This Is the End


Markets, Risk and Human Interaction

January 30, 2009

Banker Bonuses and Proportionate Pain

January 30, 2009
For a start, we can stipulate that there are a lot of people in the banking industry (and especially in the subset of that industry which, up until September of this year, would have been called the investment banking industry) who are still making obscene amounts of money while the companies generate losses for the shareholders and force taxpayers to cough up bailout funds. And then there are the end of year bonuses paid to employees. Attacking the second does not get us very far in addressing the first.

Employees in banks and investment banks get part of their pay bi-weekly over the course of the year, and then get the rest of their salary in the form of an end of year bonus. It is called a bonus, but a large portion of it is deferred salary. Even if they perform their job at a hum-drum level, they will still expect and get a sizeable “bonus”, because, however you want to put it in technical terms, the simple fact is that when they receive their bi-weekly paycheck, some of their pay has been held back. Taking away their year-end bonus would be like telling workers on a weekly pay cycle to return the second and fourth payment they received each of the last twelve months.

We are talking about the workers who install and maintain the computers, do the back office accounting, run the HR functions, generate PowerPoint presentations and maintain the client relationships. Some of those accountants are called traders, and some of the PowerPoint generators are called investment bankers, but most are a far cry from the multi-million dollar traders and investment bankers that we read about. There are a lot of extras and bit parts in movies, too.

Before getting too apoplectic, let’s at least look at the breakdown. My bet is that the majority of bank workers whose bonuses Obama finds outrageous and Dodd wants to claw back are workers who get modest base salaries during the year and whose bonuses make up more than half of their total salary. These bonuses already were cut far below those of prior years. If they are already seeing their annual salaries cut by forty percent or more, do we go further?

January 21, 2009

Changing the Reality on the Ground: Why the Government is not Like You and Me

January 21, 2009
One of the great things about having Obama as president is that Paul Krugman will now put more focus on economics and less on polemics. I was a classmate of Paul’s at MIT, and I remember him as the most natively brilliant of all of us in terms of economics. There were others who had stronger mathematical skills or who walked in the door with more economics training, but it seemed that he was genetically wired for economics. And now that there are fewer Republicans for him to kick around, he can get focused on what he does best.

But that doesn’t mean he is always right. Well, when it comes to economics I doubt he is ever actually wrong, but he might not fit the full story within the space constraints. And this is the case with a recent column of his in the New York Times related to government bail outs. He used a fictional bank called GothamGroup – I don’t know if he had any particular bank in mind, I suppose it was based on some Batman reference – to explain how the government cannot alter the basic math of the markets. If a bank has liabilities that are greater than its assets on a mark to market basis, then the bank is effectively in default. The government cannot change that; if it does not want it to fail, then it has to give the bank enough money to push it back into solvency, which means giving the equity holders a gift at the taxpayer’s expense.

The point left unsaid is that the government, unlike you or me or some corporation, is in a position to change the reality on the ground. They can take steps to alter the nature of the markets. They can push down mortgage rates, add tax benefits for new mortgage holders, and push losses forward by forcing changes in accounting rules. They can push inflation up to make all debts lower in real terms, thereby differentially taxing the lenders to the benefit of the borrowers. They can encourage the formation of clearing corporations for swaps or other instruments, thereby improving the liquidity and credit-worthiness of those markets. They can buy up weakened assets and lock them up for as long as they want, so that no one needs to look over the shoulder and wonder if an avalanche of securities is going to sweep them away should they start to invest.

An investor may be hesitant to take on the assets that are clogging up the banks. They would have a hard time finding the capital to buy them, and they have uncertainty about the future. And they fear that once they take assets on, they may not be able to dispose of them if the economy continues its tailspin. Little capital to invest, uncertainty about the future, illiquidity: no wonder the mark to market on these assets is so low.

But not so for the government. The government has no capital constraints, no concern of being forced into liquidation, and as far as uncertainty about the future, to a large extent it creates that future. The government makes the rules; if the government were clever about it, my bet is that they could make a windfall from this mess by buying up everything in sight and then changing the market reality.

January 16, 2009

A Regulatory Approach to Risk Management

January 16, 2009
There is not much mystery about how banks ended up in such a mess. It was not the malfunction of sophisticated risk models, nor was it a “100-year flood” event that swamped risk controls that would have been adequate in normal times. It was simply a huge and unrelenting build up of inventory in illiquid and often complex securities. A build-up that was there to be seen and corrected.

