Category Archives: speculation

Chesapeake takes its eye off the ball

Chesapeake Energy has been going through a shake-up of late, most recently at Friday’s shareholder meeting. The low, low price of natural gas is contributing to a cash squeeze. This has made all the more vital the many debates about corporate governance and the company’s investment strategy. To the list of items needing review, I would add the management’s short-term speculations on natural gas and oil prices.

Here’s a slide from a deck distributed in advance of last week’s meeting:

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Show me, per Dodd-Frank

The finance lawyer who blogs at Economics of Contempt has a very nice summary of what is required for JP Morgan to claim that the trades at the CIO unit are allowed under the Volcker Rule because they were “portfolio hedging”. It is a more comprehensive and textual version of our requirement that JP Morgan “show me”.

Show me

JP Morgan’s $2 billion loss on credit derivatives traded by its Chief Investment Office (CIO) has moved the debate over implementation of the Volcker Rule to the front page. Many claim that these trades are a clear example of the type of speculative, proprietary trading banned by the Volcker Rule. JP Morgan CEO Jamie Dimon insists otherwise, claiming the trades were intended as a hedge, which is clearly permitted under the Volcker Rule. Public discussion on the matter is confused, in part because many people are unclear about what defines a hedge and what defines a speculation. Who can blame the public when the premier vehicles for speculative trading are known as hedge funds?

Moreover, the current battle over financial reform and the Volcker Rule gives bankers an incentive to escalate the confusion. They want to continue their speculative trading, and that can only be done by labeling it either hedging or market making. Clarity is not their ally. When regulators, legislators and pundits advocate bright line tests for hedging, these bankers ridicule them as simpletons, accusing them of applying a dangerously unsophisticated understanding of financial markets drawn from a bygone era. These simpletons, they complain, fail to grasp the complexity of the modern world that bankers are tasked with mastering in order to serve the needs of society.

So, in order to try to make some progress and gain some insight from the JP Morgan case, let us first step back from the details of the current trades and losses, and from the debate over the Volcker Rule, and instead gain some clarity on the concept of hedging. Then we can double back and analyze the JP Morgan case in light of a sensible notion of hedging.

Two points about hedging…

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Morgan Stanley says potahto

You like potato and I like potahto,

You like tomato and I like tomahto,

Potato, potahto, tomato, tomahto!

Let’s call the whole thing off!

            from Let’s Call the Whole Thing Off by George & Ira Gershwin

This past Tuesday was the closing date for Comment Letters to the CFTC on its proposed Volcker Rule, and this gives us a second batch of responses to consider. The letter submitted by Morgan Stanley (back in February) is interesting because in Attachment 2, the company focuses specifically on commodities and provides three Example Customer Transactions that Morgan Stanley alleges would be impaired by the proposed Rule. These examples help to make concrete the actual activities that the banks allege are uniquely provided by banks and that are endangered by the Volcker Rule.

For today, let’s focus on just one of Morgan Stanley’s three examples:

Example B, Helping a Major U.S. Airline Reduce Jet Fuel Related Costs.

As part of a Chapter 11 restructuring, a leading U.S. airline sought Morgan Stanley’s help to reduce its operating costs, working capital requirements, and balance sheet usage associated with its jet fuel supply. Prior to bankruptcy, the airline managed a large jet fuel supply operation in which it maintained up to a month’s inventory, creating significant operational overhead and a need for costly financing. To reduce these expenses, Morgan Stanley provided the airline a long-term contract for delivery of jet fuel, typically one day prior to the airline’s daily need to service its fleet. Morgan Stanley provided all logistical support and sold the airline jet fuel at a lower price than it was paying previously. This enabled the airline to reduce its operating expenses, reduce the size of its balance sheet and lower its overall interest expense.

I’m missing the part where Morgan Stanley explains how this is market making. Continue reading

Credit Suisse note is not a solution to bonus culture

Credit Suisse (CS) has announced it will pay a portion of its bankers’ bonuses with a structured note instead of cash. The note pays a fixed coupon of around 6% per year, and is backed by a package of derivative contracts currently in the balance sheet of CS. Since the value of the portfolio is risky, the payout is not guaranteed.

In a memo to staff, CS CEO Brady Dougan touts the structured note as a way to address the criticism made against the financial industry’s bonus structures. But is that true?

The central criticism is that the relationship between risk and return is out of whack. The principal behind past bonus structures has been “heads I win, tails you lose”. Performance has been rewarded without regard to risk. Losses have been put to shareholders or to taxpayers. A related criticism is that the process for setting bonuses is opaque and managed by insiders, at the expense of shareholders and taxpayers. This makes it unlikely that insiders ever fail to succeed against the benchmarks that are set, and ensures that the system is skewed against shareholders and taxpayers.

Does the new CS structured note address these criticisms?

No it doesn’t.

It was designed with an entirely different purpose in mind, which is strengthening the bank’s capital position in light of new banking rules. The derivatives portfolio backing the structured note comes from CS’s balance sheet, and CS hopes the move will decrease the measured risk of its balance sheet and improve its capital ratio under the new Basel III agreement. CEO Dougan is straightforward about this strategic objective. But he also wants to advertise the move as addressing shareholder and public concerns on bonus rules.

