Certain, not all, Wall St firms, leveraged proprietary trading (LPT) desks' compensation policies may have inadvertantly (law of unintended consequences) but never the less pitted one trader AGAINST (not for) his colleague across the room and set the stage for the explosion which has rocked Main St for many years to come. LPT traders were rewarded with more cash the larger their own trading book's profits were compared to another trader across the floor. And see this excerpt from the NY Times April 18, 2010 But this camp clashed with Goldman sales staff who were working with hedge funds that wanted to bet against subprime mortgages. Mr. Birnbaum told the team to stop promoting bets against some mortgage investments since such trades were hurting the market and Goldman’s own position, according to two former Goldman employees.
But a few desks away, Mr. Tourre and Mr. Egol were quietly working on the Abacus deals. Full story link here http://www.nytimes.com/2010/04/19/business/19goldman.html?th=&emc=th&pagewanted=print
The nano-economics (and darkness) of each sponsor's OTC LPT book individually AND together wth other's LPT books sent false asset signals to each other, created a false market - how and why?
Can you spell L-E-V-E-R-A-G-E in the D-A-R-K-N-E-S-S?
How would LPT trader A seek to outperform LPT Trader B?
Leverage, like an athlete's use of steroids to get an edge, accelerate performance - only to suffer, and often die prematurely show distinct parallels to a proprietary trader's book, rolled up into the trading desk then LPT unit. How?
It's critical to understand the explosion so let me first illustrate how PT became LPT with an oversimplified example.
First – an important caveat.
Not ALL banks, brokerages or insurance companies ARE in trouble / or received US Taxpayers’ bailouts. NOT all banks, brokerages or insurers are on the FDIC or regulatory watch list ok? ONLY a handful of institutions ARE in trouble – why?
The ABUSE of leverage, swaps and derivatives. These certain few banks are concentrated where? The NY Federal Reserve district - overseen at the time by Team Geithner while he reported to Mr Greenspan, then Mr Bernanke formed LFIG (Large Financial Institutions Group). The brokerage firms were subject to oversight, regulation by the SEC - after 2004; when the SEC invented - upon the intense lobbying of same - to be called CSE's - Consolidated Supervised Entities - a root of Mr Wallison's FCIC questions Wednesday. CSE's ended the decades old calculation of required minimum net capital - and ushered in - ONLY for the "largest MOST sophisticated players" an ALTERNATE minimum net capital based upon? The broker's own proprietary valuation models.
See the NY Times article, audio/video of this fateful SEC hearing from? 2004.
http://www.nytimes.com/2008/10/03/business/03sec.html
On-the-ground-view:
NO ONE put a gun to the head so to speak to any of these few banks or brokers to be SO leveraged in their own LPT units – much of it off balance sheet and/or off shore.
They decided - on their own to take way above industry average risks and knew exactly what they were doing and why? It’s called CASH bonus compensation based upon “Marked to proprietary models Asset based compensation - thanks to the above 2004 SEC new CSE” period.
Subtract out the CASH compensation paid to traders, what would you have? It's the central point of analysis – it’s the motive.
Explaining Leveraged Proprietary Trading (LPT) - a basic carry trade - with leverage.
Example 2004 to 2007 “hockey stick era” - an oversimplified but representative example. A PT desk sees in the market AAA rated long maturity “bonds” with a coupon of 7%. The short term (money market) borrowing rate is 2%.
That desk will then borrow at the short term rate 2% invest those proceeds into the longer dated bonds at 7% - pocketing the 5% difference. To insure the principal & interest of the long bonds they enter into a credit default swap CDS – in this example at a cost of 50 bps. So subtract that from the 5% - net profit is 4.5%. If this trade was for $100 million face amount - in the basic UN leveraged example – profits would be $4,500,000 ($100 million x 4.5%).
Then the PT desk says – wow – if we can do this dollar for dollar (unleveraged) - what will profits be if we leverage this strategy (becoming LPT)?
They borrow the same $100 million at 2% short term but instead of buying the exact same amount of bonds - buy 20 times or $2 Billion. So the profit on same – everything being equal becomes $90 million (20 times $4.5 million). The profit margin is a cool 45% - $90 million divided by $200 million. Later these LPT units did not bother looking so much to other's derivatives - they simply went long their own brand; perhaps concealed from competitors, counterparties and CUSTOMERS.
Some trading desks were (at accurate but not reported marks) levered at 40, 50, 60 or more to 1. See leverage estimates as of Dec 2007 on page 4 or 13 of Mr Bass' FCIC report here: http://www.fcic.gov/hearings/pdfs/2010-0113-Bass.pdf
LPT Trader question to self - would I rather get bonused on $4.5 or $90 million? So you can see the cash bonus figures dancing in the heads of these individual traders.
