Notes and Predictions: The Stress Test

As the results of the stress test start leaking out slowly, it’s a fun exercise to make some educated guesses/predictions about what the future holds and take note of pertinent facts. As we’ve discussed before, there is a lot to take issue with when considering the results of the stress test at all, especially given the added layers of uncertainty stemming form the limited information provided in the scenarios. So, without further delay, let’s get started.

1. The baseline scenario will prove wholly inadequate as a “stress test.” Please, follow along with me as I read from the methodology (pdf).  I’ll start with the most egregious and reckless component of the mis-named baseline scenario (I would rename it the, “if payer works” scenario) : what I will refer to as “the dreaded footnote six.” From the document:

As noted above, BHCs [(Bank Holding Companies, or the firms being stress tested)] with trading account assets exceeding $100 billion as of December 31, 2008 were asked to provide projections of trading related losses for the more adverse scenario, including losses from counterparty credit risk exposures, including potential counterparty defaults, and credit valuation adjustments taken against exposures to counterparties whose probability of default would be expected to increase in the adverse scenario.(6)

[…]

(6) Under the baseline scenario, BHCs were instructed to assume no further losses beyond current marks.

(Emphasis mine.)

Holy <expletive>! In what alternate/parallel/baby/branching universe is this indicative of anything at all? Assume no further losses beyond current marks? Why not assume everything returns to par? Oh, well, that actually was a pretty valid assumption for the baseline scenario. From the document:

New FASB guidance on fair value measurements and impairments was issued on April 9, 2009, after the commencement of the [stress test].  For the baseline scenario supervisors considered firms’ resubmissions that incorporated the new guidance.

(Emphasis mine.)

Thank goodness! I was worried that the “if prayer works” scenario might have some parts that were worth looking at. Thankfully, for troubled banks, I can skip this entire section. (Confidence: 99.9999%)

2. Trading losses will be significantly understated across all five institutions that will need to report them. First, only institutions with over $100 billion in trading assets were asked to stress their trading positions. Second, from the section on “Trading Portfolio Losses” from the document:

Losses in the trading portfolio were evaluated by applying market stress factors … based on the actual market movements that occurred over the stress horizon (June 30 to December 31, 2008).

(Emphasis mine.)

Okay, well, that seems reasonable, right? Hmmmm… Let’s take a look. Here is what some indicative spread movements for fixed income products looked like January 9th of 2009, according to Markit (who has made it nearly impossible to find historical data for their indices, so I’m resorting to cutting and pasting images directly–all images are from their site):

(Click on the picture for a larger version.)

Well, looks like a big move is taken into account by using this time horizon. Clearly this should provide a reasonable benchmark for the stress test results, right? Well, maybe not.

(Click on the picture for a larger version.)

Yes, that’s right, we’ve undergone, for sub-prime securities a massive widening during 2009 already. Also, as far as I can tell, the tests are being run starting from the December 2008 balance sheet for each company. So, if I’m correct, for the harsher scenario, trading losses will be taken on December 2008 trading positions using December 2008 prices and applying June 2008 to December 2008 market movements. For sub-prime, it seems pretty clear that most securities would be written up (June 2008 Spread: ~200, December 2008 Spread: ~1000, Delta: ~800, Current Spread: ~2600, December 2008 to Today Delta: ~1600, Result: firms would take, from December 2008 levels, half the markdown they have already taken).

Also, it should be a shock to absolutely no one that most trading assets will undergo a lagged version of this same decline. Commercial mortgages and corporate securities rely on how firms actually perform. Consumer-facing firms, as unemployment rises, the economy worsens and consumption declines, and consumers default, will see a lagged deterioration that will appear in corporate defaults and small businesses shuttering–both of these will lead to commercial mortgages souring.  Indeed we’ve seen Moody’s benchmark report on commercial real estate register a massive deterioration in fundamentals. That doesn’t even take into account large, exogenous events in the sector. Likewise, we see consistently dire predictions in corporate credit research reports that only point to rising defaults 2009 and 2010.

