Trader’s Narrative

Executive compensation is one of the glaring issues at the heart of the financial crisis. We haven’t even come close to dealing with it in a meaningful way as the powerful Wall St. lobby moved quickly to throw obstacles in the path of any regulation or even discussion of the matter.

The most common argument that is trotted out to defend the obscenely disproportionate compensation packages on Wall St. is that the bonuses, salaries and stock options are needed to keep ‘talent’. But no one is able to ask how ‘talent’ that nukes the global financial system and brings down once mighty investment banks is worth even a shiny dime.

A look at the global bank CEO compensation also throws cold water on this non-sequitur:

Source: Reuters

The only non-US bank that approaches lofty compensation levels is Santander. Since the graph above shows the compensation and the market capitalization of each bank, I thought it would be interesting to show the relative compensation, so here is a graph of that:

There is incredible variation in executive compensation around the world with many very large banks being run by CEOs who are paid next to nothing (compared to US counterparts). So are they stupid to stick around? or is the North American mindset wrong?

I’m not really in favor of a government cap on compensation. But regulation is needed to bring salaries and bonuses in line with performance. And they clearly are not right now. The industry itself nor the market is going to deal with the agency issue at the heart of the matter. Shareholders theoretically are in control but in reality, there is so many layers of bureaucracy insulating them and the compensation committees appointed by the CEOs that no one really believes in this free market fairy tale anymore. A third objective party needs to step in and rescue Wall St. from themselves for the good of all.

The CFTC plans to hold hearings into revoking the exemptions they had previously give to investment firms which removed limits on the amount of assets they could hold in physical commodity markets. This exemption, called ‘Bona Fide Hedging’, circumvented a 1936 law which protected price discovery by limiting the involvement of speculators. It allowed true hedgers, producers and speculators to participate in the same market without anyone bullying the others.

Before the Great Crash of 1929 the US financial market was largely unregulated. You could say that compared to today’s market it was the wild wild west. As a consequence of the crash a lot of sensible regulations and government oversight was instituted. But most of those sensible and necessary rules were removed as the power of absolute free markets took hold. The pendulum is now swinging towards more regulation. All we can do is hope that it doesn’t swing too much and the regulations that are put in place are useful.

The danger is that politicians will make hedge funds or any speculator to be a scapegoat to score cheap points. If the limits are too restrictive, then it will reduce liquidity. But as long as we can go back to the simple rules that worked for 50+ years, I think we’ll be fine.

I don’t think that anyone can look at the underlying supply of crude oil, which has been plentiful and without interruption and then look at the demand side, which has been waning and find any justification for the kind of price swings that we have seen recently. In less than two years, we’ve seen a barrel reach $145, then crash to $33 and then rise 50% to $70! All the while, no fundamental change whatsoever has occurred in either the demand side or the supply side.

Although I believe we should let markets work, when you have speculators controlling more oil than all the commercial oil held in storage in the US combined with the US government’s Strategic Petroleum Reserve… then things are clearly out of whack. The only reason this was allowed was because the CFTC gave exemptions to OTC swap dealers who needed to hedge their own exposure through the futures markets. Due to the size and amount of their OTC transactions, the needed to take mammoth positions.

It isn’t entirely clear what the CFTC will do but the hearings coming up will provide an answer. As usual, expect the FIA to push for less regulation. One possible solution would be more transparency. The CFTC will improve the detail in its weekly CoT report by reporting swap dealers positions separately.

The result will probably be less volatility, which is not that great if you’re a trader. But if the consequence is having a sane and healthy commodity market which will provide a foundation for a stable economy, then I’m all for it.

Finally, there was a rogue trader from PVM who pushed the futures price higher by an extra $2 recently and caused a $10 million loss. But that is not even chump change compared to the size of the oil market. If there was a ‘Nick Leeson’ type trader out there who was responsible for the run up in crude oil, it would let Goldman Sachs and other investment banks off the hook.

A recent article shows the chart to the left which demonstrates the correlation between crude oil prices and the size of the passive long-only institutional investor.

This is a topic that I’ve been harping on ever since last year, as a barrel went for $135: What is really going on with the price of crude oil?

