March 19, 2008

Two articles today brought into sharp relief the issue of individuals’ compensation within the financial services industry. Naked Capitalism republishes an article from the Financial Times which brings up the old chestnut about an investment strategy that returns 10% in nine of ten years and -100% one time in ten:

We can identify two huge problems to be solved. First, many investment strategies have the characteristics of a “Taleb distribution”, after Nicholas Taleb, author of Fooled by Randomness. At its simplest, a Taleb distribution has a high probability of a modest gain and a low probability of huge losses in any period.

Second, the systems of reward fail to align the interests of managers with those of investors. As a result, the former have an incentive to exploit such distributions for their own benefit.

Further, it is claimed that:

Professors Foster and Young argue that it is extremely hard to resolve these difficulties. It is particularly difficult to know whether a manager is skilful rather than lucky.

Well, says I, no more difficult than with anything else. You have to actually look at an investment; looking at returns – whether actual or backtested – is only half the story. If we look, for instance, at the just-reported blow-up of Endeavor Capital, we see:

Endeavour Capital LLP, the London- based hedge-fund firm founded by former Salomon Smith Barney Inc. traders, has fallen about 28 percent this month because of “extreme volatility and vast moves” in Japanese bonds, according to two investors.

The $2.88 billion Endeavour Fund sold “substantially all” of its Japanese government debt this week, Chief Executive Officer Paul Matthews said today in an interview. He declined to comment on the March decline.

Endeavour seeks to profit from discrepancies in the prices of various fixed-income securities and currencies, a strategy known as relative-value trading. The fund lost money as the spread, or difference, between yields on Japanese 7- and 20-year bonds widened to 1.44 percentage points on March 17, the most in almost nine years. Investors bought shorter-term debt as the benchmark Nikkei 225 stock index fell 13 percent in March.

Let’s think about this. They lost money because the spread between 7s and 20s widened … so presumably they were long 20s and short 7s. Since they are calling themselves “relative value” investors, we will assume (assume!) that the position was duration neutral and in that case their position was most likely long cash, short 7s, long 20s in such a way that parallel shifts in the yield curve would not – to a first approximation anyway, for smaller small parallel moves – harm them. Note that the assumptions leading to this conclusion are entirely reasonable, but are still assumptions. Anybody who knows better – feel free to tell me. Anyway .. long cash / short 7s / long 20s is a coherent strategy, at the very least.

But “relative value”? Well – I don’t know what the proponents themselves called it when pitching clients for money. And, at a stretch, “relative value” can cover a lot of ground … if you feel that the value on stocks is cheap relative to cash, you can justify levering 20:1 on a stock portfolio and call it a “relative value” play.

I certainly wouldn’t call it a “relative value” play. The position I’ve described – long cash, short 7s, long 20s – is a “flattener”. It will make all kinds of money if the overall yield curve flattens, and lose all kinds of money if the overall yield curve steepens … and it appears that the Japanese government curve has just done that latter. It’s not a “relative value” play at all – it’s a macro-market call, subject to all the chaos and market risk of any other macro market call.

If they want to go long 5s, short 7s, long 10s … then maybe they can talk to me a little bit more about their “relative value” plays. Maybe. But that’s the outside limit, and too much leverage takes it out of consideration.

In a similar vein, Guido Tabellini of Bocconi University asks in VoxEU Why did bank supervision fail?:

On the other hand, there were systematic incentive distortions. First, the “originate and distribute” model entails obvious moral hazard problems. Second, credit rating agencies face a conflict of interest. Third, management compensation schemes reward myopic risk taking behaviour; it is rational for me to under-insure against the occurrence of rare disruptive events, if my bonus only depends on short-term performance indicators.

These are bare assertions – Prof. Tabellini may well have good reason to believe they are true, but they are incidental to the main point of his article, which I will not discuss.

What I find interesting is the renewed focus on short-term compensation; it’s reminiscent of the handwringing of the 1980’s – remember? When the ceaseless pressure on American corporations to post quarterly returns was blamed for all that was wrong with the world and predictions that the long-term oriented Japanese would end up owning the world? This was before the Japanese property bubble collapsed and sent them into a 15-year recession, of course.

I’ve said it before, but I never get tired of seeing my own words on screen: there are problems, sure, but most of these will be self-correcting. It’s going to be awfully difficult to sell originate-and-distribute product any more without better disclosure and accountability … the pendulum has, if anything, swung over too far on that one, at least for now. And bank supervision – via the Basel accords – needs to provide a brighter line between the (protected and regulated) banking system and the (unprotected and unregulated) shadow-banking system.

Compensation structures for individuals can always be improved – but there is always a lot competition for talent:

As more than 14,000 Bear Stearns Cos. employees watch the value of their stock sink and brace for firings, some of the company’s 550 brokers who handle individual investors’ accounts are receiving job offers from competitors promising windfalls of $2 million or more.

Merrill Lynch & Co., Morgan Stanley, UBS AG and Citigroup Inc.’s Smith Barney unit are offering Bear Stearns brokers packages that include signing bonuses of two times the revenue they bring in annually, said Mindy Diamond, president of Diamond Consultants LLC, a Chester, New Jersey-based executive search company. Someone generating $1 million in commissions and fees could receive $1.5 million up front and the rest over three years, she said.

Note that in highlighting this example, I am using the word “talent” to denote “ability to bring money in the door”.

Back to economics, Econbrowser‘s James Hamilton opines on yesterdays massive Fed easing:

suppose you believe that oil over $100 a barrel is a destabilizing influence– and I do— and that the Fed’s recent decisions on the fed funds rate are the primary reason that oil is over $100– and I do— and that further reductions in the Tbill rate have limited capacity to stimulate demand– and I do. Suppose you also saw a risk that the inflation, financial uncertainty, and slide of the dollar could precipitate a run from the dollar, introducing an international currency crisis dimension to our current headaches.

I think the Fed missed an opportunity here. A 25 or a 50 basis point cut would have sent commodity prices crashing. Even the mildly hawkish surprise of “only” a 75 basis point cut may have some effects in that direction. If the Fed did convince the commodity speculators that their path leads only to ruin– and I believe the Fed could easily have done just that– that would leave Bernanke with a lot more maneuvering room to cope with what comes next.

I agree with him, as I agreed with his recently expressed view on limits to monetary policy. It seems to me that as far as the overall economy is concerned, the Fed should be waiting to see what its cuts – now 300bp cumulative since August – do to the economy. At the moment, the problem is land-mines of illiquidity blowing up unexpectedly, and the TSLF, together with the occasional spectacular display of force are the best defense against that.

In other words, I’m worried about the collateral damage from such an unfocused tool as the Fed Funds rate. I will note that Accrued Interest is of the view that the (assumed) objective of deleveraging is being (somewhat) achieved by the spanking given to Bear Stearns:

Deleveraging continues. All the big brokers know that the surest way to avoid a Bear Stearns problem is to make sure they aren’t over exposed to hedge funds. Supposedly there have been several commodities-oriented funds which are selling today. Gold getting crushed. Haven’t heard anything about equity-oriented funds but that might be part of what’s going on today as well.

Speaking of Bear Stearns, the SEC has released some FAQs, one of which supports Bear Stearns’ story of sudden and unforseeable liquidity collapse:

Why was Bear Stearns’ loss of credit so critical to its ongoing viability?

In accordance with customary industry practice, Bear Stearns relied day-to-day on its ability to obtain short-term financing through borrowing on a secured basis. Although Bear Stearns continued to have high quality collateral to provide as security for borrowings, as concerns grew late in the week, market counterparties became less willing to enter into collateralized funding arrangements with Bear Stearns.

Late Monday, March 10, rumors spread about liquidity problems at Bear Stearns, which eroded investor confidence in the firm. Bear Stearns’ counterparties became concerned, and a crisis of confidence occurred late in the week. In particular, counterparties to Bear Stearns were unwilling to make secured funding available to Bear Stearns on customary terms.

This unwillingness to fund on a secured basis placed stress on the liquidity of the firm. On Tuesday, March 11, the holding company liquidity pool declined from $18.1 billion to $11.5 billion. On Wednesday, March 12, Bear Stearns’ liquidity pool actually increased by $900 million to a total of $12.4 billion. On Thursday, March 13, however, Bear Stearns’ liquidity pool fell sharply, and continued to fall on Friday.