The structured note fails to address either of the two key criticisms.

Most importantly, it is terribly opaque. Many details haven’t yet been released, but in his memo to staff, CEO Dougan acknowledged that “Instruments such as PAF2 are inherently hard to value. It’s obviously not something that is traded in regular markets so has to be modeled.” Only an investment banker still locked in a pre-2008 mindset would structure a note like this as a step forward to transparency and accountability?

It is also hard to see how the structured note provides a sensible risk-reward relationship for the bank’s senior staff. No one starting from a blank piece of paper would design a compensation scheme based this way on the portfolio of derivatives now on the bank’s balance sheet. Indeed, CS has designed the arrangement with an escape hatch should the capital regulations surrounding its real strategic objective change:

PAF2 represents an effective and real sharing of risk but, nonetheless, we still need to reserve the right to amend this structure in the event of changing requirements. The most likely change would be to amend PAF2 to an instrument that instead of referring to our specific portfolio would reference a public index of credits. In our view this would be just as good for our employee investors. We also need to include a call at market value in case these requirements change so materially that the instrument is no longer effective.

If the note were also a real solution to the bonus problem, it would survive changes in the regulatory capital rules that are its real objective.

If CS’s management were serious about addressing the compensation problem, they would design a durable scheme, not a one-off gimmick. The scheme would include a clear downside for managers and a clear tie to the long-term fortunes of the bank. Simon Nixon at the Wall Street Journal’s Heard on the Street column mentions UBS’s plan to pay bonuses as contingent convertibles as one example in this direction. Another alternative would be the explicit clawback provisions being pushed by New York City Comptroller John Liu. The key is that managers should not be able to walk away from the future fortunes of the bank, and the scheme should encourage cross monitoring of risks among managers within the bank. And these incentives should be clear to all, inside and out. The CS proposal is not a step forward on this front.

The lesson from MF Global for the management of a prop trading unit.

Much has been said about MF Global, the US brokerage and clearing group that filed for bankruptcy in late October. In March 2010, when Jon Corzine was brought in as the CEO, MF Global’s franchise in brokerage and clearing operations was strong, but had tallied a string of losses. Corzine was tasked with cutting expenses and returning those operations to profitability. But that wasn’t good enough for him. He wanted to transform the firm into a major league investment bank, expanding into market making in fixed income instruments as well as adding asset management, advisory and capital market services. Corzine also sought to transform proprietary trading into a major source of profit for the firm.

Proprietary trading was something more to Jon Corzine than simply another line of business. He personally stepped in to make an outsized bet on the Eurozone sovereign debt crisis. The firm took a long position in bonds of financially stretched European countries with loans secured by the bonds themselves. To avoid the risk of refinancing, MF Global arranged the trade to be funded until the maturity of the bonds. If everything went according to plan, for a ten percent haircut on the collateral, the spread between the EU high bond yields and the overnight rate would generate €400-€500 million in profit for the company.

As Aaron Lucchetti and Julie Steinberg, of the Wall Street Journal report, MF Global’s Chief Risk Officer, Michael Roseman, warned of the dangers of the trade: he “contended MF Global didn’t have enough spare cash to withstand the risks of its position in bonds of Italy, Spain, Portugal, Ireland and Belgium. He also presented gloomy hypothetical scenarios of what could happen if MF Global’s credit rating was downgraded because of the exposure.” Nevertheless, Corzine held firm and the Board did not restrain him.

MF Global’s lenders grew worried over the summer as the collateral lost a good deal of value. They demanded the company post additional margin, and when the company was unable to do so, they called the loans. With no additional credit available to the firm, MF Global had no choice but to liquidate the portfolio at very disadvantageous prices, for the market for bonds of highly indebted European countries is very illiquid. Ultimately, the bad bet forced the company into bankruptcy.

There are many lessons that can be drawn from the collapse of MF Global. One that we would like to highlight has to do with the proper place of prop trading in a larger business. We see no problem with standalone prop trading units – hedge funds, as they are sometimes called. When the prop traders are gambling using their own balance sheet, they are forced to fully bear any risk of failure. But when the prop traders share a balance sheet with other lines of business – like MF Global’s brokerage and clearing operations – the danger arises that they are gambling using the capital of other units without paying for it. When MF Global’s bet went bad, it lost more than the price of that bet. It wiped out the long-term health of the brokerage and clearing franchise. That is a dead weight cost produced by having the two operations share a balance sheet.

Was that potential cost factored in when taking the original bet? We doubt it. Measuring the capital at risk from proprietary trading is a difficult task. Traders habitually underestimate the risks of their trades and the capital required to run their operation. MF Global structured it’s repo-to-maturity deal to seemingly hedge out key risks, thereby benefitting from an accounting trick that kept its bet off of its balance sheet and out of sight of the market. But that accounting treatment ignored the huge liquidity risk created by the need to hold onto the position to maturity. That liquidity risk put the entire balance sheet of the firm on the line. Ultimately, one of MF Global’s regulators, FINRA, flagged the risk and demanded more capital, forcing more disclosure.