It also confirms the previous chart showing the stampede of hedge funds and other large speculators to the long side of oil. Back then I couldn’t prove what was going on but the inflation adjusted price of oil certainly looked like a bubble.

There wouldn’t be a problem of course if these powerful market participants were taking both or either sides in legitimate speculation or hedging. But there is a problem for everyone, including these same institutions, when they pile into only one side, continuously going long the crude oil futures.

According to the article:

Passive investors increased their crude-oil holdings to the equivalent of more than 600 million barrels in June, up more than 30% from the end of last year…

So what is going on? How can these behemoth institutional players treat the crude oil market like their very own ponzi scheme? Last year the effects on the world economy were devastating. Wealthy economies stalled into a recession and poor economies were thrown into chaos as staple food prices soared.

Isn’t there a regulation to prevent the manipulative “walking up” of prices in commodities? Yes, yes there is. Or more accurately there was.

Matt Taibbi’s scorching article on Goldman Sachs (GS) in the most recent edition of Rolling Stone magazine explains. There was a 1936 government regulation which had successfully stopped this type of shenanigan. In effect it did not allow large speculators to lean on any commodity market and crowd out real producers and consumers. Until 1991. That’s when Goldman Sachs’ (GS) commodities subsidiary, J. Aron, request an exemption based on the flimsiest justification.

Amazingly enough it got it. And over the years the CFTC handed out 14 other similar exemptions. Goldman and its ilk were busy with a few other schemes and it wasn’t for a while that they started to really take advantage of the loophole they had gained. What followed was nothing short of astonishing. For example:

Between 2003 and 2008, the amount of speculative money in commodities grew from $13 billion to $317 billion, an increase of 2,300 percent.

What makes this even more astonishing is that last year’s oil spike (or bubble) happened when the world was awash in oil supply and faced a drastically reduced oil demand!

…according to the US Energy Information Administration, the world oil supply rose from 85.24 million barrels a day to 85.72 million. Over the same period, world oil demand dropped from 86.82 million barrels a day to 86.07 million.

By the summer of 2008, in fact, commodities speculators had bought and stockpiled enough oil futures to fill 1.1 billion barrels of crude, which meant that speculators owned more future oil on paper than there was real, physical oil stored in all of the country’s commercial storage tanks and the Strategic Petroleum Reserve combined.

This whole bear market has been a massive lesson in the validity and value of smart government regulations. As Ritholtz counts off in his book “Bailout Nation”, over a number of years and even decades, the threads of regulation where one by one removed. As the regulatory framework deteriorated in tatters, things started to go wrong.

Of course, as you may recall, that explanation was not the one offered when we were in the thick of things last year. The old and tired theory of “Peak Oil” was on everyone’s lips and many actually believed it.

The problem with that is, in the market when something is obvious to everyone, it is obviously false. And as I’ve said before many times, while no one disputes that the supply of oil is finite, it is a non sequitur to posit that as this resource is exhausted, the price of oil will spike.

If you believe otherwise, then get into your time machine, go back to the 1800’s and corner the whale blubber market.

The SEC has recognized that the present rules for short selling haven’t worked out that well. It doesn’t take a genius to recognize that rampant naked short selling exacerbated the crisis, especially within the financial sector. The most egregious example is Bear Stearns but many other well known Wall St. investment banks saw their shares pummeled mercilessly late last year. As usual, the SEC is playing catchup. But if it acts intelligently it may still benefit everyone by creating a more stable, fair and balanced market.

As a consolation, any changes to the present rules won’t be sprung on traders as a surprise. We are presently in a 60 day consultation period, after which when or if a decision is made, it will be implemented after 3 more months to give everyone involved plenty of time to prepare. There are five possible options:

The first suggestion is to bring back the uptick rule that we have known so well over the past 70+ years. This was implemented in 1937 as a result of rampant manipulation of the market by wealthy speculators (the precursors to hedge funds) during the roaring 1920’s. It was eliminated July 3rd 2007 with little fanfare; The Uptick Rule: Nice Knowing You.

