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Derivatives remain a dark secret with undocumented risks to economies and consumers


Derivates were a hot topic during the height of the banking crisis and we all remember they were the specific reason that AIG went out of business because they had been speculating in those products to an extent that far exceeded business requirements.  When the markets froze AIG were unable to meet their off balance sheet commitments in the form of derivatives and went under. What followed in September 2008 was an $85 bn bailout.

The level of derivatives in the world was close to $700 Bn.  To place that figure in perspective, world GDP is around $60 Bn.  Derivatives which are in theory a financial hedge or insurance against shifts in markets or currencies are worth an astounding 10 times the value of world trade.

Even when we allow for secondary hedges (similar to re-insurance) there can be no good reason for derivatives at that level other than financial speculation. 

Which brings us to this piece in the New York Times that describes the method being used to manage that global risk in the wake of the crisis.  The regulators have delegated the responsibility to the group responsible for much of those derivatives, and the names will be familiar.

The NY Times piece focusses on the profits that come from the derivatiaves, and the extraordinary efforts to ensure that the trading in them remains with the banks and in a non-electronic form which appears to be related to retaining control of the market.  It refers to similarities with Nasdaq in the ‘90s when it was pressured to become an open electronic exchange and that fees dropped significantly.

A Secretive Banking Elite Rules Trading in Derivatives | NY Times

None of the three clearinghouses would divulge the members of their risk committees when asked by a reporter. But two people with direct knowledge of ICE’s committee said the bank members are: Thomas J. Benison of JPMorgan Chase & Company; James J. Hill of Morgan Stanley; Athanassios Diplas of Deutsche Bank; Paul Hamill of UBS; Paul Mitrokostas of Barclays; Andy Hubbard of Credit Suisse; Oliver Frankel of Goldman Sachs; Ali Balali of Bank of America; and Biswarup Chatterjee of Citigroup.

Mr. Griffin said last week that customers have so far paid the price for not yet having electronic trading. He puts the toll, by a rough estimate, in the tens of billions of dollars, saying that electronic trading would remove much of this “economic rent the dealers enjoy from a market that is so opaque.”

It remains unclear why the C.M.E. ended its electronic trading initiative. Two people with knowledge of the Chicago Mercantile Exchange’s clearinghouse said the banks refused to get involved unless the exchange dropped Citadel and the entire plan for electronic trading.

Relevance to Bankwatch:

There are two points to be made here.  The NYT makes the point that significant profits are being protected by a closed group, and you can bet those revenues are costs that end up costing consumers more for for underlying services and products such as petroleum.

The second point to consider is the larger need for a market that reflects 10 x world GDP.  The lack of transparency means that we cannot really explain that, and I still believe this to be a large and undocumented risk.

I am not expert enough to begin to quantify the risk associated with derivatives, and I am in good company on that score.  What I am qualified to state is the there can be no good associated with management of derivatives that amount for alongside your savings account.  The parts of the new regulation that separate investment and retail banking must have some merit on that score.

But we know regulators will never get it all right, and lobbying efforts to retain the status quo will likely be based on ideas that the tremendous risk associated with another freeze up with the credit markets as we had in September 2008 could re-occur in a heartbeat.

All we know is the risk remains, and in this respect nothing has really changed since September 2008 with one key exception.  The banking system has been guaranteed by governments implicitly since 2008 (explicitly in the case of Ireland) and this guarantee is the only thread holding it all together.  That is why the US in particular is so keen to ensure maximum liquidity for banks (Quantitative Easing).

Why does it still feel that all we are doing is postponing inevitable tough decisions.

Written by Colin Henderson

December 12, 2010 at 15:44

The value of patience | Haldane BofE


This is a remarkable paper from Andrew Haldane at the Bank of England.  There are lessons and direction here for everyone and it is not as dry as one might expect.  It is the more remarkable because it addresses human behavior and relates to economic context.  Not your typical Central Bank speech.  Lessons from Asia are being learned.

The most amazing for me is the HFT (high frequency trading) stat about Accenture in bold.

A few quotes to whet your appetite.

