Trader’s Narrative

This is a response to Smith’s essay in the Wall Street Journal on February 7th, 2009 titled “Greed is Good“. In the essay Smith, a former partner at Goldman Sachs argues that bonuses are a necessary part of compensation on Wall Street and that changing this would damage the competitive nature of firms as the best and brightest would leave for greener pastures. Smith uses exhortations and an anecdote from his own past to make his case:

I was … horrified to learn that my annual take-home pay would be limited to my small salary, which accounted for about a quarter of my previous year’s income. Fortunately the partners decided to pay a small bonus out of their capital that year to help employees like me get by.

This was 1973, a time of tremendous economic shock for the average American. What Smith conveniently leaves out is just how much his salary was. I’m willing to bet that even without the bonus (that he did end up getting) he wouldn’t have had to rely on food stamps like many of his fellow citizens.

Of course, the problem is that unlike the story he recounts from the 70’s, current investment banks are not private partnerships but public enterprises which have a fiduciary responsibility to their shareholders. When you look at the amount of shareholder wealth that has been nuked and compare it to the billions that were paid in ‘bonuses’ to generate these losses, you get a glimpse into the lopsidedness of things. Oblivious to reality, Smith expects Wall Street firms to act as if they are still private partnerships when in reality they are public.

We seem to be living in an altered reality: one where a $700 billion ‘blank cheque’ can be written to corporations based on nothing more than the flimsy support of vague promises on 3 pages, while a similar amount for everyone’s benefit has to run the gauntlet of Congress and go on for hundreds of pages in detail. One where banks claim that bonuses are needed to keep ‘talent’… yes, the very same so called ‘talent’ that replaced Wall St. with a giant maw. One where capitalism’s banner is raised proudly when the money is flowing in but where it is hastily lowered and stowed away for CEOs to play the mendicant. One where a person receiving welfare has to jump through hoops and tolerate intrusive government involvement in their personal lives but where banks rage against even the smallest concession when receiving billions of tax-payer’s money.

Camel-Birds
The best analogy to describe this is a Persian parable that I grew up hearing when I would make excuses to evade sacrifice or hard work. As preamble, in Farsi, the word for an ostrich is shotormorgh, a composite of two words: camel (shotor) and bird (morgh).

The story goes that an ostrich was approached and asked to help carry a load. It balked saying, ‘How can you ask this of me? Can’t you see I’m just a bird?’. Then it was asked to fly and take a message for a faraway town. To which it then replied, ‘What? you ask me to fly even though you can see clearly that I’m a camel?’

This insistence to have it both ways has become a hallmark of Wall Street. Just recently there have been a spate of hedge funds that have decided to simply shut down when faced with large losses. Prentice Capital and Tontine Associates are two of them with losses of 88% and 60% respectively. Rather than work hard at earning back the money they lost to clients and reach their high-water mark, they want to start a new fund and start to earn 2/20 commissions right away. Heads, I win - tails, you lose.

As far back as 12 years ago the Bank of England saw the inherent problem with a system that compensated employees for profitable risk-taking, but refused a consequence for any potential losses. Daniel Davies, a senior economist at the Bank of England wrote in 1997:

Employees’ contracts almost always involve limited liability; they may share profits from favorable trading outcomes but it is difficult or impossible to make them compensate their employers for losses…

The recommendation was to stretch out the time period for bonuses but it was firmly rejected by the City who saw it as intervention and an attempt at regulation. Of course, now these same laissez-faire disciples have no problem demanding that the taxpayer rescue them. The Royal Bank of Scotland is 68% owned by the UK government and yet, they are fighting tooth and nail to keep their bonuses.

Heads, I win - Tails, you lose
But beyond this paradox the lesson here is that greed is not good. That may be an odd thing to read on a blog about trading but I say that because, in fact, anything taken to excess will, eventually, create its own downfall. This is a truth that is self-evident. To all, that is, that choose not to ignore it. The rampant excess, hubris and sense of entitlement on Wall Street would make Caligula blush.

