Thursday, September 18, 2008

Investment Bank. Dodo. What's the diff?

It's the end of the financial world! A catastrophe of epic proportions the likes of which we never thought we'd see in our lifetimes... unless you count the IMF Crisis of '97.  Or perhaps LTCM's collapse in '96.  Or the 1987 stock market crash. Or the S&L Crisis of the '80s or the...
Okay so maybe you've seen other 'once-in-a-lifetime' crashes and we'll probably see another Wall Street crisis in the future, but I have to admit that, as the country wades into the second recession of the Bush Presidency, things over on The Street look particularly insane right now.  
Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch and AIG have all fallen and before it's over Morgan Stanley, Goldman Sachs and Washington Mutual will probably go with 'em (and take another, as-yet unknown AIG down too).  Seems like a pretty big deal. I obviously gots lots to talk about.  Buckle up and let's get started with the oldest stuff first:
The Fannie Mae and Freddie Mac (or Frannie) collapses played out exactly as I predicted. Shareholders of both companies feared a Fed takeover the minute takeover rumors began. Since a takeover would wipe out shareholders, investors bailed and knocked the stock price to zilch.  
The two mortgage giants were suddenly cash strapped and neither company stood any chance of raising capital through equity issuance and no financial institution out there had the kind of cash on hand Frannie needed (not that they'd have loaned them the money if they did have it).  This self-perpetuating downward spiral was inevitable once it started.  But it's not a bad thing that this has happened.
Frannie was far from collapsing, like Bear and Lehman, yet the sheer size of the two institutions, as I've lamented before, needed to be scaled back.  The larger a financial institution becomes, the greater the odds of a systemic collapse of the entire financial system if, or when, that huge institution fails.  So Frannie's been taken over (at least for the short-term) by The Fed and will be downsized or chopped up or whatever (the process will take years, most likely).  As I've said, this is a good thing.  But events are shaking out in the private sector in a diametrically opposite way.  Lehman collapsed but used a combination of bankruptcy and a buyer (Barclay's) for their separate divisions.  Merrill Lynch has been acquired by Bank of America.  Morgan Stanley and Goldman Sachs will probably merge with a traditional bank before the year's out.  These are not good things.  A troubled bank absorbed by a healthy bank only creates a bank twice as big but a bank that still has the same chance of failing.
To understand how we got here let me first examine the rise and fall of the current investment bank business model over the last 25 years.
In the early 1980s Salomon Brothers became the first investment bank to actively trade (and trade heavily) with their own in-house prop desk (basically an internal hedge fund).  Until then the investment banks were mostly advice firms, set up to advise corporations on what would happen to their stock price if they issued more shares, bought another company or sold off a division. A publicly traded company wants to know how their stock price and financial position is going to be affected by their actions. 
But once Salomon set up their prop desk, everything changed.  The advice they gave to corporations got better and more accurate.  The Merger & Aquisition advisers at Salomon suddenly had direct access to highly intelligent people who studied the markets minute-by-minute.  The in-house traders had intimate, inside information about worldwide capital markets and how they worked and how they'd react.  To tap into this information, all the M&A advisers had to do was walk over to the prop desk and talk with the traders (as a side note, this is what gave rise to insider trading scandals in the '80s and '90s -- in-house traders, trading on proprietary information could ply the market however they wished).  With an active prop desk raking in profits, the i-bank itself could now also provide cash for deal financing.  
A small, advisory investment bank cannot compete with one that trades because the smaller firm lacks the most accurate information about the capital markets.  But to get that intimate understanding of the capital markets requires a lot of money -- usually more money than an M&A advising operation alone generates.  In addition to the computers and floor space, the people needed to monitor the different worldwide markets are expensive.  And the people who really know what the markets are going to do, and how they're going to react, are even more expensive. After all, these are not people who are likely to want to give M&A advice for a living.  
The in-house prop desk was the only solution.  And all the other i-banks either had to copy the model or disappear.  Incidentally, the i-bank that's least likely to collapse, Goldman Sachs, was also the last one to create a prop desk (reluctant until 1992).  Goldman's execs were always concerned about their client relationships and were hesitant to set up an in-house trading desk that might take positions against their cients (i.e. shorting a company that the M&A guys knew was distressed). But Goldman's nervous hand-wringing stopped once the desk opened and made obscene amounts of money.
The internal hedge funds all got up and running and by the mid-'90s and the i-banks had mulitple income streams (from the prop desk, the M&A services, etc.) and they started believing they had the strength and capital position of an actual bank.  They started believing they had consumer or commercial deposits rather than completely leveraged positions.  Which would eventually come back to bite them all... but we first have to understand why they started leveraging themselves to the hilt.  
The initial, outrageous success of the prop desks came mostly because extremely intelligent people with proprietary information were trading on that information and recognizing opportunities and quickly jumping on them.  I-bank traders knew the markets so well and had been steadily hiring a stream of freshly minted M.I.T. and Harvard grads that they were constantly recognizing big opportunities in small, previously unprofitable markets.  The i-bank traders weren't making money trading the ho-hum stocks on the S&P 500.  They were trading bonds.  Until Salomon began trading bonds in the early '80s, nobody on Wall Street thought there was any profit to be made in bond trading. 