  • Take happiness. Studies have shown that happy people save more and spend less. Happy people also take longer to make decisions and expect a longer life. In short, they are patient.
  • Just as patience can self-generate, so too can impatience. And while patience generates self-improving cycles, its alter ego can create self-destructive cycles. Addiction is the classic self-destructive cycle. Drugs and alcohol chemically alter the balance of the double-self, increasing the value of instant gratification. This shortens time horizons, increasing further the value of instant gratification in a downward spiral. Unless arrested, this unfulfilling equilibrium becomes self-fulfilling.
  • John Maynard Keynes. He quipped: “markets can remain irrational for longer than you or I can remain solvent”.
  • By the time of the stock market crash in 1987, the average duration of US equity holdings had fallen to under 2 years. By the turn of the century, it had fallen below one year. By 2007, it was around 7 months. Impatience is mounting.
  • A decade ago, the execution interval for HFTs (high-frequency traders) was seconds. Advances in technology mean today’s HFTs operate in milli- or micro-seconds. Tomorrow’s may operate in nano-seconds.
  • HFT firms are believed to account for more than 70% of all trading volume in US equities
  • HFT is believed to account for between 5 and 10% of Asian equity volumes. This evolution of trading appears already to have had an effect on financial market dynamics. On 6 May 2010, the price of more than 200 securities fell by over 50% between 2.00pm and 2.45pm.32 At 2.47pm, Accenture shares traded for around 7 seconds at a price of 1 cent, a loss of market value close to 100%. No significant economic or political news was released during this period.
  • So disliking goods price inflation and liking asset price inflation suggests a potential time-inconsistency in preferences. It is leaving as a bequest for your children the mortgage but not the house.

Written by Colin Henderson

September 2, 2010 at 22:10

Mortgage regulation in US has worked judging by dramatic impact on brokers


Here is one set of regulation that seems to have worked. The article recounts one broker who is down from 85 on staff to 3.

What is intriguing is that the bankrate article seems to suggest this is a bad thing. The reasons provided in the quote below just sound like back to basics banking process that provides lenders and customers protection.

In fact it suggests brokers can only operate in a loose credit/ no diligence environment. I do not believe that and surely there is a model for brokers that involves lending discipline.

http://www.usatoday.com/money/economy/housing/2010-08-28-mortgage-brokers_N.htm

Credit histories must be dutifully compiled for all borrowers. And any number of new criteria can lead to a refusal to lend. One new practice closes the door on loans to anyone who’s done a short sale — a way of selling a house when the sale proceeds fall below the balance on the mortgage — in the past three years.

Written by Colin Henderson

August 28, 2010 at 14:42

Greece and what it means


I cannot but help believe there is a deeper problem relative to the situation in Greece.

Three people died in a central Athens bank that was set ablaze by Greek protesters on Wednesday during a march against government austerity measures, aimed at saving the country from bankruptcy

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At one level it is a financial crisis and it should get sorted out with banks involved taking losses eventually as debt will have to be written off or at least placed on such terms as to make repayment unlikely.

But this situation is altogether different and deeper than Argentinean or Thai defaults of the past decades.  Here we have a population with the same passport as Germans, French or British killing people and blaming the IMF for their own profligacy.

The world is in a state of transition between old style nations (nation states) with finite borders that largely contain their problems internally insulated from the world to a world of globally interconnected market states where responsibilities are much fuzzier and it is all to easy to blame others for ones own misfortunes.  This new market state world has an objective of enhancing the opportunity of individuals versus the previous state that was designed to enhance opportunities of groups including unions, the aged, youth etc.

This new world brings responsibilities and accountabilities with it but the Greeks are at the front end of the change and not liking it much.  The implications for Europe and their responsibilities in all this is also embarrassingly clear too.

All of this makes it hard for banks to operate effectively and responsibly with these upheavals in financial markets which have no clear end game.

Written by Colin Henderson

May 5, 2010 at 10:30

You truly know when a country is dysfunctional when its AIR FORCE goes on strike


The always insightful John Mauldin speaks about the crisis that is Greece and the steps towards another banking crisis.  When you have full countries falling apart this is not good for anyone.  The degree of failure inside Greece is astounding, and will only lead to worse before it gets better. 

The larger impact is on currencies, interbank lending (again) and banking system confidence if it is first Greece, then Spain and Portugal … then?

MACRO-EUROPE: The Titanic is SINKING | Investorsinsight.com

There are no good solutions here, only very difficult ones. In order to get financing, Greece must willingly put itself into a multi-year depression. And borrowing more money when it cannot afford to pay back what it has will not solve the problem. 61% of Greeks now favor leaving the euro. How has Greece responded? By banning short selling on its stock market for the next two months. That should make things better. Greeks are responding by rioting and going on strike. But you truly know when a country is dysfunctional when its AIR FORCE goes on strike. Yesterday Reuters reported that hundreds of Greek pilots called in sick in protest. The response from government? The Minister of Defense said he was "profoundly disappointed." Now that had to make the pilots feel bad.