In short, for all securities, it seems clear that using data from 2H2008 and applying those movements to December 2008 balance sheets should produce conservative, if not ridiculously understated loss assumptions. (Confidence: 90%)

3. Bank of America will have to go back to the government. This, likely, will be the end of Ken Lewis. It’s not at all clear that Bank of America even understands what’s going on. First, if I’m correctly reading Bank of America’s first quarter earnings information, the firm has around $69 billion in tangible common equity. Also, it should be noted that the FT is reporting that Bank of America has to raise nearly $34 billion.  Now, with all this in mind, let’s trace some totally nonsensical statements that, unlike any other examples in recent memory, were not attributed to anonymous sources (from the NYT article cited above):

The government has told Bank of America it needs $33.9 billion in capital to withstand any worsening of the economic downturn, according to an executive at the bank. […]

But J. Steele Alphin, the bank’s chief administrative officer, said Bank of America would have plenty of options to raise the capital on its own before it would have to convert any of the taxpayer money into common stock. […]

“We’re not happy about it because it’s still a big number,” Mr. Alphin said. “We think it should be a bit less at the end of the day.” […]

Regulators have told the banks that the common shares would bolster their “tangible common equity,” a measure of capital that places greater emphasis on the resources that a bank has at its disposal than the more traditional measure of “Tier 1” capital. […]

Mr. Alphin noted that the $34 billion figure is well below the $45 billion in capital that the government has already allocated to the bank, although he said the bank has plenty of options to raise the capital on its own.

“There are several ways to deal with this,” Mr. Alphin said. “The company is very healthy.”

Bank executives estimate that the company will generate $30 billion a year in income, once a normal environment returns. […]

Mr. Alphin said since the government figure is less than the $45 billion provided to Bank of America, the bank will now start looking at ways of repaying the $11 billion difference over time to the government.

(Emphasis mine.)

Right around the time you read the first bolded statement, you should have started to become dizzy and pass out. When you came to, you saw that the chief administrative officer, who I doubt was supposed to speak on this matter (especially in advance of the actual results), saying that a bank with $69 billion in capital would be refunding $11 billion of the $45 billion  in capital it has already received because they only need $34 billion in capital total. Huh? Nevermind that the Times should have caught this odd discrepancy, but if this is the P.R. face the bank wants to put on, they are screwed.

Now, trying to deal with what little substance there is in the article, along with the FT piece, it seems pretty clear that, if Bank of America needs $34 billion in additional capital, there is no way to get it without converting preferred shares to common shares. There is mention of raising $8 billion from a sale of a stake in the China Construction Bank (why are they selling things if they are net positive $11 billion, I don’t know). That leaves $26 billion. Well, I’m glad that “once a normal environment returns” Bank of America can generate $30 billion in income (Does all of that fall to T.C.E.? I doubt it, but I have no idea). However, over the past four quarters, Bank of America has added just $17 billion in capital… I will remind everyone that this timeframe spans both T.A.R.P. and an additional $45 billion in capital being injected into the flailing bank. Also, who is going to buy into a Bank of America equity offering now? Especially $26 billion of equity! If a troubled bank can raise this amount of equity in the current environment, then the credit crisis is over! Rejoice!

I just don’t see how Bank of America can fill this hole and not get the government to “bail it out” with a conversion. The fact that Bank of America argued the results of the test, frankly, bolsters this point of view. Further, this has been talked about as an event that requires a management change, hence my comment on Lewis.  (Confidence: 80% that the government has to convert to get Bank of America to “well capitalized” status)

Notes/Odds and Ends:

1. I have no idea what happened with the NY Times story about the results of the “Stress Test.” The WSJ and FT are on the same page, but there could be something subtle that I’m misunderstanding or not picking up correctly. Absent this, my comments stand. (Also, if might have been mean.unfair of me to pick on the content of that article.)

2. The next phases of the credit crisis are likely to stress bank balance sheets a lot more. The average bank doesn’t have huge trading books. However, they do have consumer-facing loan and credit products in addition to corporate loans and real estate exposure. In the coming months, we’ll see an increase in credit card delinquencies. Following that, we’ll see more consumer defaults and corporations’ bottom line being hurt from the declining fundamentals of the consumer balance sheet. This will cause corporate defaults. Corporate defaults and consumer defaults will cause commercial real estate to decline as well. The chain of events is just beginning. Which leads me to…

3. Banks will be stuck, unable to lend, for a long time. I owe John Hempton for this insight. In short, originations require capital. Capital, as we see, is in short supply and needed to cover losses for the foreseeable future. Hence, with a huge pipeline of losses developing and banks already in need of capital, there is likely not going to be any other lending going on for a while. This means banks’ ability to generate more revenue/earnings is going to be severely handicapped as sour loans make up a larger and larger percentage of their portfolios.