But the i-bank traders were geniuses.  They saw that bond's were priced two percent higher (or lower) than they should be and were able to bet that they'd fall into line.  So the i-bank traders traded bond futures and credit spreads and international currencies; weird things that the rest of Wall Street didn't understand. But Salomon's guys were also making a killing, and their huge profits drew attention and the rest of the i-banks quickly joined the party. 
By the mid-90's every one of them had prop desks up and running, staffed with MBAs from M.I.T., PhDs from Harvard, and Nobel-Prize winning academics.  But what happens when every investment bank monitors obscure markets and each one has perfect mathematical models and perfect financial analysis?  The opportunities disappear.  Spreads tighten.  The bonds that were mispriced fell back into line.  When this happened the margins on trades shrunk and the previously opportunity-rich obscure markets began returning the same profits as the ho-hum index of the S&P.  So what did the genius traders to?  First they began heavily leveraging their positions... they started betting $500 million on half-percentage point moves to make the same $10 million they'd made before.  That strategy caused the collapse of the first major hedge fun, LTCM in 1996.  So what next?  Well the i-bank traders began trying to create mispricing opportunities. And this is what gave rise to the popularity of the derivatives market.
Derivatives are financially engineered instruments that Wall Street brainiacs began using to try to outsmart the other Wall Street brainiacs.  Derivatives were bundled up into such complex packages that counterparties and rating agencies didn't understand them.  This led to mis-priced securities, it led to the re-widening of bond spreads, it caused interest rates to move in the wrong direction. And voila, all of sudden, new opportunities!
But once again, the guys working at the other i-banks were no slouches, so the derivatives continued spiraling upward in complexity to achieve their ultimate end. They eventually became so complex that even the CEO's and upper management of the i-banks themselves didn't know how they worked or what positions their trading desks were taking.  And when an investment bank CEO, who's a Wall Street lifer, doesn't understand the derivatives trades his traders are making it's probably not something he should actively involve his firm in.  
Perhaps the most recent notable example of this was when JPMorgan's analysts combed through Bear's books during the buyout negotiations.  JPM's analysts couldn't decipher Bear's positions, that's how complex they were.  The only thing the analysts really knew was that the underlying assets of the trades were junk (defaulted sub-prime mortgages). The analysts piled together as much information as they could and made a recommendation to JPM's execs for an $8 per share offer for Bear  The Bear execs immediately fired back.  The current CEO and former CEO both claimed that the analysts hadn't properly understood the trades.  They said that only Bear's in-house traders were smart enough to understand the positions and that Bear's positions were incredibly valuable (obviously they weren't).  If this doesn't scream that nobody understood the derivatives markets then I don't know what does.  
Let me put their complexity into better context.  Most of us are willing to admit that, on average, the top graduates from the top business schools, (Wharton and Harvard MBAs for example) are smarter than the average Joe.  Probably a lot smarter. But by late 2005, every Billy SixPack in the country knew the housing bubble was bursting, and every Billy SixPack also knew that subprime mortgages would eventually start defaulting.  Meanwhile, what were all the Ivy-League geniuses doing?  Still trading mortgage-backed securities... almost three years later.  
The fact that Wall Street's wizards were still trading worthless junk long after the housing bubble burst proves the geniuses had finally managed to outsmart not only each other, but themselves as well. Congrats guys. You wanna put those big brains toward something more useful now?  Something that might benefit society at large?  
Anyway, as this crisis deepens and Morgan Stanley and Goldman Sachs join the other i-banks on the scrap heap I think we're going to see a lot of criticism levied at derivatives and perhaps rightly so.  In a letter to BerkshireHathaway's investors in 2003, Warren Buffett said, "derivatives are the financial weapons of mass destruction."  Seems like a prescient statement by the Sage of Omaha, and he's certainly no dummy.  Derivatives definitely helped get us into this mess but I don't necessarily think they're as evil as he claims and blame gets thrown everywhere (not necessarily wrongly) during a crisis.  Derivatives are only evil, if they're used for evil ends.  
They're useful tools for every business, not just Wall Street firms.  With derivatives for instance, I can financially engineer any kind of situation for a company to smooth out its cash flows.  If you're a CEO of a manufacturing company concerned that the prices of your raw materials are going to rise, or fall, or fluctuate wildly, or rise dramatically for three months and then flatten out or fall for two years or whatever... basically if you think you have any kind of idea on how your prices are going to move, then with derivatives I can engineer the situation so that your cash flows remain smooth.  That's useful.  
Credit Default Swaps are also invaluable.  They help hedge risk. But it's when they're used to create profit rather than to simply hedge risk that they can become problematic. What derivatives really need (if they're not evil, like most critics claim) is better monitoring and oversight. 