Joe Lewis is opposing the JPM / BSC deal:

Lewis, a former currencies trader born in an apartment above a pub in London’s East End, will take “whatever action” he deems necessary to protect his $1.26 billion investment in New York-based Bear Stearns, he said in a filing today with the U.S. Securities and Exchange Commission. He said he may “encourage” the firm and “third parties to consider other strategic transactions.

“If he gets others to vote with him he may be able to get some token increase in the price,” said John Coffee, a securities law professor at Columbia University in New York, referring to Lewis. “He’s not going to get a significantly higher bid because no one else can get the Fed’s support and the Fed’s financing.”

Lewis paid an average of $103.89 apiece for his 12.14 million Bear Stearns shares, according to today’s filing. He started accumulating most of his shares last July and has lost about $1.19 billion on the investment, or almost half his wealth, which Forbes magazine estimated at $2.5 billion in its 2007 survey.

The SEC filing today showed that Lewis purchased 1.04 million Bear Stearns shares during February and March, raising his total stake 8.35 percent of common shares outstanding. His price per share ranged from $55.13 to $86.31. He said he may dispose of his holdings entirely or bet that the stock will drop further.

Naked Capitalism highlights some rumours about European banks, which brings to mind Accrued Interest‘s prescient emphasis on the effect of rumours in a bear (Bear?) market reported here March 12

And in the regular trickle of news about LBOs in general and how the market is affecting the chances for Teachers / BCE, there is a snippet about current conditions on Bloomberg:

U.S. banks have whittled their holdings of leveraged buyout loans to $129 billion from $163 billion at the beginning of the year by offering the debt at discounts, according to Bank of America Corp. analysts led by Jeffrey Rosenberg.

Goldman reduced its backlog of loans by $20 billion in the past quarter from $43 billion, chief financial officer David Viniar said on an investor call yesterday. The New York-based firm, which booked a loss of $1 billion on the loans, also added $4 billion of new commitments during the period.

Lehman, the fourth-biggest U.S. securities firm, booked losses of $500 million on leveraged loans last quarter, CFO Erin Callan said on a conference call with investors yesterday.

Morgan Stanley, the second-biggest U.S. securities firm, reduced its leveraged finance pipeline to $16 billion from $20 billion during the first quarter, CFO Colm Kelleher said in an interview today after the company reported first-quarter profit fell 42 percent.

Make of it what you will!

In other jolly news, DBRS has announced that it:

has today withdrawn the ratings of the below-listed Affected Trusts under the Montréal Accord. This action has been taken at the request of the Affected Trusts.

Well, I guess the court appointed monitor didn’t want to pay rating bills for trusts that were under CCCA protection anyway! Speaking of ratings, by the way, I am participating in an exchange with Naked Capitalism in the comments to an almost unrelated post.