4. From what I’ve read, it seems that the actual Citi number, for capital to be raised, is between $6 billion and $10 billion. This puts their capital needs at $15 billion to $19 billion, since they are selling assets to raise around $9 billion, which is counted when considering the amount of capital that needs to be raised (according to various news stories). Interestingly, this is 44% to 55% of Bank of America’s needed capital. This paints a very different picture of the relative health of these two firms than the “common wisdom” does. Granted, this includes a partial conversion of Citi’s preferred equity to common equity.

5. I see a huge correlation between under-performing portfolios and a bank trying to negotiate it’s required capital lower by “appealing” the stress test’s assessment of likely losses in both the baseline and adverse scenarios. As I’ve talked about before, not all portfolio performance is created equal. Citi has seen an increasing (and accelerating) trend in delinquencies while JP Morgan has seen it’s portfolio stabilize. So, for the less-healthy banks to argue their losses are overstated by regulators, they are doubly wrong. It’ll be interesting to see how this plays out–for example, if JP Morgan’s credit card portfolio assumes better or worse performance than Citi and Bank of America.

Guest Post at Clusterstock

Hey, I wanted to let you, my loyal readers, know that I guest posted over at Clusterstock. The post, entitled “Investment Bank Scorecard” is my take on this past quarter as a whole. I think it’s worth clicking over and taking a look. I’d sum it up here, but, in all honesty, the value is in the nuances and small insights more than the general thesis.

Also, here is the chart attached to that post, in its orginal form.

Why Stress Test Really Means Guesswork

Well, we’ve heard a ton about stress tests recently. Want some details on what a stress test entails? The Journal has some details about the tests here. Now, as much as I think GDP and unemployment are fine things to project forward for economists, let’s walk through the way one would use this to actually price an asset. Let’s start with something simple, like a 10-year treasury note (note that treasury bond specifically refers to bonds with a 30-year maturity). Here are all the components one would need to stress test the value of a treasury note.

1. Characteristics of the note itself: coupon, payment dates, maturity dates, etc.
2. What the yield curve would look like at the date you’re pricing the note.

Why would one need to know the shape of the yield curve (term structure of rates)? This is important, in order to “PV” the bond’s cashflows most accurately, one would discount each cashflow by it’s risk–the simplest proxy is to discount each cash flow by the rate of interest one would need to pay to issue a bond maturing on that date. For the government, this rate of interest is the point on the treasury yield curve (actually, the par zero curve) with the same maturity date. An example would be, if I were going to price a cash payment I will receive in two years, and the government can currently issue two-year debt at 5%, I should discount my cash payment (also from the government, since it’s a treasury note) at 5%. Treasuries are the simplest of all instruments to value.

Here’s an example, form the link above, of what a treasury yield curve might look like:

Now, it is completely and totally guesswork to figure out, given unemployment and GDP figures, what the yield curve will look like at any date in the future. Indeed, one can plug these projections into a model and it can come up with a statistical guess… But the only thing we know for sure about that guess is that it won’t be accurate, although it might be close. However, things like inflation will drive the longer end of the yield curve and monetary policy will drive the shorter end, so these certainly aren’t directly taken from the stress test parameters, but would need to be a guess based on those parameters. This is a large source of uncertainty in pricing even these instruments in the stress test.

Next, let’s examine a corporate bond. What would we need for a corporate bond?

1. Characteristics of the bond: coupon, payment dates, maturity dates, special features (coupon steps, sinking funds, call schedules, etc.), where in the capital structure this bond sits, etc.
2. What the yield curve would look like at the date you’re pricing the bond.
3. The spreads that the corporation’s debt will carry at the date you’re pricing the bond.

Oh no. We already saw the issues with #2, but now we have #3. What will this corporations credit spread (interest/yield required in excess of the risk free rate) at the time of pricing? Will the corporations debt, which could trade at a spread of anywhere from 5 to 1500 basis points, be lower? higher? Will the corporations spread curve be flatter? steeper?

