare outcomes. Fat tails mean
catastrophes are more likely than one would guess given normal
day-to-day fluctuations. Risk managers are quick to point out that world
events don't always hew to the shape of a bell curve. "The abnormal is
really abnormal," says a risk manager who was part of the team that
bailed out Long Term Capital Management.
At least one big investor isn't taking many chances on banks. Anton V.
Schutz, who manages the $131 million Burnham Financial Services Fund,
held almost every investment bank stock last year. Now he holds only
Morgan Stanley. Why? "Investment banks are trading like there's no risk
in the world," he says.
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. It's possible that all of the
banks will show more restraint this time as they chase returns in the
red-hot risk market. But don't bet on it.
By Emily Thornton, with David Henry in New York and Adrienne Carter in
Chicago
--
Michael Perelman
Economics Department
California State University
michael at ecst.csuchico.edu
Chico, CA 95929
530-898-5321
fax 530-898-5901
