Sunday, 8 November 2009

Goldman Sachs doing God's Work?

Interesting, but for my taste, not revealing enough insight into the workings of Goldman Sachs today;

They sure are a money making machine! I have no issue with any bank making money by allocating capital to its trading and investment arms skilfully and deftly. My problem lies when those companies securing the lion's share of the finance transactions have an oligopolistic pricing structure coupled with access to the scarce resource of modern times, capital.

Now, I also have no issue with bankers being paid multi-million dollar bonuses if they add value of, say $100m to a client company bottom line. Simply sitting on assets that have gone up (and not even to pre crash levels) and making a margin on each trading deal simply because clients have few other options to go to execute their orders annoys me. For a bank to be rescued by the state (ie bust) and to be paying put $billions in bonuses 12 months later is frustrating to say the least.

The majority of Goldman's profits, it seems, comes from creaming off a profit margin from other companies activities (pension funds, insurance companies etc). The rest comes from betting on the financial markets and, I believe, influencing the level of those bets with the weight of its own capital.

Remember, making $10b profit on assets of $1trn (1%) doesn't sound that great and even on cash its a little more than 6%. I think that the majority of the earnings power of Goldman comes from its oligopolistic status and control over capital. With these advantages, making the sort of profits seen recently seems, well, a bit pathetic.

Thursday, 5 November 2009

Trading Styles of CityOdds Traders

Now that we are seeing a good number of regular traders on CityOdds, it is becoming apparent there are distinct categories of trader.

1. The Long Risk Trader

The trader tends to seek high payout, less frequent transactions. These trades often lose money for the trader but the ones that win can multiply the stake by 200% to 500% in a day, often offsetting the losses previously suffered. These traders tend to trade in and out of positions to try and capture shorter term movements in the underlying market.

2. The Short Risk Trader

These traders tend to regularly place trades that are very likely to make a profit but this profit would be small. These traders tend to make money on a regular basis but occasionally lose a great deal if the underlying market suddenly moves in one direction or another.

3. The Reactionary trader

Traders may purchase low cost, speculative trades either side of the current market level and should the underlying suddenly jump in one direction or another, the trader sells the winning trade for a profit, and closes the losing trade (hopefully for less loss than the profit on the winning trade)

It hasn't taken long for CityOdds to see these trends emerging and it is still not clear if any of these three strategies is the better in the long run.

It is very clear, however, that the behaviour of CityOdds traders is no different from the traders that sit inside large investment banks (apart from the £10m bonuses that is!!)

..till next time.


Monday, 9 March 2009

Duck, it's a Black Swan!

The Times Economic Review today (9th March 2009) eloquently described the pratfalls of the traditional stochastically based risk models so ineptly used by the banks to give balance sheet risk analysis. As Nassim Taleb regularly points out, these models have little use in predicting unusual or “Black Swan” events.

We’ve seen a flock of black swans cruise into view recently and asked “why didn’t we see the incoming fleet of Cygnus heading our way?”

In my humble opinion, the “machine” always did know there was a chance of a devastating implosion in the financial markets due to the burden of debt. I recall gasps of astonishment when a dynamic synthetic credit product using a form of leverage/deleverage to offer a yield of 2% above risk free and a ‘AAA’ rating. So, a ‘AAA’ rating (pretty much riskless) offering 2% above standard ‘AAA’ instruments such as RaboBank or EIB? Seriously…did nobody ask questions? Billions of Dollars of this product were sold despite the niggling worry.

For the vices known of traders such as hubris, arrogance, self-interest and greed, stupidity is not one of them. Any fool would, at least, wonder, what an earth was going on when two “riskless” instruments offered such wildly differing yields.

The bottom line was, if it could be rated, it could be sold. Ratings buckets guided many customers, almost entirely. Give it a ‘AAA’ rating and you could sell it anywhere it seemed. Here lies the lesson. Models may offer some form of comfort, whether for options, derivatives of debt default estimates, but without common sense can lead to catastrophic mis-allocations of capital.

Scientists can pour over statistics and provide ever more elaborate valuation models, as detailed in the Times article, but the same fate awaits the next generation of bankers as has befallen us. Here’s how;

Looking forward in time, perhaps to 2010 or 2011 and the financial system is propped up by the tax-payer and credit becomes easier to source. Rates will be low, probably 0% to .5% across the developed world economies. Models will be deployed in banks that value “shock” events, (black swans) highly and instruments that capture this risk trade at high premia.

Some smart cookie will realise that with rates at zero, one needs to generate little in the way of profit to garner a nice management fee and an annual performance fee by taking these highly priced elements of risk (perhaps engineered out of other products) and generating regular income from them. The selling of out-of-the money put options is a simple example. It may be quite easy to generate a return of 2% above base rates by selling these options or risk units.

