Monday, September 14, 2009

Fired Up? Ready to Go?

The CBC reports that President Obama spoke to a Wall Street audience on Monday, the anniversary of the collapse of investment bank Lehman Brothers Inc., lauding his administration's moves to prevent future financial calamities while warning that further bailouts are unlikely:

"I certainly did not run for president to bail out banks or intervene in the capital markets," Obama told an audience of bankers at the Federal Hall in New York City.

Since Lehman Bros. declared bankruptcy on Sept. 15, 2008, setting off the worst financial crisis since the Great Depression, the U.S. government has spent $787 billion bailing out struggling industries, and has taken equity stakes in companies as diverse as insurer AIG Inc. and automaker General Motors Corp.

According to government data, some 31,476 economic stimulus projects are also underway, worth some $103 billion.

"While there continues to be a need for government involvement to stabilize the financial system, that necessity is waning," Obama said.

In addition to drawing attention to the new regulatory agencies proposed by his administration, Obama urged Wall Street to do a better job policing itself.

"Those on Wall Street cannot resume taking risks without regard for consequences, and expect that next time, American taxpayers will be there to break their fall," he said.

Among his proposed legislation, Obama trumpeted his recently created Consumer Financial Protection Agency with being the best weapon to protect American buyers.

The agency will enforce new regulations designed at making credit agreements more transparent and ensure rates are fair without stifling consumer choice, he said.

His administration has also proposed the creation of an oversight council to bring together regulators from across markets to share information, to identify gaps in regulation, and tackle issues that don't fit neatly into any single organization's purview.

The U.S. president also spoke on international trade issues, suggesting the issue will be a key item on the agenda for G20 finance ministers when they meet in Pittsburgh later in September.

"Abuses in financial markets anywhere can have an impact everywhere," he said. "As the United States is aggressively reforming our regulatory system, we will be working to ensure that the rest of the world does the same."

He vowed that the United States will work diligently to expand free trade agreements, and implement existing agreements.

A recent U.S. decision to impose trade penalties on Chinese tires infuriated Beijing, which condemned the move as protectionist and said it violated global trade rules.

In addition to trade discussions, stronger regulation of financial markets is likely to be on the agenda at the G20 summit. French President Nicolas Sarkozy has threatened to walk out if summit participants don't reach a deal to rein in bankers' bonuses.

Despite public pronouncements, Congress has yet to approve most of the Obama administration's legistlation on financial market reform.

Washington has been gripped by the contentious debate over changes to the health-care system. Public outrage over those reforms have left some legislators wary of moving further into corporate board rooms — and the short-term incentive to do so has waned as most major banks have returned to profitability.

Obama's speech served to remind financiers and legislators in attendance that more work is to be done if the United States is to pull itself out of recession.

"The growing stability resulting from these interventions means we are beginning to return to normalcy. But … normalcy cannot lead to complacency," he warned.

Nice speech but I am not sure it will resonate much with the banksters on Wall Street. For them, and their pension parrot clients, 2008 was an "outlier year, a once in a lifetime event, a 10 sigma statistical fluke".

The banksters want money. They want to go on printing money by trading and creating new financial derivatives which they will sell to the buy-side dummies who will buy them for that "extra yield" (ABCP ring a bell?).

A year after the financial system nearly collapsed, America's biggest banks are bigger and regaining their appetite for risk:

Goldman Sachs, JPMorgan Chase and others — which have received tens of billions of dollars in federal aid — are once more betting big on bonds, commodities and exotic financial products, trading that nearly stopped during the financial crisis.

That Wall Street is making money again in essentially the same ways that thrust the banking system into chaos last fall is reason for concern on several levels, financial analysts and government officials say.