One way to discipline traders is to give them their own balance sheet. With no one to blame but their operation, the tradeoff between risk and return is more carefully scrutinized. A stand alone balance sheet isn’t the only tool for disciplining traders, but it is certainly the most reliable. Companies that decide, for whatever reason, to put the proprietary trading unit onto the same balance sheet with other activities, had better have superior disciplinary tools at their disposal than what MF Global had.

Prop trading under the guise of hedging: The forgotten lesson of Metallgesellschaft and the Volcker Rule

In the world of finance, the name Metallgesellschaft (MG) is known primarily as one of the early “derivative disaster” cases. MG was a metal, mining and engineering company, and the 14th largest corporation in Germany. At the start of 1994, the company stood on the brink of bankruptcy because of more than $1 billion in losses racked up by a small trading office in New York with a big bet in oil futures. MG’s debacle sparked a vigorous debate—our contribution is here, and a collection of many contributions is available here.

MG was short on a set of long term contracts for the delivery of refined oil products to small businesses for periods of up to 10 years. Many of the contracts were negotiated with a fixed price, while others had more complicated terms. On the other side, MG was long a set of crude oil futures or OTC swap contracts for delivery in one to six months. Taken together, this looked like a long dated short position in the physical hedged by a short dated stack of futures. The critique focused on two questions. First, was the short dated stack a successful value hedge, or had traders at MG failed to accurately “tail the hedge”? Second, did the attempt to hedge such a long horizon physical obligation using derivatives subject the firm to one-sided margin calls, producing a liquidity crisis that the firm could not withstand? From these two questions flow a host of related questions about alternative designs of a better hedge, about the accuracy with which the accounting reflected the underlying financial reality, and governance.

From the narrow perspective of financial engineering, these are all useful questions to consider. However, these questions all start from the premise that the task is to hedge the company’s given exposure on the physical contracts. That is what the situation looked like at first glance, from outside. But courtesy of the acrimony between the team that crafted the failed futures trading strategy and the corporation that dismissed them, a number of internal documents with details on the strategy became public.

Those documents reveal that this premise was incorrect. The traders at MG operated under a very different premise: the long futures position was the real source of profit. If it had been up to them, they would have concentrated on building it up. However, corporate risk management rules limited the quantity of long futures contracts to the volume of physical deliveries. The traders, therefore, had an incentive to market the physical delivery contracts. The more they expanded their long positions in the futures contracts, the more they could loosen the limits imposed by the internal risk limitations, and expand speculative trades. The long futures position only looked like a hedge. In fact, it was a speculation. Traders used hedging to engage in risk taking.This was a classic prop trade disguised as a hedge of a customer facing transaction. When the prop trade blew up, it nearly brought down the entire firm. This aspect of the case is often forgotten.

Eighteen years later, this lesson from the MG case has renewed relevance in light of the $2 billion trading loss by trader Kweku Abdoli at the Delta One desk of the Swiss bank UBS. That spectacular loss gave a fresh reminder of the dangers posed by prop trading at banks, and of the need for prohibitions like the Volcker Rule. So long as taxpayers are the backstop for banks, the traders, the management and shareholders do not suffer the full penalty of the risks from trading. Opposition to the Volcker Rule by bankers is strong, and takes many forms. They argue that any customer facing business, like a Delta One desk, is protected from the prohibition by the mere fact that it is customer facing. This is nonsense. Thankfully, the current draft regulations for the Volcker Rule look to all of the fingerprints of prop trading, and do not provide any such simplistic exceptions. Both the MG case and the UBS case show that prop trading can operate under various guises. It’s prop trading that is the problem, regardless of how it is cloaked.

Song of the Martingale

John Kay at the Financial Times has a nice column reminding us of the delusions of following a martingale betting strategy. It’s a persistent delusion that shows up in many different contexts.

Exelon, E.On and the Volcker Rule

The Volcker Rule contained in the Dodd-Frank financial reform act bans banks from proprietary trading. In order to implement the Rule, it is necessary to distinguish proprietary trading activities, which are proscribed, from market-making activities and other traditional banking functions, which are allowed.

Many traders at banks claim that this distinction is impossible to make in any rational way. Also that it will bury them in a maze of complex and arcane rules and costly compliance systems.


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Cash & Carry, #4: Other resolutions to the puzzle

We began this series of posts recapping the finding that a currency carry trade investment has historically produced high return relative to the low risk. This finding is not consistent with models in finance that focus on the correlation between an investment’s return and the return on some benchmark stock portfolio. Using these models, and looking at the historical distribution of returns, the carry trade looks like a good bet, even accounting for bad outcomes. Posts #2 and #3 in the series reported on one route of the research effort to explain the puzzle, which attributes the abnormal return to the “peso problem”. But other researchers have been pursuing different routes. To wrap up this series, we’ll quickly mention some of this work.

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