Here is a good illustration of what I’m referring to (from the same source as the figure above):

There, the spread is the difference between the purple line and the black line. As you can see, it’s different for different maturity corporate bonds (which makes sense, because if a company defaults in year two, it’ll also default on it’s three year debt.. but the companies’ two year debt might never default, but the company might default during it’s third year, creating more risk for three year bonds issued by that company than two year bonds). It shouldn’t be a surprise, after our exercise above, to learn that the best way to compute the price of a corporate bond is to discount each cashflow by it’s risk (in my example above, regardless of whether the company defaults in year two or year three, the interest payments from both the three year and two year debt that are paid in one year have the same risk).

Well, how does one predict the structure of credit spreads in the future? Here’s a hint: models. Interest rates, however, are an input to this model, since the cost of a firm’s borrowing is an important input to figuring out a corporation’s cashflow and, by extension, creditworthiness. So now we have not only a flawed interest rate projection, but we have a projection of corporate risk that, in addition to being flawed itself, takes our other flawed projections as an input! Understanding model error yet? Oh, and yes unemployment and the health of the economy will be inputs to the model that spits out our guess for credit spreads in the future as well.

Next stop on the crazy train, mortgage products! What does one need to project prices for mortgage products?

1. Characteristics of the bond: coupon, payment dates, maturity dates, structure of the underlying securitization (how does cash get assigned in the event of a default, prepayment, etc.), etc.
2. What the yield curve would look like at the date you’re pricing the bond.
3. The spreads that the debt will carry at the date you’re pricing the bond.
4. What prepayments will have occurred by the date you’re pricing the bond and what prepayments will occur in the future, including when each will occur.
5. What defaults will have occurred by the date you’re pricing the bond and what defaults will occur in the future, including when each will occur.

Oh crap. We’ve covered #1-3. But, look at #4 and #5 … To price a mortgage bond, one needs to be able to project out, over the life of the bond, prepayments and defaults. Each is driven bydifferent variables and each happens in different timeframes. Guess how each projection is arrived at? Models! What are the inputs to these models? Well, interest rates (ones ability to refinance depends on where rates are at the time) over a long period of time (keep in mind that you need rates over time, having rates at 5% in three years is completely different if rates where 1% or 15% for the three years before). General economic health, including regional (or more local) unemployment rates (if the south has a spike in unemployment, but the rest of the country sees a slight decrease, you’ll likely see defaults increase). And a myrid of other variables can be tossed in for good measure. So now we have two more models, driven by our flawed interest rate projections, flawed credit projections (ones ability to refinance is driven by their mortgage rate, which is some benchmark interest rate [treasuries here] plus some spread, from #3), and the unemployment and GDP projections.

I will, at this point, decline to talk about pricing C.D.O.’s … Just understand, however, that C.D.O.’s are portfolios of corporate and mortgage bonds, so they are a full extra order of magnitude more complex. Is it clear, now, why these stress tests, as they seem to be defined, aren’t all that specific, and potentially not all that useful?

TARP Performance: Way Too Early to Judge

Felix has a post focused on some of the numbers in the CBO report on TARP. Specifically, it looks at subsidy rates (amount lost from various “bailouts” due to mark-to-market as a percentage of the original investment). First, I’ll note my strong objections to using mark-to-market at any given point in time as a true measure of what something has “cost” taxpayers. One issue that permeates this crisis is the government officials managing their response to (and this is borrowed from somewhere, but I simply cannot remember from where or find it) have something released before the asian markets open. Mark to market, however, is definitely the easiest to measure, hence the use of it. Things like economic activity, bank lending, credit rates for banks, etc. should be used as measures of TARP effectiveness.

Now, let’s move on to my other point–this is like calling the winner in the first few minutes of a game. Any analysis of the effectiveness of the bailouts is likely to be a bit skewed since what would have happened without them isn’t truly known. But drawing any conclusion on a five year investment less than three months after it was made is especially premature. The probability of taxpayers’  investments seeing an actual loss is, actually, quite low in my estimation. Why? These institutions were bailed out already, and that is, in some sense, an endorsement of not letting them fail in the near future. Be dismantled? Perhaps. Be sold? Possibly. But die, like Lehman did? Certainly not. In fact, if Bank of America and Citi prove anything, it’s that politicians are more likely to buy back into the game than face the taxpayers and explain how they lost tens of billions of dollars backing the wrong horse. Don’t get me wrong, I think there significant holes in the strategy for TARP.