This game continued and was enabled, in part by the underlying bonds being created, traded and valued where and by whom? In the cover of darkness of dealer to dealer OTC private and proprietary markets - ALL set by "the traders" - thank you very much. We know that these dealers created their own private label securities which were in many cases ONLY tradable upon THAT dealer's desk; an affront to basic price discovery (and in my view subjects that dealer to an even higher suitability standard if not fiduciary standard). In part because THAT dealer defined the market for that brand of security whether MBS, CDO, CPDO or whatever they decided to name a pool of derivatives.
The LEVERAGED strategies’ profits, in part, were recycled (and signaled) through the direct issuance of Asset Backed Commercial Paper (ABCP) in the money market. April 2006 NY Fed carved out a new category to track ABCP – why? Perhaps because ABCP was oft issued by sponsors’ OFF balance sheet entities, special purpose entities like SIV’s. See NY Fed Commercial Paper link here http://www.federalreserve.gov/releases/cp/about.htm then page down to the April 11, 2006 announcement regarding ABCP.
Retail money market funds, seeing the higher yields on AAA rated ABCP compared to other MMF eligible investments jumped for the higher yields to reward / attract MMF shareholders. But apparently, did not perform basic due diligence as to why a AAA rated piece of paper paid 50 bps more. NOTE: A better use of any TARP funds should have gone direct - I repeat direct to the shareholders of these MMF - as rightly or wrongly they were assuming the safest investment posture in stark contrast to the massive speculation and risk inherent in the issuers of CP and ABCP. AND it tells us why / where did all the US taxpayer TARP funds and related Federal Reserve, NY Fed and FDIC direct and indirect support go directly to the LPT sponsors?
Answer - to cover up their own margin / collateral calls!
Even more the FDIC TLGP $313B (not a typo) includes support for NON FDIC insured affiliates of certain banks and thrifts - true not making it up. See the recent FDIC TLGP report here http://www.fdic.gov/regulations/resources/TLGP/total_issuance11-09.html
Bank Deposit Sweep Account litigation: Some brokerage firms, about 5 or 6 - diverted hundreds of billions of their customers money market funds into their own affiliated banks; wonder if any of these dollars were loaned out at arms length to businesses? The diversion is not in question; what is in question is did the brokerage firms breach their fiduciary duty to customers. See link to a June 2007 article here in Investment News http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20070611/FREE/70611006&ht=bank
We can see that this game continues until? The value of the underlying collateral comes into question; home values and the continued timely payments of principal and interest thereon by homeowners and real estate investors / speculators; not with standing CDS itself an OTC customized bespoke transaction; in other words in DARKNESS.
Darkness for the benefit of which parties? Not customers, not public investors and not US taxpayer – the erstwhile underwriter of same bailout.
And Fannie reported in 2005 – that speculative borrowers represented 20% of mortgages – QUADRUPLING from the historical 5%.
Sponsors continued to book record paper profits through 2007 – and pay record CASH bonuses and were slow to mark down value (or may have never marked down – instead off loaded >$1T to the Fed) of so-called AAA rated “long” collateral. The Fed – which is THE LAST TO KNOW (and based upon Mr Rosen’s testimony, that the Fed even when they ought to know, ignored Mr Gramlich’ work in 2006) because it is NOT the creator of trading data, rather receive only “after- the-fact” recorded history means that the SPONSORS – KNEW first – but did what?
Like Kubler-Ross' 5 stages of “dying” - they hoped it would not come to pass, then denied it, importantly never accepted it; then turned their OWN counterparty failure emergency into what our trusted friends in the financial MEDIA whipped up into? The official Hallmark card event "financial crisis" popularized as an ECONOMIC emergency – when the sparks were KNOWN by whom and when?
2006 if not 2005, ALL I repeat ALL self created, self inflicted only AFTER their narrow self – interests were protected.
And with respect to Mr Blankfein’s FCIC testimony this past Wednesday “(individual) GS traders did not know minute by minute” of course not, in classic principal agent conflict, why would they want to question then extinguish the VERY party of leveraged, proprietary models' ASSET values allowing the extraction of the preferred and different currency - CASH bonuses?