As time goes by, more and more funds jump on the bandwagon and the supply of these risk units increases and the price begins to fall. Though the probability of the event happening that underlies the risk element is unknown, the longer it doesn’t happen the lower the premium becomes.

Many years of satisfied fund holders and highly paid hedge funds (or whatever they’ll be called in 2015 or so) will convince the world that we have, indeed entered a new period of growth and expansion and the toxic past is cleansed and in the history books “we’ve learnt from our mistakes of our predecessors”: President Palin, June 2015 (oh god no!)

The markets rise, implicit leverage climbs again, debt is re-accumulated as rates remain low. Once again the system becomes debt fuelled and ripe for another “pop”

The long and short of this is to agree with the authors of the Times article, that putting shocks and more historical data can help the analysis of what the banks hold today but as a forecasting tool as to future behaviour of investors is of little use. Behavioural biases will tend to take advantage of “perceived” over-priced assets, construct ways to exploit them until a form of equilibrium is reached once again.

The market, whether it for equities, bonds (‘AAA’ or not), real estate or volatility, is simply the consensus or “crowd” valuing the asset to its group value and risk tolerance. Modelling this is difficult, it changes every day. Its what makes the markets fun!

Monday, 9 February 2009

Regulation of Financial markets? - perhaps its already done!

Rain, snow, slippery roads, we've had it all last week and most councils have run out of grit because the snow we've received is a "one in 20 year event". Perhaps the councils got a little over-confident that we would not see such weather in British winters so didn't stock up on salt and grit. I remember, when I was a kid, that it snowed every winter and there were always lorries running up and down our little village in Oxfordshire - that was in the 1970's though.

Is the council decision to stock "only enough to cope with a median winter" no different from a rating agency rating a pile of junk mortgage debt 'AAA' because , in the past, no more than 10% of it had ever defaulted so those holding the safest 90% would never lose money? I think yes - its just the way things are - we had better get used to it.

In my ramblings, I often (and will continue to do so) comment on the spanners that are often thrown into the market machine to alter its smooth running. These spanners are often regulatory in nature and tend to cause more problems than they solve. These spanners may be comments from governments, unaware of the money machine that punishes market inefficiency and actively seeks out ways to profit from such gaffes and ill thought out policies.

In my view, what we've seen in the past 18 months has demonstrated that there is no free lunch in the financial markets. Good I say! Reward has to come from trying to understand risk/reward and committing capital to that position. Where it doesn't work is buying a bond yielding 6% and borrowing money at 5% to finance it and telling your shareholders "don't worry - this bond won't never has and look, even Moody's and Standard and Poors agree with us and have given it a AAA rating!" The clever chaps convince another bank to lend them a billion dollars to do the trade and a "profit" of $10m a year is created - right...yes..okay then..

Now its all gone pop - and to most people a huge surprise. But why? - everyone knows the phrase "no such thing as a free lunch" but everyone forgot about it...or did they. If you were a lucky hedge fund manager with our little 6% bond wheeze detailed above, that trade would make you up to $30m a year profit for your fund and up to $2m for yourself in "performance" fees. Often paid in cash, these performance fees were the asymmetrical golden goose that sustained the noble art of managing money for the length of the last boom in asset prices - ahh, good old days.

So, it popped, what happened to the hedgie after his fund imploded leaving the bank who lent the billion dollars with a headache? Off to set up a new fund perhaps, clean as a whistle.

Will it be so easy in future to make such profits...I'm not convinced. Even in the absence of regulatory muddling (which will provide some avenues for profit), the trusted models used to establish risk/reward have to be re-calibrated. This time, they will have to include these "25 standard deviation events" (A Goldman Sachs quote) rendering most of the staple diet of trades unviable. The modelling will just show the deals work for a period of time then blow up - this will have to be made clear to the investing clients under more stringent transparency rules pending.

So where does that leave us? - well, the long painful removing of layers of accumulated debt will continue. It will hurt and be longer than most expect. Easy money will not be found and "picking up pennies in front of the steamroller" a euphemism for the 6% bond game we described will no longer work. The market appears to have already re-regulated itself and we won't see the likes of it for a generation.

The opportunities? Well, Unleveraged Global Macro funds will flourish as will transparent trading opportunities (such as the product provided by my firm, Perhaps CityOdds is the shape of future risk management and liquidity provision...I aim to find out.

Thursday, 29 January 2009

Common sense in the financial markets? Shock horror!

Just like the, now legendary, Captain Chesley Sullenberger, age, wisdom and experience can count for far more than simulators, 28yr old "masters of the universe" and Phd grads. George Soros, oft criticised for "breaking the Pound" some years back nailed some of the gross inefficiencies that contributed to the financial crisis we now have to struggle through.