This situation, of course, defines moral hazard when the current management is allowed to stay. Citi management can go around doing whatever they want to fix Citi, if they fail we pay. If they win, they look good. Same for Bank of America… Ken Lewis decides to acquire Merrill in a shotgun wedding and then plays chicken to get a subsidy. Did they lower the price of the Merrill acquisition? No. As a matter of fact, the government didn’t just have a right to put their boot on the professional throat of Ken Lewis, but they had a responsibility to–Mr. Lewis actually showed an active interest in leveraging the financial crisis and government strategy. But, I digress.

The point is we won’t know how our investments perform for quite some time, and if the strategy the government employs remains constant then taxpayers are unlikely to lose a dime. So, you won’t find me with a real-time accounting of the TARP investments in Bloomberg anytime soon.

Dear Pundits: Citi isn’t Proof of Financial Supermarket Viabilty

Let’s be honest, Citi has some serious problems it has to fix. I’ve touched on many of them on this blog. But Citi’s failure is hardly an indictment of the “one stop” business model. It stands to reason that Citi is the example of how one cannot merely staple business together, allocate capital according to best returns for shareholders, and hope that a finance company can be run like a portfolio (ala G.E.).

One need only look at two competitors (and I’m sure Jamie Dimon thinks about this right before he lulls himself to sleep)–JP Morgan Chase and Citi. JP Morgan Chase has had a recent history of successful integrations, merging of businesses, stable leadership, and a cohesive corporate culture. No one at JPM sits around wondering how they can squeeze out the “other guys.” If you’re a Chase person you’re not trying to get all the JP Morgan people fired. Citi, on the other hand, has had management change after management change–each one is followed by an exodus of top, experienced executives. Guess what happens when one cobbles together a management team of people who are holdovers, new guard, and new hires… Citi! Guess what happens when no one takes the time to integrate businesses that have redundant product lines and systems, but rather let them operate all on their own… Citi!

In fact, one could be forgiven for thinking that standalone institutions are the business model in peril. Merrill, Lehman, and Bear, all pillars in the stand-alone investment bank community have disappeared from the landscape. Goldman and Morgan Stanley, the two remaining firms that were stand-alone investment banks six months ago, now include consumer banking in their business lines–much closer to the business mix of Citibank plus Salomon Brothers. Indeed, I would argue Citi’s investment bank performed like the lower tier of standalone investment banks, and ther mere existence of the consumer bank and deposit base “added in” allowed it to survive.

My theory is further bolstered by what Citi hopes to become and why. CitiCorp (Citi Corp? Citicorp?) is essentially a bank, an investment bank, and a brokerage all put together… And it’s half the size of Citi today. If that doesn’t say, we got the execution wrong but the model correct then I don’t know what does.

Oh, and don’t use BofA as a counter example… It was doing just fine on its own before swallowing Stan O’Neil’s mess whole (although the Ken Lewis negotiating tactics didn’t help). Further, Wachovia and Washington Mutual are examples for the opposite side of the equation–banks hoping to make money through capital markets operations and doing it poorly. Think of their problems as having evolved from having singularly focused, very poorly run investment banks attached to them.

The basic point: We’ve seen two financial supermarkets emerge here in the U.S. Both are still alive, and one is still profitable (The WSJ news alert shouldn’t have been “J.P. Morgan Chase’s Net Income Falls 76%” it should have been “J.P. Morgan Chase’s Net Income is Positive!”). The other’s problems are widely acknowledged as being cultural and borne of historical shortsightedness. Declaring the business model dead now would be silly.

Tips for a New Regulatory Structure

Since the candidates are making such a fuss about all these recent issues, and especially calling for more regulation, here are some helpful hints to ensure we all benefit…

1. Organize your regulatory structure like financial institutions organize their businesses. For example, instead of the C.F.T.C., M.S.R.B., N.A.S.D., and exchanges all regulating various parts of the financial infrastructure, build an overarching financial regulatory agency (you can even call it that, the F.R.A., I won’t charge you a quarter to use it each time). Have a division for banks and a division for broker dealers. In the division for broker dealers have the departments that oversee mergers and acquisitions, issuance of debt and equity, and trading in distinct units. Then, within each, subdivide it further–futures trading, exchanges, fixed income trading, etc. This is how firms organize their businesses. When a transaction crosses multiple areas, in the same way an investment bank would bring in multiple people “up the food chain” regulators can mimic that same structure and bring in people with similiar experience and oversight responsibilities.

