Prometheus

Out of Recession……Just         

What a let down for all the financial market writers this mornings Q4 GDP figures were, as their clearly pre-penned articles discussed the good news for the government as we finally left recession behind. Well that’s optimism for you when the rebound from the sharpest annual economic contraction on record (4.8%) and the longest since 1955, is just a measly 0.1%.  While this may get revised this still represents a real disappointment and supports our base case that it will take time for us to recover to where we were at the start of 2008, let alone move forward.

We will revisit this following the US GDP figures that are released at the end of the week. In the meantime let us look at the recent Obama announcement and why the issue is somewhat more complicated than the headlines indicate. This is a little longer than normal but we hope worth the extra two or three minutes for some of the views you are unlikely to find in the financial press and a fresh insight on the workings of a leading hedge fund.

Volcker Rules, OK?

Much has been written in the press since the new Volcker Plan was announced in an effort to reign in the excesses of Wall Street. While there is merit in such a move we should first point out that investment bankers, while very guilty, have become a scapegoat for a decade of financial illiteracy where politicians, central bankers, regulators, TV property pundits and of course the debt ridden consumer all have their share of culpability.

More to the point such is the complex nature of modern investment banking and financial markets the early sketch looks too simplistic and what we discuss below demonstrates the need for greater regulation and knowledge on the part of regulators and governments. First, as some commentators correctly point out Lehman Brothers was not a high street bank and did not take deposits so the new rules would not have prevented the global financial crisis. But is this true?

Well yes. But no

Ignoring the fact that the now shrunken investment bank world operates like a state backed, rent seeking oligopoly (we are being kind) some of the innovations of this sector spread like a disease that infected the banking system, to the point where almost every major name was at systemic risk. Indeed once you understood this (and regardless of very justifiable concerns over moral hazard) it seemed clear that no major name would be allowed to go bust due to the inevitable calamity that would follow. Indeed following the saving and takeover of Bear Stearns we wrote in April 2008:

“Armageddon is off the table.” This sounds melodramatic, but it isn’t. It is truly scary how close we have come to the possible meltdown of the Western banking system (this is an issue we will address in the near future), however the decisive intervention by the Fed to support Bear Stearns and to open funding to a wider range of financial institutions has signalled that it will do whatever is necessary to avert catastrophe.

Re-reading these words two things spring out, firstly that we didn’t actually delve into the details of why a meltdown was possible, in large part because that seemed no longer a risk in light of our second assumption; that the authorities “got it” and wouldn’t allow catastrophe to happen. Yep, have to hold our hands up there; we didn’t see Lehman’s coming.

In light of this let’s go back and address why the banking meltdown was inevitable if a major player got taken out. In simple terms the modern inter-bank market is monumental in size and largely unregulated. Perhaps the poster boy for these markets with regard to Lehman’s and crucially the concurrent collapse of AIG, is the market for Credit Default Swaps, more commonly known as the CDS market.

Now I know many will be stifling a yawn at this point but bear with us and we will try to make the boring bit as succinct as possible and then use a real life hedge fund trade to highlight the risks still involved in this market.

CDS basics

As the name implies the CDS was originally developed as insurance to protect a bond (credit) holder from a default on corporate and government bonds they held. Effectively the Swap part of the term is the swapping of risk between an investor and a specialist in financial insurance.

From small beginnings the market grew as investors could trade with others, changing their risk profile in many varied ways. With this flexibility came more and more trading and investing ideas that could be uniquely tailored to suit a specific view or strategy, most of which didn’t have anything to do with simple insurance. The hedge fund trade we highlight at the end clearly illustrates this.