In an article in The Financial Times today, Mr Soros deftly picks through the mire of regulatory oversights, their lack of grasp of the asymmetry of long and short positions and the opaqueness of many derivative instruments. He described the snowball effect of hedge funds, fat with cash, combining to short bank equity with long CDS positions to take massive bearish bets on some of the largest financial institutions. This capital "bullying" had the, hardly unexpected, result of sapping confidence in the whole sector. This reduction in confidence further enhanced the hedge fund profits by demolishing the banks ability to lend and borrow forcing them into a corner. Soros calls this "reflexivity" and its something not modeled in orthodox financial theories.

Soros argues that the catalyst for the seizing up of the financial sector was the Fed and The Treasury allowing Lehman to go under. The inability of many CDS or any other form of OTC (over the counter) counterparty to settle their transactions rendered the system frozen. The lack of interbank lending looks set to continue until confidence returns.

The sheer size of the outstanding CDS contracts defies belief. When I spoke at The TraderTech conference late last year, the total notional outstanding CDS nominal exposure was more than $400 trillion, yes TRILLION Dollars. The nominal is not just IOUs but multiplicities of exotic structured instruments with, I kid you not, legal documents extending to well over a thousand pages (densely written and leaglese too). The opaqueness of these instruments requires tedious unraveling and without a clear picture of what is owned, the tendency is to mark down the asset price.

None of the cataclysmic problems were forecast by the financial models, whzz-kids, VAR specialists or Phds. With little management information feeding through to the boards of the big financial institutions, all seemed well in the world and profligate spending, borrowing and $1.2m office refurbs continued. It was always going to pop when the boards no longer understood the companies they were running.

Perhaps a little more common sense or standing back and seeing that there were some glaring inefficiencies feeding the bubble (rating agencies being a clear example - I'll be writing on that topic separately) would have stopped us getting so close to the systemic breakdown we now face.

I know that I'd prefer a 55yr old captain of my financial 747 if it encountered danger than a over-confident 28yr old with a first class degree in maths more concerned with getting over his hangover and wondering if Jenny Smith from payrolls is up for it. Perhaps Mr Soros, though wrong-footed at times is the Chesley Sullenberger of the financial world. Age, experience and an holistic approach to the capital markets is a breath of fresh air and I know who I'd trust in a crisis.

Friday, 23 January 2009

Time I started to write!

Morning paper and coffee time is often when most ideas and observations happen in my CityOdds world.

This morning was the turn of The Times and an article about two musicians seeking funds to help them produce an album. Firstly, good on Martyn Shone (the guitarist) for getting out of the moribund banking business and embarking on an adventure with the band Honey Ryder. The curious and innovative thing about this band was the choice of method of funding. Forget going to a bank where the large cheeky chappie ignores the customer then refuses any help in the money department - this model seems dead for some time - why not try selling shares in the band instead?

Selling shares is not new but in such a small size it is. As Sean Park, of Nauiokaspark, correctly points out that risk can be broken down into small units, repackaged like Lego and built into a variety of shapes to suit the buyer or seller. In today's information centric world, the size of these risk "quarks" it is shrinking. Shares in Honey Ryder are £3,500 each and only 100 available - small by company standards but enough to launch a pop career..

So how do you value the share? Here comes the fun bit. There are no fundamental ways to value this share - its just hope and your guestimate of the odds of them succeeding. Offer me £10 if I can predict whether a coin lands heads, on a fair flip, and I'll pay up to £5 to enter the game. £5 is thus the fair value of the share, it matters not that the coin has not yet been flipped. It is the prospect that values the share. Its up to the fans to see whether they think £3,500 is a fair price to share in the band's success. You won't find these shares being sold by your local IFA!

Do I like Honey Ryder? - they seem funky, cool and I'd happily have a drink in a bar with them but I bet they don't know what a revolution they are beginning...the story has only just started and the time when financial products are bought rather than sold is coming...

More soon..

Wednesday, 1 October 2008

Another lesson learned

Here I am, sitting in my pajamas reading (and typing) the FT and thinking I've seen all this before in the financial markets and beginning to believe that these shocks and disjoints are just a feature of how monetary systems work. Quants seem to believe that markets behave predictably, they predicted that the probability of AIG defaulting was less than one in a thousand the year before it, technically, did. What can be learned from this?

Unregulated markets, given enough "rope" will hang themselves. Free market competition dictates the one holding the ticking bomb whilst getting paid and successfully passing it to the next guy is "the winner". Its time we understood the bombs and ensure that one of the passees understand what they are being handed from the passors (or should I say stuffees and stuffors?)

Transparency is the key and this blog is a melting pot of ideas, some ridiculous, some sensible and some plainly wacky - feel free to contribute and I'll pass all sensible suggestions to Hank, over there in Wall St!

Ta ta for now