A part of this is to merge banking oversight with broker-dealer oversight. This is because soon there will be no more standalone broker dealers… Ok, I’m kind of kidding… or am I? Another reason for this change is that, the same way large firms unite their operations and inter-weave their market activities, banks and broker dealers have become much more inter-connected. Let’s be honest, the average bank is less likely to be stable if it has a broker dealer that is massively leveraged and buying risky securities. Need an example? How about looking at Citi vs. J.P. Morgan Chase? Or E*Trade bank versus Commerce Bank?

2. Don’t let financial institutions lobby. Simple, right? Hank Paulson immediately put his boot on the throat of the Fannie and Freddy lobbying machine when bailing them out. Simple! With all the terrible things being said about lobbysists this cycle, you wouldn’t know politicians were running–so I’m sure there will be support for this kind of reform. Also, all things being equal, the average American is left worse off by lobbyists (hence the “reform” candidates all rail against lobbyists). Sadly, even the institutions the lobbysist were lobbying on behalf of seem to be in a situation where they would be better off had they not gotten what their lobbyists were lobbying for… Whew!

However, it must be difficult for a congressman to pass a law stopping a corporation from lobbying. It might even be illegal… not sure, I’m no lawyer. What I do know, however, is that if the governement decides to have their resources used to facilitate business for institutions, one could probably make the cessation of lobbying a condition. Would you rather put your money in an F.D.I.C. insured bank? Would you rather your bank could borrow at the discount window? Special tax breaks for profitable business lines? All these things should require the institution in question doesn’t lobby for, say, five years. I bet banks can get themselves into trouble often enough that, if they ask for help each time, a five year cessation of lobbying or hiring lobbyists will mean no more lobbying. Want to increase your leverage by borrowing freely from any of the Fed’s various sources of money? No lobbying.

3. Increase capital requirements for financial institutions. Make very strict rules for what counts as capital and how regulated ratios are determined. For example, perhaps holding Goodwill against sub-prime–backed C.D.O. squared’s isn’t the way to go. Or, maybe, allowing banks to book earnings from their credit deteriorating isn’t the way to go either. Suggesting that capital be better defined and more plentiful shouldn’t be a shock… this crisis of capital, with institutions begging investors to buy equity, is an issue with banks, capitalized as required, not having enough capital and failing (banks being used broadly). Lowering leverage lowers raises the economic margin of error. While lots of people will argue that an over-levered instution that invests in risky securities deserves to fail, why not avoid the over-levered institution that invests in risky securities in the first place? Actually, stop listening to me… Instead, for this, listen to The Deal Professor:

Lesson 4: Sometimes, You Can Only Raise Capital When You Don’t Need It

Lehman issued $4 billion in preferred stock in April — the share offering was oversubscribed. Even then, though, people whispered that the capital raise was a sign of weakness, reflecting Lehman’s anemic balance sheet. This paradox helped bring about the death of both Bear and Lehman: They needed capital, but raising it only made people more concerned about their state.

It is a Catch-22 for which we have yet to find a solution. And that is why, even to the bitter end, Lehman didn’t access the Federal Reserve’s emergency loan facility. If it had, everyone would have assumed it was in trouble.

The whole conundrum supports raising the capital reserve levels for investment banks. Ultimately, Lehman, Bear, Merrill and their balance sheets couldn’t stand the predicament

(Emphasis mine.)

See? Much more eloquent than I was…

4. Disclosure. One simple word. Require a lot more disclosure. How about setting well-defined scenarios that must appear and be spelled out in annual and quarterly filings? Report more sensitivities, using standard methods that are also disclosed, of assets to model parameters or market changes. If, for example, each investment bank was required to tell investors how their balance sheet would look if defaults ticked up to “5 CDR for life” there would be a lot less trouble today.