The pref market eased downward today on modest volume, enlivened by some sharp declines among financial-based splitShare corporations.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 5.46% 5.49% 33,376 14.68 2 -0.5081% 1,084.5
Fixed-Floater 4.79% 5.54% 63,204 14.80 8 +0.1124% 1,037.5
Floater 4.77% 4.77% 78,590 15.94 2 -0.1294% 872.2
Op. Retract 4.85% 3.84% 76,295 3.20 15 +0.1968% 1,044.8
Split-Share 5.43% 6.29% 94,470 4.14 14 -0.2585% 1,014.4
Interest Bearing 6.23% 6.71% 67,573 4.23 3 -0.2041% 1,082.2
Perpetual-Premium 5.79% 5.53% 262,010 10.81 17 -0.1244% 1,019.3
Perpetual-Discount 5.56% 5.62% 301,837 14.46 52 -0.0516% 928.3
Major Price Changes
Issue Index Change Notes
PIC.PR.A SplitShare -1.6880% Asset coverage of 1.4+:1 as of March 13, according to Mulvihill. Under Review-Developing by DBRS. Now with a pre-tax bid-YTW of 7.38% based on a bid of 14.56 and a hardMaturity 2010-11-1 at 15.00.
ENB.PR.A PerpetualPremium (for now!) -1,6746% Now with a pre-tax bid-YTW of 5.62% based on a bid of 24.66 and a limitMaturity
FFN.PR.A SplitShare -1.6495% Asset coverage of 1.8+:1 as of March 14, according to the company. Under Review-Developing by DBRS. Now with a pre-tax bid-YTW of 6.19% based on a bid of 9.54 and a hardMaturity 2014-12-1 at 10.00. 
FTU.PR.A SplitShare -1.5730% Asset coverage of just under 1.4:1 as of March 14 according to the company. Under Review-Developing by DBRS. Now with a pre-tax bid-YTW of 8.64% based on a bid of 8.76 and a hardMaturity 2012-12-1 at 10.00.
CM.PR.P PerpetualDiscount -1.5231% Now with a pre-tax bid-YTW of 6.16% based on a bid of 22.63 and a limitMaturity.
HSB.PR.C PerpetualDiscount -1.4376% Now with a pre-tax bid-YTW of 5.48% based on a bid of 23.31 and a limitMaturity.
CU.PR.A PerpetualPremium (for now!) -1.3861% Now with a pre-tax bid-YTW of 5.87% based on a bid of 24.90 and a limitMaturity.
CM.PR.I PerpetualDiscount -1.2922% Now with a pre-tax bid-YTW of 6.02% based on a bid of 19.86 and a limitMaturity.
HSB.PR.D PerpetualDiscount -1.2609% Now with a pre-tax bid-YTW of 5.52% based on a bid of 22.71 and a limitMaturity.
SLF.PR.B PerpetualDiscount -1.1261% Now with a pre-tax bid-YTW of 5.48% based on a bid of 21.95 and a limitMaturity.
BCE.PR.B Ratchet -1.0309%  
GWO.PR.G PerpetualDiscount -1.0213% Now with a pre-tax bid-YTW of 5.60% based on a bid of 23.26 and a limitMaturity.
PWF.PR.J OpRet -1.0054% Now with a pre-tax bid-YTW of 4.35% based on a bid of 25.60 and a softMaturity 2013-7-30 at 25.00.
BNA.PR.C SplitShare +1.0363% Asset coverage of 3.3+:1 as of January 31, according to the company. Now with a pre-tax bid-YTW of 7.40% based on a bid of 19.50 and a hardMaturity 2019-1-10 at 25.00. Compare with BNA.PR.A (6.98% to 2010-9-30) and BNA.PR.B (8.30% to 2016-3-25).
BMO.PR.J PerpetualDiscount +1.2054% Now with a pre-tax bid-YTW of 5.65% based on a bid of 20.15 and a limitMaturity.
GWO.PR.H PerpetualDiscount +1.3066% Now with a pre-tax bid-YTW of 5.59% based on a bid of 21.71 and a limitMaturity.
BAM.PR.I OpRet +1.3137% Now with a pre-tax bid-YTW of 5.13% based on a bid of 25.45 and a sofMaturity 2009-7-30 at 25.00. Compare with BAM.PR.H (5.24% to 2012-3-30) and BAM.PR.J (5.26% to 2018-3-30).
PWF.PR.L PerpetualDiscount +1.5015% Now with a pre-tax bid-YTW of 5.46% based on a bid of 23.66 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
BCE.PR.A FixFloat 125,000 CIBC crossed 124,900 at 24.10.
TD.PR.R PerpetualDiscount 122,290 National Bank crossed 40,000 at 24.90. Now with a pre-tax bid-YTW of 5.66% based on a bid of 24.87 and a limitMaturity.
SLF.PR.E PerpetualDiscount 109,250 Desjardins crossed 50,000 at 21.00, then CIBC crossed the same number at the same price. Now with a pre-tax bid-YTW of 5.38% based on a bid of 21.00 and a limitMaturity.
SLF.PR.B PerpetualDiscount 20,450 Now with a pre-tax bid-YTW of 5.48% based on a bid of 21.95 and a limitMaturity.
CM.PR.I PerpetualDiscount 19,860 Now with a pre-tax bid-YTW of 6.02% based on a bid of 19.86 and a limitMaturity.

There were fourteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.

2 Responses to “March 19, 2008”

  1. prefhound says:

    I believe traders and other financial types ARE rewarded (at least to some degree) on the basis of a Taleb distribution: they can lose their job in the 10th year when things blow up, and may never get back into the industry, nor earn anything like their previous salary/bonus.

    With few exceptions, most of the huge bonuses go to young bucks. The odd market shakeout tips them into early retirement from a pretty stressful job.

    Not everyone in BSC is getting $2M bonuses to move.

  2. […] agree. As written here on March 19: I agree with him, as I agreed with his recently expressed view on limits to monetary policy. It […]

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