There was nothing tricky in fixing this problem before it got out of hand. When you are seeing the inventory of complex structured products grow from a few billion dollars to ten billion, then on their way to 20 or 30 or 40 billion, a natural question to ask in the course of the build-up is “why aren’t we selling any of this stuff”. And a natural answer to that question is “maybe we aren’t pricing it correctly”. Any risk manager with a fifth grade education will note that if the price of the inventory is off by just ten percent, that will mean a loss of billions of dollars, and so will propose selling some of the inventory, say a few billion dollars worth, and see the price at which it clears. At that point, the gig will be up.

So why didn’t this happen?

One hypotheses is asleep-at-the-switch incompetence by the risk mangers: they just missed the inventory build-up. But given the simplicity of the problem and the fact that any of these banks have hundreds of personnel in the risk management division, that’s hard to believe.

A second hypothesis is incompetence or poor incentives in senior management: the problem was passed up the chain of command and then ignored. This seems reasonable; there are, after all, tensions that pull against the in-house Cassandra. Senior management is reluctant to reduce risk because it means lowering earnings. And management gets backing for this from a powerful constituency, the traders who control the profit centers and make their money by taking risk. The traders are at loggerheads with the risk manager because of skewed incentives, the so-called “trader’s option” where if the firm wins they win while if the firm loses big time they miss their bonus for the year and head off to greener pastures. Indeed, senior management might be swayed by similar incentives.

Under this hypothesis the risk failure within the banks is organizational; it has to do with incentives, communication and plain old fashioned bureaucracy.

So how do you fix it?

The government needs to create a market risk management function with direct lines to the Chief Risk Officer of each financial institution. The CRO should be required to provide full risk information to the government risk authority. It sees whatever he sees. And it should go one step further, to require the CRO to notify the government risk authority of any risk concerns that have not been resolved by senior management. In essence, the CRO would have dotted-line reporting to his government counterparts. Think along the lines of the Sarbanes-Oxley Act, which requires the CEO to attest to internal controls and certify the accuracy of the financial statements.

As important as the specifics of the structure is the spirit with which the regulatory role is executed. For the CRO engaged in fulfilling his responsibilities, the government risk authority can act as his ombudsman, an outside voice with the power to get things done if his own voice is not being heard within the firm. The CEO is less likely to ignore risk concerns if he knows who might be making the next knock on his door. And if the CEO has a legitimate disagreement about the degree of risk, he might welcome the outside view.

For this to work, we need to change the mindset behind regulation. Marching in with a subpoena in one hand and a sixty page questionnaire in the other is not the way forward. Which means we also need a different type of regulatory staff. Some jobs cannot be done by SEC lawyers or career government workers. We need to entice market professionals into government service, market professionals who are on par with those in industry. It might cost some money to get them on board, but I bet the bill will be way south of a trillion dollars.

January 15, 2009

I am now the Lorax -- I speak for the markets

January 15, 2009
Dawn Corrigan has written a rendition of Dr. Seuss's The Lorax, replacing the forests with the markets and with me in the starring role.

The original version focuses on the damage of clear-fell logging, and is used by Doctors for Native Forests in their fight to preserve, well, native forests:
I am the Lorax. I speak for the trees.
I speak for the trees, for the trees have no tongues.

January 12, 2009

The Regulator as Risk Manager versus Risk Monitor

January 12, 2009
I have recommended in various forums that we need a government-level market risk manager. (See my House testimony (October, 2007) and Senate testimony (June, 2008), both linked via posts in this blog, and the Preface for the paperback edition of A Demon of Our Own Design). Such a role has also been recommended by the Treasury in the form of a market stability regulator.

I was discussing this idea yesterday with a colleague in government, and he mentioned that one concern for such a role is the potential for a concentration of power. Risk taking is at the center of the financial industry, and whether it is the Federal Reserve, Treasury or SEC, the ability to dictate risk limits puts this role in the position of controlling the industry’s profitability.

To answer this concern, it is useful to make a distinction between risk management and risk monitoring. In the financial industry, be it in hedge funds or in banks, what is called risk management is really a risk monitoring function. The risk management team, headed by the Chief Risk Officer, oversees the aggregation and analysis of exposures. But it does not make decisions on the appropriate risk appetite for the firm, and it does not unilaterally set the risk limits or otherwise force the risk takers to hedge or reduce their positions. If the CRO thinks action is needed, the baton is passed up the chain of command to the firm’s decision makers. This might be the head of the trading division, the CFO, the CEO, or a risk management committee with these as its members. The decisions of how much risk to take, the limits to set, when to make exceptions all are made at this level.