The disadvantage with the uptick rule was that it was easily circumvented by those that count. That is pro traders, institutions, etc. As always, in the end, the retail trader was left out in the cold while those with insider knowledge and more resources simply side-step the rules and sold short despite the uptick provision. Another disadvantage is that the market has become faster and more fragmented so it is getting harder to determine what exactly the immediate last price was. The advantage is that the uptick rule is well known to all market participants and it would be psychologically easy to simply revert back to them (or circumvent them, depending on who you are).

The second suggestion is to slightly modify the old uptick rule by making it more stringent: a short sale could only take place if the stock price traded at least a penny higher than before. I’m not sure what this slight ratcheting up of conditions really accomplishes. I suppose we could say 2 cents, 5 cents, and so on. In the end we’re really talking about a similar restriction to the old uptick rule with the same advantages and disadvantages.

The third suggestion is to introduce a restriction in trading only if a stock price experiences a decline of, say, 10% in a day. The simplest of these “circuit breaker” type suggestions is a blanket ban on short selling a stock that falls 10% within a trading session. This would be similar to limit days in commodity markets. Although, under this condition, the stock price could very well continue to fall much further than 10% - it simply couldn’t be pushed by short sellers.

The fourth suggestion is to soften the circuit breaker idea by just re-introducing the uptick rule for the remainder of the day if a stock falls 10%. So rather than no short selling at all, you could sell a stock short as long as it met the uptick conditions.

The fifth suggestion is to introduce a “bid test” if a stock falls 10% (in a trading session). This would mean that a short sale could occur only if it takes place at the highest available bid and not just an uptick.

My hunch is that if the SEC goes with any of the circuit breaker ideas it will introduce them in staggered fashion rather than in one fell swoop. There are two main perspectives on this sort of thing: leave the market alone and to regulate heavily. I fall somewhere in the middle. The trick is that while we do need to interfere with the market, it has to be done intelligently and minimally.

I can’t understand those that want a completely free market. We are constantly interfering with the systems that we live in. We have laws (that are constantly changing and adapting), we have police and courts that react to our behaviors and actions, etc. How is the stock market different?

The problem is when regulation is done with a sledgehammer it becomes outright intervention, which is at best useless and at worst, disastrous. If the SEC takes this short selling restriction too far, it won’t stop the practice but simply force it to take place in different forms and in different places. For example through swaps or other unregulated dark corners of finance.

Take a look at the Karachi stock exchange chart below to see what happened when the government of Pakistan put an artificial floor on prices:

Obviously a government mandated floor for stock market prices doesn’t work. And recall how last year, the SEC along with the equivalent regulatory body in the UK (the FSA) halted short selling from September 19th to October 8th 2008. Although it originally covered mainly financial and bank stocks, it was quietly expanded to include other companies as well. In the end, it had really as much effect as standing in front of a runaway freight and yelling ‘STOP!’.

But that doesn’t mean that we should throw our hands up and do nothing. Everyone involved with the market knows that naked short selling is a problem. It shouldn’t be allowed because it undermines the integrity of the stock market. If the SEC can put a stop to the abusive short selling practices it would go a long way in restoring confidence in the stock market. That would be much more productive than ruminating about the minutia of short sale restrictions.

So basically a small group of bankers (Summers, Paulson, Rubin) that saunter back and forth between private and government jobs, along with regulators (Greenspan, Bernanke, Geithner, SEC, etc) - who don’t really regulate - created a situation where the US taxpayer would foot the bill when the bank’s had finished their shenanigans. Check out the interview with William K. Black, the article about Brooksley Born’s attempt to regulate the CDS market, and other similar articles. Oh and by the way, Fannie and Freddie are about to pay $210 million in bonuses.

Those are just a few picks from the past week’s reading list at news.tradersnarrative.com. Follow the link below to get much, much more:

• FASB’s Mark-to-Market Ruling
• A Few Drops Don’t Make the Glass Half Full
• Geithner’s Plan is worse than nationalization
• Fine-Tuning Candlestick Trading: Combine Moving Average Techniques
• The Regulatory Charade
• One Secret to Life Success
• MIT Blackjack Team perspective on the financial crisis
• 6 reasons I’m calling a bottom and a new bull
• I helped build the bomb that blew up Wall Street

And remember to check regularly since there are new links added everyday.

Lawrence Summers Comments on Jobs, Economy: