Trader’s Narrative

So the Fed gave $2 Trillion to some banks but won’t name them. Remember that? Bloomberg is suing them to get the information, Congress is asking and being rebuffed. But the WSJ got the scoop!

That and more, in this week’s reading list at news.tradersnarrative.com:

• Fed Using Enron Style Acctg to Bailout Wall St.
• WSJ Names Names: Who Got Secret Fed Money
• (Expected) SEC Fee Increase in April
• Tricks of the VIX
• When Will the Bull Return?
• Credit crunch tent city haunts California
• Investment Banks receive $50 through backdoor
• USO Finds Itself at the Mercy of Traders
• Dispelling Myths About Stocks in the 1930s

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

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.

This is a hilarious Alex cartoon about the many uses of quant jocks in investment banks:

A slightly better use of a quant jock’s talents would be to find correlating stocks. But what do I know?

For more, check out alexcartoon.com.

Last Friday when I found myself agreeing with Jim Cramer, I felt very uncomfortable for obvious reasons. But it seems that the central banks around the world, including the Federal Reserve are now on the same page.

It is all over the news that today and yesterday that the European central bank injected billions of euros into the banking system. The same was done on this side of the Atlantic with both the Fed and the Canadian central bank. Here’s the statement:

OTTAWA – In light of current market conditions, the Bank of Canada would like to assure financial market participants and the public that it will provide liquidity to support the stability of the Canadian financial system and the continued functioning of financial markets.

These activities are part of the Bank’s normal operational duties relating to the stability and efficient function of Canada’s financial system. The Bank is closely monitoring developments, and will deal with issues as they arise.

The same went for Australia, Japan, Korea and other major markets. But the reason why international markets had to move was that the Fed was slow off the mark (just as Cramer schreeched).

Paging Helicopter Ben
Had the Fed acted last week, things would have been much more contained. Again, I’m not calling for an interest rate reduction. That would be a blunt instrument for this type of situation. And in fact it could trigger a panic if it is interpreted the wrong way (like Bear Stearns’ statement). But increasing liquidity, as the central banks around the world have done, is the right way to go.

It is lamentable that they didn’t take action earlier. This isn’t about rescuing fat investment banks or hedge funds, it is about ensuring the stability of the financial system. When banks are timid to borrow from each other, when trust starts to evaporate, that’s when things can fray at the edges.

By not acting fast enough, what happened was that the overnight lending rate actually shot higher than the benchmark rate. This kind of move is so extreme because you have to understand that the short term rates were significantly below the benchmark rates set by the Fed. So in essence we had a pseudo tightening of the Fed funds rate. Definitely the opposite of what the market has needed for a while and most definitely not what it needs in this stressful times.

Contrarian Comedic Insights
On the plus side, usually when things trickle down to the general media and the public, the move is almost unwound. Take for example these two videos from Comedy Central. In the first Cramer tries to explain his on camera meltdown:

In this one, the sub-prime market is explained in rather, shall we say, simple terms… to comedic effect:

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