By the beginning of 2008 it was estimated that the total value of outstanding CDS contracts stood at around $60 Trillion (yes, Trillion, roughly the same as global GDP). The view of the market at the time was that this posed little risk as traders would offset their positions (often wrong and basically naïve about traders) and that at least risk was broadly spread across markets, which of course it was, but on a vast scale. Now maybe it’s just us but in a $60 Trillion market if only a small percentage of deals have problems you rapidly begin to talk about a lot of money. And so it came to pass in autumn 2008…

Financial Weapons of Mass Destruction

Is what Warren Buffet called financial derivatives in 2003 and that they posed “mega-catastrophic risk”. Smart bloke that Warren Buffett. Probably worth a bob or two.

Now the CDS market is unregulated and has no central counterparty, so most of these contracts were written by a few key investment banks, including Bear Stearns and Lehman Brothers, who traded with each other (and third parties) directly. Now if one of those bank counter-parties goes bust a black hole, potentially worth hundreds of billions of dollars appears in the banking system (we won’t know the full extent of the losses for years as it will take that long to sort out Lehmans trading books). In a world full of banks struggling with the impact of US mortgage debacle, and the seizing up of the inter-bank deposit market, this was too much.

So you see it didn’t matter that Lehman’s wasn’t a high street clearer, the fact is many others in this inter-connected world were, such is the nature of systemic risk

But worse was yet to come

Just as the banks were reeling from Lehman’s an even worse problem was unravelling at insurer AIG all because of the humble CDS. As concerns about the US housing market began to surface in 2006/7 some investors in Mortgage backed CDOs (Collateralised Debt Obligations) wanted protection from possible risks and the result was the CPDO (Constant Proportion Debt Obligation, we thought you might want to know) which effectively protected the CDO capital value, income, or both and the cost was only a small drop in the yield. But how was this possible, well the humble CDS was doing something it was designed for, insuring a bond. But who would write protection on a bunch of overvalued, opaque and often geared products with exposure to the unfolding disaster of US housing that would ultimately result in over $100 bln losses.

Surely not the company who underwrote and insured much of the global banking network, not conservative, dull AIG. Unfortunately without a proper market place and regulatory oversight nobody knew. You really couldn’t make it up.

AIG was saved. It really had to be because although it wasn’t a bank many have argued that the banking system it underwrote (and we include banks with absolutely no investment banking interest) could not have survived. All hail the humble CDS.  Lets be clear the Volcker rule wouldn’t have stopped AIG.

Clever CDS trade

And just to prove that the CDS continues to be used for things other than insurance take a recent trade by a highly regarded hedge funds manager (lets call him Harry Hedge, or HH for short).

Now HH knows a company in the Far East. It is heavily indebted, in a market with excess capacity, has a higher cost base than its competitors and HH has good reason to think it is about to loose its biggest customer. He reckons they have a very good chance of going bust, say 50/50.

But he doesn’t bet against the shares in the market, that’s too messy, unpredictable, costly, fraught with regulatory oversight, and frankly unprofitable compared to what he has done. Instead he buys a CDS to provide default protection on £10m worth of the company’s bonds. Now he doesn’t own any bonds; he just wants the insurance payout if the company goes bust, which after some recovery of assets he reckons will be 95% of the sum insured. So if he gets his 50/50 bet right he gets £9.5m for a £50,000 stake. That’s a 190 times uplift for the same odds as flipping a coin.

That’s great if you are him or an investor in his hedge fund but what of the bank where a trader looking at his standard risk models, little macro or fundamental analysis and with little imagination has effectively done the equivalent of insuring a driver who has a 50/50 chance of totalling his £20k car for just £100. With those odds HH has a fair margin for error but if you have an interest in the bank you should worry about risk management.

And finally

Sorry no joke today. Writing about this tends to remove your sense of humour. The sad simple truth is that this is about much more than just splitting up the banks and the authorities need to get a grip with this underlying reality but they aren’t. We’re not sure they get it even now. Vast amounts of money have been pumped into the markets but the banks have largely kept it to themselves, while credit supply to the real economy craters and the imbalances begin to grow all over again. If they don’t get a grip soon….well lets just hope they do