But a suggested litmus test for LB's testimony – WHAT positions were the one and the same Goldman holding – long or short – minute by minute in its own LPT and related and possibly conflicted on and OFF shore securities lending units? In contrast to contemporaneous representations / sales / transactions with customers. In concert / contrast with counterparties' units. See the previous blog post here about Goldman's customers' potential litigation. http://fiduciaryforensics.blogspot.com/search?updated-min=2009-01-01T00%3A00%3A00-08%3A00&updated-max=2010-01-01T00%3A00%3A00-08%3A00&max-results=46
IMPORTANT - there is NO need whatsoever, repeat NO need at all, as LB would have the FCIC believe, for ANY leverage when it comes to making a market or helping customers execute a trade or as LB has cleverly coined "put on a desired exposure" - it's time for Mr B to stop conflating (confusing and or intimidating the FCIC) and to call a spade a shovel - because that's what it is.
LPT units and trader's book profits and CASH Compensation.
And for whose benefit? And in the role of a REGULATED financial intermediary - whose interests were placed first? Compared to customers, public investors and US taxpayers? Compared to the fiduciary duty owed to most customers; especially as Joseph Stiglitz has pointed out in markets characterized by "asymmetric information" largely if not completely defined and/or controlled by the sponsors.
And I hope that ONE THING IS CLEAR – leverage at the LPT level of 20 or more to 1 on top of leverage at the homeowner level zero down = 100 times leverage equals minimum 2000 times leverage - went BANG! Now is it clear why leverage and darkness are the ROOTs?
IMPORTANT - many of these Wall St firms, when sued by a customer for bad advice or unsuitable investments vigorously defend themselves based upon the customers' ratification - you see anyone reminding these firms of their own self R-A-T-I-F-I-C-A-T-I-O-N? Time to look very closely in the mirror.
No one ever put a gun to the head of ANY banker to extend a mortgage loan or add leverage to an LPT unit – they did it as adults, professionals, armed with over $1B / daily with full information - see link here http://www.celent.com/124_483.htm , knowledge, capacity and knew the risks, repercussions but cried out – for what? A CASH bailout.
In many, but not all, cases look at the dearth of insider ownership and dispositions of stock – before the “crisis” but certainly after the crisis – so what did they know and how were they showing / signaling the markets in that respect? Not with a lot of confidence huh? Of course, why worry due to the sweet sound and comfort of cash in the bank.
Unbelievable – that US taxpayers are still paying for (in time and money) this easy to understand but leveraged carry trade.
A four letter word comes to mind for many of these actors – JAIL.
And they, not the US taxpayer should pay for their own prosecutions and incarceration!
Certain actors - upon conviction should - under extraordinary authority - be forced to disgorge ALL ill gotten gains along the way; now that's real change (in coin - that is - not in the currency of Obama's "change" and I voted for him) and deserved truth and payback for the financial rape of current and future generations of US taxpayers and global creditors of the US Treasury!
And one last fact don't blame it all on AIG and AIG FPG specifically - a large part yes - but when several major banks, brokerage firms and insurance companies were NOT AIG CDS counterparties - that may tell you - among other things that those who were counterparties failed in or were perhaps conflicted in their own due diligence.
See page 24 of Mr Barofsky's November 2009 SIG TARP report for those counterparties. See link here http://www.sigtarp.gov/reports/audit/2009/Factors_Affecting_Efforts_to_Limit_Payments_to_AIG_Counterparties.pdf
So a brief list of NON (not a typo) AIG counterparties would seem to include:
- Citigroup / Smith Barney
- JP Morgan
- Morgan Stanley
- Wells Fargo
- Nearly all US regional banks
- GE Capital
- Berkshire Hathaway
And as suggested last fall in an email to Mr Barofsky's office - asking the above when and why they were NOT AIG counterparties would perhaps be a non-costly and useful line of questioning - what's to hide?
The best for last - AIG stops insuring Brokerage firms Excess S.I.P.C.
Saving the best for last "the icing on the cake" - AIG stopped insuring the Brokerage firms against bankruptcy (otherwise known as Excess S.I.P.C.) in when ? 2003. Because according to the quote from AIG's spokesman "It's too much exposure" huh? After 30 years of NOT one claim paid ever; there's too much new exposure to what? And the NASD, the brokerage's primary regulator did what? Nada, nothing, zilch. See the August 2003 (not a typo) NY Times article here : http://www.nytimes.com/2003/08/09/business/to-insurers-a-long-free-ride-is-looking-risky.html
But then the pros at the unregulated AIG FPG went fast to work - trotting out as many CDS upon one and the same brokerage firms' risks how? A la carte; as in many a fine dining establishment. Not to mention the 3 to 6 bps, Mr Greenberg testified to before one Congressional committee March 2009, its securities lending unit was making - on a DAILY basis!
It's past time to end the siesta on the Taxpayers' dime.
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