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Written by Colin Henderson

April 28, 2010 at 20:49

Posted in Business Models

The Magnetar Trade – otherwise known as ‘The Black Hole”


This is a complex article at ProPublica that in simple terms illuminates all that was wrong with CDO’s and synthetic CDO’s. These instruments allowed investment bankers like Magnetar to circumvent insider trading rules.  The story of Goldman Sachs being charged by the SEC for fraud is only the beginning.  Financial reform is the last thing many financiers and bankers will have to worry about as this story takes hold.

Magnetar involved all the big names and most are listed here.  You will see many recognisable names, eg. Citi, Wachovia, Deutsche, Lehmans, UBS, Mizuho, JP Morgan.  At this point it appears to be only guilt by association, however there is nothing good or right in this tale.  Propublica quote this participant.  “The deal was a disaster. He shook his head at being reminded of the details and said: “After looking at this, I deserved to lose my job.”

The Magnetar Trade

Magnetar’s approach had the opposite effect — by helping create investments it also bet against, the hedge fund was actually fueling the market. Magnetar wasn’t alone in that: A few other hedge funds also created CDOs they bet against. And, as the New York Times has reported, Goldman Sachs did too. But Magnetar industrialized the process, creating more and bigger CDOs.

Magentar founder Alec Litowitz speaks at a private equity conference held at Kellogg School of Management at Northwestern University in February 2007. (Nathan Mandell)

Magentar founder Alec Litowitz speaks at a private equity conference held at Kellogg School of Management at Northwestern University in February 2007. (Nathan Mandell)

What Magnetar were able to do was fund the housing bubble and bet against it bursting all at the same time.  They were able to do this using CDO’s and building them all the while knowing the bubble would burst.  The beauty of what they did was to create cash flow to fund their short selling of their own CDO.

Magnetar’s (Nearly) Perpetual Money Machine

By buying the risky bottom slices of CDOs, Magnetar didn’t just help create more CDOs it could bet against. Since it owned a small slice of the CDO, Magnetar also received regular payments as its investments threw off income.

Written by Colin Henderson

April 17, 2010 at 20:46

The Impact of the Internet on Institutions in the Future | PEW


There is lots of wishful thinking contained in this PEW report which is not one of their better ones imho.  The people interviewed are by PEW’s admission skewed and several silicon valley names are included.  However the views follow the predictable linear thought process, such as, we have social networks therefore tomorrow everything will be social.  Clearly there are themes and directional indicators, but there are competing themes such as organisational inertia, shareholder needs, economic crises and last but not least, human nature. 

Some extracts.

The Impact of the Internet on Institutions in the Future | PEW

Some 26% agreed with the opposite statement, which posited:

  • ”By 2020, governments, businesses, non-profits and other mainstream institutions will primarily retain familiar 20th century models for conduct of relationships with citizens and consumers online and offline.”

Once past the headline, the sense of change remains, but some doubt expressed about the 2020 date and that it might be too early for consequential change. 

While their overall assessment anticipates that humans’ use of the internet will prompt institutional change, many elaborated with written explanations that expressed significant concerns over organization’s resistance to change. They cited fears that bureaucracies of all stripes – especially government agencies – can resist outside encouragement to evolve. Some wrote that the level of change will affect different kinds of institutions at different times. The consensus among them was that businesses will transform themselves much more quickly than public and non-profit agencies.

Many selected the “change” option, but said they were not sure drastic change will occur in organizations by the 2020 time frame. They said the most significant impact of the internet on institutions will occur after that. Some noted this change will cause tension and disruption.

And this final pessimistic note from Andy Oram is one that I can see being true.

The positives and negatives of technological change do battle. Will the result be a triumph of networking or more-concentrated, centralized control?
“I’m sure the survey designers picked this question knowing that its breadth makes it hard to answer, but in consequence it’s something of a joy to explore. The widespread sharing of information and ideas will definitely change the relative power relationships of institutions and the masses, but they could move in two very different directions. In one scenario offered by many commentators, the ease of whistle-blowing and of promulgating news about institutions will combine with the ability of individuals to associate over social networking to create movements for change that hold institutions more accountable and make them more responsive to the public. In the other scenario, large institutions exploit high-speed communications and large data stores to enforce even greater centralized control, and use surveillance to crush opposition. I don’t know which way things will go. Experts continually urge governments and businesses to open up and accept public input, and those institutions resist doing so despite all the benefits. So I have to admit that in this area I tend toward pessimism.” – Andy Oram, editor and blogger, O’Reilly Media.

Thoughts?  What will organisations look like in 2050 say?  Will the enterprise be open and participative with looking more like todays Google, or todays Bank of America?

Written by Colin Henderson

March 31, 2010 at 19:20

Posted in Business Models

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