Also, force diclosures to occur more frequently. Make banks release some key metrics every Friday, for example. Having a 45-day delayed disclosure that is a snapshot from the last day of a 90-day period is completely ridiculous. We have computers now. One needen’t get out their abacus and punch cards to figure out earnings for a given period. Stop “month-end” dressing up of the balance sheet by requiring more frequent disclosure. Require banks to disclose maximums from the past x days. This way, if a bank tries to shrink it’s balance sheet purely to look like it’s done so, so that it can diclose soemthing that “looks better,” it will show up. Hiding information from shareholders or whomever else reads filings is not just troublesome, it shouldn’t be allowed.

These are just some of my random thoughts. I’m not sure they have merit, except where they are quoted from others. I’m no regulator, but if the next president needs and S.E.C. chairman, I suppose I can make myself available…

Build an Investment Bank: Introduction

As I hinted before, I have been thinking about this for a while. This series is going to be about taking some discrete pieces of what makes a modern day investment bank, making a choice about how that part would be setup under DJT’s tyrannical rule, and stating the case for setting things up that way. Here are some example topics:

• Risk management and organization surrounding risk management
• Business mixes and core competencies
• Management structure and other nuances of configuring management roles
• Proprietary trading / risk taking
• Technology
• Operations and support roles
• Ownership / corporate structure and other things (owned by a bank or not, for example)
• Deciding on what, if any, presence in consumer markets should exist
• Compensation
• Culture and approach to H.R. and other people issues
• Reviews and performance management
• Anything else that comes to mind

I think that feedback on other areas or how to group these would be interesting to receive. The first one of these issues I think should be tackled is technology. It’s a topic I have thought a lot about and is extremely important in figuring out how day-to-day operations occur. I hope to have this up shortly. I have lots of skeletons of these entries written about, and more thoughts, so hopefully this series will have a lot of meat to it soon.

The Rumor Mill is Going Strong

Well, hold on to your hats. The chosen ones have some problems coming. There is talk of about $500 million to $1 billion in writedowns coming. Also, some unusual layoff chatter surrounding the Golden firm. Specifically there is word that they are cutting people beyond their usual trimming of the bottom layer. I’m working on a much bigger post about how Goldman is lucky in addition to being good, but if these rumors turn out to be true, then whatever is in the water there seems to be working.

The Merrill-izing of Goldman?

There was an interesting note in the FT’s Alphaville noting that John Thain is actually not just a dog that you can’t teach new tricks to–he is making Merrill Lynch more like itself than his old shop. It occurs to me that it’s actually Goldman whose business model is easy to copy. Merrill is known for of having an excellent brokerage division and has a strong brand with individual investors. This naturally leads it to have a strong distribution channel for stock offerings, structured products focused on retail investors, and various other financial instruments. This is a franchise that is hard to replicate–it requires advertising, lots of infrastructure and manpower, and lots of work creating a culture whose focus is on keeping retail customers (a very different breed from institutional clients, obviously, on all fronts). Leveraging platforms and systems is both key and difficult. There are extra legal liabilities.  Many things make a successful retail operation hard to replicate.

Now, look at Goldman. What is their business model? Essentially, with the exception of their banking business (which is the lower margin business for them), their business model is to take smart people and give them a tight leash (not that it isn’t a long leash, but they keep close tabs and aren’t afraid to shorten it at any time). How difficult is this? I think it’s certainly non-trivial to replicate (Stan O’Neill certainly checked all boxes–more Private Equity investments, more risk taking, same organizational structure as the Goldman boys), but it doesn’t take decades and decades of building a brand with finicky individual investors.  One needs to develop a disciplined and well defined method for tracking risk. Their traders need to be a smart and talented bunch (as anyone in the industry knows, not having these kinds of people is a problem you can generally throw money at). Your leaders need to emphasize a free-flow of ideas and cultivate a culture where working together is rewarded. Lastly, your pay structure needs to emphasize both working together and rewarding performance while not providing an perverse incentive to take a big gamble (or, if it does, you need someone high up to monitor the risk positions as a check). These changes all seem very like they could occur (keep in mind it might be a slight shift from the status quo, instead of what would be a glacial re-engineering of a firm) in a much smaller time scale than building a recognized brand amongst the millions of individual investors in the U.S. (speaking nothing of international investors).

Now, I’m not saying that what Goldman is missing is a retail division. I’m also not saying that it’s easy for an investment bank to break into any business (commodities, fixed income trading, currencies, etc.), but it is essentially the case that changing how one practices their craft is different from changing the craft they practice.