  • There have been no significant changes to the federal rules governing their behavior. Proposals that have been made to better monitor the financial system and to police the products banks sell to consumers have been held up by lobbyists, lawmakers and turf-protecting regulators.
  • Through mergers and the failure of Lehman Brothers, the mammoth banks whose near-collapse prompted government rescues have gotten even bigger, increasing the risk they pose to the financial system. And they still make bets that, in the aggregate, are worth far more than the capital they have on hand to cover against potential losses.
  • The government's response to last year's meltdown was to spend whatever it takes to protect the financial system from collapse — a precedent that could encourage even greater risk-taking from the private sector.

Lawrence Summers, director of the White House National Economic Council, says an overhaul of financial regulations is needed as soon as possible to keep the financial system safe over the long haul.

"You cannot rely on the scars of past crises to ensure against practices that will lead to future crises," Summers says.

No one is predicting another meltdown from risky trading in the near term. Rather, the concern is what happens over time as banks' confidence grows and the memory of the financial crisis of 2008 fades.

Will they pile on bets to the point that a new asset bubble forms and — as happened with mortgage-backed securities — its undoing endangers banks and the broader economy?

"We're seeing the same kind of behavior from the banks, and that could lead to some huge and scary parallels," says Simon Johnson, former chief economist with the International Monetary Fund.

Some risk-taking is good. When banks are willing to invest in companies or lend to home-buyers, that nurtures economic growth by generating employment and consumer spending, feeding a cycle of expansion.

The problem is when banks' quest for profits leads them to take on too much risk. In the case of the housing bubble, which burst last year, banks lent too freely to consumers with weak credit and wagered too much on complex financial instruments tied to mortgages. As real-estate prices turned south, so did the financial industry's health.

Because the largest banks' trading divisions make their bets with each other, their fortunes are intertwined. The collapse of one can threaten another — and another — if it is unable to pay off its debts.

This so-called counterparty risk is a major reason the Obama administration's regulatory overhaul plan calls for the creation of a "systemic risk regulator."

The administration is also seeking tougher capital requirements for banks, arguing that banks' buying of exotic financial products without keeping enough cash on reserve was a key cause of the crisis. Treasury Secretary Timothy Geithner has urged the Group of 20 nations — which meets this month in Pittsburgh — to agree on new capital levels by the end of 2010 and put them in place two years later. Geithner hasn't said how much extra capital banks should be required to keep on hand.

Data from the April-June quarter show that the banks are leaning heavily again on their trading desks for revenue.

  • During the fourth quarter of 2008, when the financial crisis made even the shrewdest bankers risk-averse, Goldman's trading of risky assets nearly stopped. But in the second quarter of 2009, trading revenue had climbed to nearly 50 percent of total revenue, closer to where it was two years ago before the recession began. JP Morgan's reliance on trading revenue has exhibited a similar pattern.
  • Also in the second quarter, the five biggest banks' average potential losses from a single day of trading topped $1 billion, up 76 percent from two years ago, according to regulatory filings.

The government hasn't just watched banks resume their freewheeling ways and prosper. It has been an enabler in the process. The Federal Reserve, the Treasury Department and the Federal Deposit Insurance Corp. — during both the Bush and Obama administrations — have made trillions of dollars available to the biggest banks through bailouts, low-cost loans and loss guarantees designed to stabilize the financial system.

The failure of Lehman Brothers — the biggest bankruptcy in U.S. history — and the panicky sales of Bear Stearns to JPMorgan and Merrill Lynch to Bank of America, also have transformed Wall Street. The surviving investment banks have fewer competitors and more market share.

Five of the biggest banks — Goldman, JPMorgan, Wells Fargo, Citigroup and Bank of America — posted second-quarter profits totaling $13 billion. That's more than double what they made in the second quarter of 2008 and nearly two-thirds as much as the $20.7 billion they earned in the second quarter of 2007 — when the economy was strong.

Meanwhile, Bank of America and Wells Fargo today originate 41 percent of all home loans that are backed by Fannie Mae and Freddie Mac, according to Inside Mortgage Finance. The banks made $284 billion in such loans in the first half of this year, up from $124 billion during the same period last year.

"The big banks now are more powerful than before," said Johnson, now a professor at the Massachusetts Institute of Technology's Sloan School of Management. "Their market share has grown and they have a lot of clout in Washington."