The ratings agencies have, thus far, escaped this whole mess with their reputations intact, but they should have done a better job of understanding the derivatives markets.  Their mis-rating of mortgage backed securities is partly to blame for the situation we're in.  Had they downgraded some of those securities in 2005, Wall Street might not be in the dire straits it's in.
And, looking back, how hard could it have possibly been for them to recognize that housing bubble had burst.  Once home prices evened out and began falling, subprime borrowers (who were mostly loaned short-term ARMs) were bound to start defaulting.  If they couldn't use rising equity in their houses to payoff their ballooning loans what happens?  Default.
Somehow Wall Street and the rating agencies didn't see this coming when everbody else on the planet did. A more likely explanation than an inability to 'see' it coming is that none of the genius i-bankers cared enough to put in the hard work and actually look.  Unwinding a derivative trade is time consuming and difficult but as the i-bankers raked in the money, I'm sure it also became a tiresome chore. Why bother to check whether the stuff being traded is actually worth anything, when everyone else is still trading it?  It's gotta be worth something because the geniuses at the other four i-banks haven't stopped.  So the collective arrogance of the highly intelligent overruled common sense and stopped them all from realizing they were all making colossal mistakes. 
So the i-banks kept trading and the rating agencies shirked their responsibilities but, like an umpire trying to make up for a bad call, the ratings agencies apologized to the world by making sure they correctly rated AIG.  The downgrade of AIG's credit led to the its government takeover and the sweep of fear throughout the market.  Great job fellas.       
Most of what I've talked about in this post has already been mentioned by the big media, but the one thing nobody's talking about (yet) is the end result of all this financial distress:  the merger of i-banks into consumer banks.  The Gramm-Leach-Bliley Act of '99 deregulated the industry and allowed investment banking operations, insurance, and consumer banking to all reside within one institution. Financial experts now seem seem to think that Merrill will be safe trading within the confines of Bank of America's insulated vaults.  Or that Bear's trading desk will be safe within JPMorgan.  But this is only more dangerous.  
What happens five years from now when Merrill's traders lose a billion on some ridiculous trade?  Will the Bank of America CEO bail them out?  They're now people who work within his own company. He's friends with the traders, they drink together after work, his kids go to school with their kids. Will he use consumer deposit funds to bail out the trading desk's massive losses? Perhaps he won't.  Perhaps he's cold-blooded enough to let the trading desk collapse. Perhaps he can be that surgical and simply cut off a limb. But fear and panic rule the markets and what happens when The Street gets word that Merrill is collapsing within BofA?  The share price starts dropping, the depositors and shareholders start scrambling to get their money out and BofA falls into a downward spiral.  Does any of this sound familiar?  Does it sound like Fannie and Freddie?  'Cause it really oughta should.
So far, one-year into this credit crunch, we've seen three i-banks fall, but the average American hasn't been directly hurt.  Sure, loan requirements are up, money's tighter, unemployment's spiked, the economy's screaming at breakneck speed into a recession, but imagine what would happen if Merrill collapsed Bank of America tomorrow?  There's more than $700 million in deposits in there. Those are "average American" deposits.
I hear you saying that Fannie and Freddie had $5 Trillion in mortgages and we saved them. That's true. But the numbers that have been tossed about by the media thus far ($30 Billion for Bear / $200 Billion for Frannie / $85 Billion for AIG) are not real.  Most of that money won't be used and will never really change hands.  If $700 Billion in deposits at BofA go up in smoke however, the FDIC and The Fed will have to fork over that money to all the average Americans who lost their savings.   
Newsflash.  The FDIC and The Fed do not have that much money.
As it stands, financial experts are quite happy letting the banks consolidate into these new massive entitites we haven't seen since the Great Depression.  Before the Gramm-Beach-Bliley Act of '99 repealed the 1933 consolidation laws, the i-banks would have simply withered and died.  If this had happened in 1998 the i-banks would have collapsed and been seen no more. Their business model became a fundamentally flawed one, so why shouldn't they wither and die like every other flawed business model in the free market dies?  Why do experts seem to think it's acceptable to let them merge into the confines of bigger, consumer banks? 
Banks can't "consolidate away" risk.  A chart might explain it better, but I can't make one.  Just picture in your mind that a bank's size is sometimes capable of limiting its risk: if, for instance a bank is operating solely in Texas and wants to insulate itself from regional failures in the Texas economy it can grow and expand into other sections of the country.  This growth helps spread risk, but there's a final limit -- a final end to the amount of risk that's ever capable of being "consolidated away".  Whatever this nebulous, nearly impossible to determine top end is, that's ideal size of a bank.  In any event, the current crisis has proven that size doesn't prevent collapse yet the private sector's answer to bank failures is to consolidate failed banks into healthy ones and grow even bigger.  
The "too big to fail" label has thus far been given to finanicial institutions whose possible collapse threatens the very fabric of the worldwide banking system.  LTCM was too big to fail.  Bear was given the label.  Fannie, Freddie and AIG too.  Please make sure you welcome JPMorgan-Bear, Bank of AMerrill, Wachovia-Stanley and Goldman bank-to-be-named-later, to the party.

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