A similar structure could exist for the risk management role within the government. The role of risk manager would be staffed by technocrats, in the positive sense of that word, who would develop systems to acquire the necessary risk information from the institutions, analyze that data and determine if new areas of risk are emerging. They would connect with their industry counterparts, the CROs of the various institutions, to understand areas of concern, to help identify common or emerging risks, and to constantly refine the risk management process. If a market crisis did occur, they would have all of the data at their disposal to revisit the risks to monitor and the limits to set. Think in terms of what the NTSB does when there are airplane accidents. All of this would lead to recommendations to a decision making committee, perhaps a subcommittee of the House or the Senate.

Don’t worry about too much back and forth with the decision makers. On a practical level, it would be rare for the government risk manager make one-off suggestions that this or that bank lower its risk beyond the risk targets that have already been established. More likely, the government risk manager would see that a number of banks are starting down a particular path, building up exposure to a new market or diving into a particular structured product space, and recognize that, while each bank’s actions might be reasonable on a stand-alone basis, there is too much concentration and potential systemic effect once the exposure is aggregated across the banks.

And, by the way, no one can make such an observation in our current regulatory structure.

January 2, 2009

Reflections on Madoff

January 02, 2009
The Madoff Ponzi scheme will (I hope) be the high watermark for financial fraud for many decades to come. It is hard to overstate the harm it has done, with lifesavings and fortunes lost, charities and schools left foundering.

“It fell off a Truck”
Did his investors really believe Madoff was doing split-strike conversions? Given that there were not enough options in the world for Madoff to do such a strategy? And given that no one in the industry heard of him as a player in that market?

An alternative view is that the split-strike conversion story is the equivalent of the “it fell off the truck” story for people buying stolen goods; that investors suspected he was involved in illegal front running, and would just as soon not have had that spelled out for them while the money kept flowing in.

It’s the same old story, just bigger – and smaller
Bigger because people have more money. Bigger because it is easier to create links and indirect “circles of trust” by using banks and other feeder funds as agents. Bigger because it was bigger: people implicitly trusted the regulators to do their job, and thought that surely nothing could be fraudulent if it was this large and well known.

But part of his genius was that in one respect his scheme also was smaller. He did not make the classic confidence artist’s play on avarice. The good, old fashioned Ponzi schemes are of the get-rich-quick, double your money in three months variety. Madoff’s was conservative, offering lower expected returns than many other investment opportunities.

Putting all your eggs in one basket

Madoff could get away with modest but steady returns because with credit so abundant his investors could use leverage to push the returns up. My guess is that in many cases the people who were wiped out did not have their entire portfolio in just this one fund, but rather borrowed money to create a levered position. If you can make 10% almost for certain, why not lever four times and get 40% return with a little more volatility? Because of that leverage, the fund’s failure engulfed their other investments.

We are shocked, shocked
The day after the story broke, I wondered why Madoff didn’t just grab $30 million and skip town. The likely answer is that then his kids would have been left holding the bag. I would have loved to hear the conversations between him and his sons the night they heard the gig was up, and decided they would have to turn him in.

How could anyone so close to the scheme, and in the market making business to boot, not see any of the red flags that Harry Markopolos was waving in front of the SEC for the past ten years? I wonder if they had all of their money in their Dad’s fund?

Is there a managed account in your future?
A lot of investors are going to be asking, “So remind me again what the problem is with putting me in a managed account?’ Why can’t a hedge fund operate by doing trades pari passu across various client accounts – especially if the fund is in liquid markets? With a managed account the investors then have control over their money, so it is a lot harder to do any sort of monkey business.

The usual argument is the risk of transparency. In most hedge funds, I don’t buy it – especially if transactions are available for view only with a delay. In any case, my bet is that we will see more demand for managed accounts down the road.

Are we all a Ponzi scheme?
I suppose it is irresistible. If you are a columnist who has to find something to write about three times a week, latch onto the Madoff story with a metaphor to the growth of leverage by banks and individuals. Even intellectual luminaries like Paul Krugman and Thomas Friedman have gotten into the act.

But I don’t see the connection. With Madoff you have someone who is committing fraud. With leveraged investing you have people making investment decisions. Those decisions might not have been the right ones ex post, but a Ponzi scheme?

There is plenty to think about without straining that hard. Still, I don’t think we’ve heard the last of this.