Wall Street's recovery is also being aided by a stock-market rally that has driven the S&P 500 index up nearly 54 percent since March 9, when it hit a 12-year low.

Despite the return to profitability, these aren't the high-octane days from before the crisis. To qualify for government backing, the biggest Wall Street firms are no longer allowed to supercharge their returns by borrowing up to 30 times the value of their assets to place bets on stocks, bonds and other investments.

Businesses supported by Wall Street bankers and traders say they've also noticed changes. Namely, their customers aren't spending as much on food, drinks and entertainment as they did during the boom years.

At Fraunces Tavern, a high-end bar just around the corner from the New York Stock Exchange, the Wall Street workers who used to drink $25 glasses of port are scarce these days.

"Now we're doing happy hours," says Damon Testaverde, one of the owners of Fraunces Tavern. "We never did that. There's just less bodies around."

But one thing fundamental to Wall Street hasn't changed: Big banks and their traders are still finding creative — some say speculative — ways to profit.

They're still packaging risky mortgages into securities and selling them to investors, who can earn higher returns by purchasing the securities tied to the riskiest mortgages. That was the practice that helped inflate the real estate bubble and eventually spread financial pain around the globe.

In a way, the government has emboldened banks to keep selling risky securities: Since the crisis erupted, federal emergency programs have helped keep the banks from failing. But now, as the financial system recovers, the government plans to phase out these backstops — leaving banks more vulnerable to big bets that go bad.

One investment gaining popularity is a direct descendant of the mortgage-backed securities that devastated many banks last year. To get some lesser performing assets off their books, banks are taking slices of bonds made up of high-risk mortgage securities and pooling them with slices of bonds comprised of low-risk mortgage securities. With the blessing of debt ratings agencies, banks are then selling this class of bonds as a low-risk investment. The market for these products has hit $30 billion, according to Morgan Stanley.

"It may be unpleasant to hear that the traders are riding high," said Walter Bailey, chief executive of boutique merchant banking firm EpiGroup. "But, hey, it's a pay-for-performance thing, and they're performing like mad."

And that means the return of another Wall Street mainstay: Lavish compensation.

After 10 of the largest banks received a $250 billion lifeline from the government last fall, some lawmakers were outraged that employees were being paid seven-figure salaries even though their companies nearly collapsed. A handful of top executives, including Citigroup CEO Vikram Pandit, have agreed to accept pay of just $1 this year. But the compensation of most high-performing traders hasn't changed.

Goldman spent $6.6 billion in the second quarter on pay and benefits, 34 percent more than two years ago. And Citigroup, now one-third owned by the government after taking $45 billion in federal money, owes a star energy trader $100 million.

The CEO of Goldman, Lloyd Blankfein, said at a banking conference in Germany last week that excessive banker pay works "against the public interest." He said bonuses are important to attract and retain top talent, but "misapplied, they can also encourage excess."

The Obama administration has proposed measures to diminish the risk posed by large banks. They include forcing banks to hold more capital to cover losses and trying to increase the transparency of markets in which banks trade the most complex — and potentially risky — financial products.

One major component of the Obama plan — creating an agency to oversee the marketing of financial products to consumers — will be difficult to pass in Congress. Industry lobbying against it and other proposed financial rules has been fierce.

Lobbyists for hedge funds, the large investment pools that cater to the rich, have been able to fend off proposals that would require them to register with the SEC and regularly disclose their holdings.

And they, too, are profitable again after a dismal 2008. The 1,000 largest hedge funds in Morningstar's database posted average returns of 11.9 percent through July. In 2008, those same funds lost 22 percent on average.

"Have there been changes around the edges?" says Timothy Brog, portfolio manager of New York-based hedge fund Locksmith Capital. "Absolutely. Have their been systematic changes? Absolutely not."