The obvious answer is if you want a market economy, then you take your losses along with your profits. If you want to bask in a performance based compensation, then you can’t be compensated as a star when you are the biggest loser. These watershed moments are what underlie cultural shifts. It isn’t just coincidence that the number one movie in the US is Slumdog Millionaire a story of a poor young man triumphing in a society where the rules are written by the wealthy, not the sequel to Wall Street.

To see what you missed, here are a few samples from this weekend’s reading list from news.tradersnarrative.com:

• Cramer’s fame outshines his stock picks
• Taking apart the $819 stimulus package
• Salary cap hijinks (little substance underneath all the noise)
• Dubai real estate collapse
• Bank of England cuts again (to the bone)
• Markopolos : tell me again why this guy isn’t running the SEC?
• Trader Monthly magazine shuts down (no more bottles and blondes, sniff)
• Using VWAP to Determine the Structure of the Trading Day
• Housing Affordability at Record High (try getting financing)

And remember to check regularly since there are interesting links added regularly throughout the week.

Speaking of monetary policy, I thought it would be interesting to look at the global central banks. Here is a chart for six of them for the past 10 years: European Central Bank (ECB), Bank of Canada, US Fed, Reserve Bank of Australia, Riksbank (Sweden), and the Bank of England (EDIT: after a request I added Japan).

Not surprisingly, they more or less move in synch with each other. Sometimes even cutting rates in quick succession to catch up with the leader. The outlier in this group is Australia. Not only did they take their rate higher than others, they also haven’t lowered it to match the others. But in the previous easing cycle (2001) they only came down to 4.25% also.

The Fed was the first central bank to lower key interest rates. The next was the Bank of Canada. The slowest among the 6 in the chart is the European Central Bank and Australia. These laggards have tried to make up for their mistake by making some incredibly deep cuts recently. I’m especially surprised by the 0.75 cut from the ECB.

The Bank of Canada will most probably deliver a 50 basis point rate cut when they meet next week, on December 9th.

Considering the swiftness of rate cuts, their global coordination, as well as their level in comparison to previous easing cycles, we are probably close to the end of the easing cycle. But, and I hate to say this, if this time is different, then who knows if history is any kind of a guide.

At this point, it is tempting to throw out all historical templates because they have done a monumentally poor job so far. While keeping in mind the danger of thinking that “this time it is different”, we are seeing signs that the world is undergoing a dramatic downturn in economic activity.

Just today, data was released showing the largest one month increase in unemployment in the US since the 1970’s - taking the unemployment rate to 6.7%. Add to that a swan dive in consumer confidence, an implosion in Detroit, melting real estate, etc.

It is safe to say that the central banks will continue to prioritize economic growth over inflation for the moment. Especially since we may very well experience a bout of deflation.

As I mentioned a few days ago, my gut instinct tells me that the major central banks are about to turn and enter into an easing cycle. The Australian monetary authority and their European counterparts stayed pat but the British had a surprise in store for the markets today.

Bank of England’s “Surprise” Cut
Today, the BoE reduced the bank rate by 25 basis points to 5.5% - at which, it is still the highest rate in Europe. According to Bloomberg, the vast majority of economists were not predicting the reduction.

This is the Bank’s first cut in more than 2 years and brings the rate down from a 6 year high. Most are now expecting that this will be accompanied by further cuts in the near future.

Similar to the Bank of Canada, the decision was spurred on by concern of an expanding credit crisis brought about by the sub-prime mortgage crisis in the US. An excerpt from their statement:

Although output in the United Kingdom has expanded at a brisk pace for the past two years, there are now signs that growth has begun to slow… conditions in financial markets have deteriorated and a tightening in the supply of credit to households and businesses is in train, posing downside risks to the outlook for both output and inflation further ahead.

According to HBOS plc, the UK’s largest mortgage and savings provider, house prices fell for a 3rd month in November by 1.1%. That’s the worst streak for property values since 1995.

European Central Bank Stands Aside
Citing an unexpected rise in inflation, the ECB decided to hold rates steady at 4%. If inflation hadn’t come in at 3% - a full percentage point above their target - I’m think they would also have reduced rates.

Unlike the Bank of England’s decision most economists and analysts expected the rate decision, so no surprise.