As you can see, nothing has really changed. Wall Street still wants free reign to "compensate their top talent". Sure no problem. Why don't we start compensating these top traders based on risk-adjusted returns? That fella that made billions for Citigroup took huge risks to deliver those returns, so why are they not taking that into account when compensating him?

I'll tell you why, because they're myopic idiots who only look at the bottom line and they want to make sure they're competing with the Goldmans of this world. It's absolute nonsense.

I heard Steve Forbes on Good Morning America telling Diane Sawyer that Citigroup has a "contractual obligation" to pay these bonuses. What a genius that Steve Forbes is! How about we also scrutinize the risks these "star traders" are taking to deliver these results? I can show you a few "star portfolio managers" at Canada's largest public pension plans who took enormous risks and went from heroes to zeroes after 2008.

As long as you're compensating someone excessively to deliver huge returns, then you're exposing your financial institution to huge risks. PERIOD.

I don't care if you're Goldman Sachs, J.P. Morgan, Ontario Teachers or the Caisse, it's only a matter of time before you get creamed by some big swinging dick trader who thinks he's bigger than the market.

What have they learned on Wall Street? Absolutely nothing. That's pretty much what I see on Wall Street and at the large "sophisticated'' Canadian public pension funds. Behind the rhetoric, it's business as usual. Who needs risk management when the markets are on fire and you're looking to shoot the lights out?

I agree with Nassim Taleb, we still have the same disease. And Joseph Stiglitz is right, bank problems are bigger than pre-Lehman. That's why James Galbraith says forget reform and move to a total restructuring of Wall Street.

But total restructuring won't happen because every administration panders to the banksters on Wall Street. That is the one thing you can count on. Intense lobbying has totally corrupted the U.S. financial and health care industry.

Finally, a year after Lehman's collapse, here is something interesting I read today from Crediflux:

Credit Derivatives Research has reported that while its Counterparty Risk Index (CRI) is trading back to July 2008 levels (post Bear Stearns), cognitive biases to anchor on the worst case (last September, post Lehman bankruptcy) are misleading as the largest 14 OTC derivative counterparties remain 5-10 times more risky than early 2007.

The CRI is trading 40bp (26% less risky) below 12 September 2008 levels, still above recent tight levels as the average equity price of the CRI components is down over 21% over the same period. CDR says this seems appropriate in terms of the TLGP/TARP/ZIRP support for the capital structure (senior unsecured outperforming equity). The drop in credit risk for the major CDS dealers has also been driven by counterparties lifting protection measures as centralised clearing and regulatory pressure to margin more effectively appear closer by the day.

Only two (Citi and Dresdner Bank) of the CRI members are wider than pre-Lehman levels with Royal Bank of Scotland, Bank of America, and Credit Suisse all practically unchanged since then. US banks and brokers outperformed European banks in credit but underperformed in equity as JPMorgan, Merrill Lynch, Morgan Stanley, and Goldman Sachs were the best performing credits of the CRI over the last year.

Dispersion, the range of spreads among the members of the CRI, has been cut in half over the past year indicating much more systemic than idiosyncratic discrimination among these institutions as Europe’s spread volatility has been far lower than in the US banks. This relative difference in risk compression and volatility is opposed by the changes in European and US sovereign risk levels.

The systemic risk transfer from corporate/financial balance sheets, as well as currency volatility, has played out aggressively in the sovereign protection markets with the CDR Government Risk Index (GRI) only back to October 2008 levels and 20-25 times higher than the levels of early 2007. While financial institution risk (as measured by the CRI) is about even with July 2008 levels, major sovereign risk (as measured by the GRI) is almost three-times its July 2008 levels and coupled with the massive derisking seen in the DTCC data for sovereigns, it is apparent that systemic risk remains elevated but has been transferred to the most creditworthy balance sheets.

As governments begin to unwind emergency relief measures such as TLGP/QE/POMO, CDR questions where systemic risk will appear next.

Where will systemic risk appear next? That's the question that should preoccupy all of us, but for now, it's business as usual on Wall Street. And after President Obama's speech, the banksters are fired up and ready to go!

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