Wednesday, October 21, 2009

The risk of talking about risk

In a recent article in The New Yorker entitled "Rational Irrationality" John Cassidy seeks to explain how bubbles occur. In deconstructing the tech bubble and the housing bubble, the article basically argues that there is no such thing as the "irrational exuberance," so famously described by Alan Greenspan. According to Cassidy, it is precisely rational behavior that leads to bubbles and that fact pretty much guarantees the occurence of bubbles in the future. "In a market environment the individual pursuit of self-interest, however rational, can give way to collective disaster. The invisible hand becomes a fist," writes Cassidy.

Wall Street is particularly succeptible because of the pressure to generate earnings forces banks into riskier and riskier businesses. As Cassidy writes, "In the midst of a credit bubble, though, somebody running a big financial institution seldom has the option of sitting it out. What boosts a firm’s stock price, and the boss’s standing, is a rapid expansion in revenues and market share. Privately, he may harbor reservations about a particular business line, such as subprime securitization. But, once his peers have entered the field, and are making money, his firm has little choice except to join them."

As early as July 2007, Charles Prince, CEO of Citigroup acknowledged that a collapse in the credit markets could result in huge losses for Citi. He also understood the Catch-22 he was in. “When the music stops, in terms of liquidity, things will be complicated,” Prince said. “But as long as the music is playing, you’ve got to get up and dance," he said.

The game of musical chairs appears to have started up again and is playing in real time. Morgan Stanley had a serious brush with insolvency last fall. The bank retrenched and posted losses while gutsier firms like Goldman Sachs scored huge profits from trading.

Now Morgan Stanley is playing catch up. Value-at-risk reached $123 million, the highest level since 2007 and its strong earnings of $2.1 billion are still more than $1 billion lower than Goldman's. VaR at Goldman hit $208 million last quarter. Morgan Stanley plans to hire 400 people to bolster its trading businesses and its VaR is bound to rise, whether they like it or not.

What is a bank CEO to do? Clearly there are massively complex business decisions to be made. But CEOs also need to begin speaking clearly and publicly about risk and it's not the big risk-takers that need to start that dialog. Rather, the imperative falls on those firms (banks, insurance companies, hedge funds, etc.) that do not want to get trapped in a game of financial musical chairs.

The conversation centers on articulating how an enterprise is prepared to balance reasonable growth with reasonable risk and the limits the firm is willing to accept to protect its strategy and growth plan. It takes vision and it takes courage and it will take perseverence because firms will see their earnings lag other, potentially riskier, firms.

Why can't a bank, for example, make a case for controlled growth? Don't firms like investment banks that tend to have volatility in their earnings have lower PE ratios than slower growing, but more predictable institutions?

CEOs with something to lose should be ready to begin the risky discussion about risk. If someone doesn't stop the game of musical chairs, we will know that the cynics are right and that on Wall Street the game really is heads I win, tails you lose.

Update: Warren Buffet in a new interview touches on Wall Street compensation. He says, "in addition to carrots, there need to be sticks...We need to create a downside to people who mess up large institutions...too many people have walked away from the troubles they've created for scoiety...and they've walked away rich." Creating this downside will bring risk management and communicating about risk to the forefront of the financial industry.

Update: Here is commentary advocating that investment banks need to return to being private partnerships in order to effectively manage risk.

Tuesday, October 20, 2009

The sinking feeling about Galleon

The Wall Street Journal's editorial page jumped to the defense of Galleon yesterday. "When Wall Street and business are as politically unpopular as they are now, the media temptation is to chalk up every indictment to "greed" and assume prosecutors are always right. In this case they may be right, but when political calls for scalps are in the air is precisely when the rest of us should reserve judgment until they prove it in court."

It is a curious move for the Journal's editorial board, which has been pretty muted about hedge funds, despite ample opportunities to address issues like short selling, risk management, compensation, etc. Yes, the accused are innocent until proven guilty, but there seems to be a lot of smoke in this case. The market seems to sense this too and Galleon is facing $1.3 bn in redemptions -- more than one-third of its assets under management -- and counterparties like Merrill Lynch and Barclays are cutting Galleon off from trading.

The New York Times explains that insider trading is difficult to prove, but author Dan Strachman suggests on CNBC (see clip below) that trading on insider information could be an issue for the entire money management industry, not just hedge funds. Indeed, Reuters reports that the SEC is poised to announce more cases involving insider trading and people in the financial industry.

How big a black eye the Galleon episode is for the hedge fund industry is unclear. Certainly it is not a good thing. However, for the first time in a year, the industry is net positive for asset inflows and many funds are posting solid performance amid the broad recovery in the markets since March.

We can expect that cases like Galleon, so close on the heels to the Madoff fraud, will rightly make investors even more cautious. Hedge funds need to embrace a higher bar for transparency and they must be prepared to communicate better with investors about their strategy and the specific drivers of performance. Funds which cannot explain their performance to proactive investors are going to be told to walk the plank.

Update: Galleon is winding down the fund. In a letter dated October 21, founder Raj Rajaratnam wrote to clients, "I have decided that it is now in the best interest of our investors and employees to conduct an orderly wind down of Galleon’s funds while we explore various alternatives for our business."

Thursday, October 1, 2009

Hedge fund conspiracy theory about to go mainstream?

Everyone has heard about the 9-11 conspiracy theory. Millions have seen the slickly produced video which argues that a plane did not hit the Pentagon. It's easy to dismiss as the work of a small group of whatever you want to call them. However, one cannot deny the pervasiveness of that particular conspiracy nor the effectiveness of the Web in propagating the allegations.

Here's a conspiracy theory that the financial industry needs to watch: that short selling and the outsize power of firms like Goldman Sachs were at the root of the financial crisis. At the center of that theory is a blog site called Deep Capture which rails against short selling and in particular the destructive nature of naked short selling. A video on the site that attributes the fall of Bear Stearns and Lehman Bros. to massive spikes in naked short selling is eerily similar in tone and style to the 9-11 video. The name of that video: "Hedge funds and the global economic meltdown."

Deep Capture is founded and probably funded by Patrick Byrne, CEO of Mr. Byrne is infamous for consistently alleging that the shares in are unfairly and illegally targeted by short-sellers. In the About section of the site, it writes:

"...short-sellers and affiliated investors use a variety of other tactics to drive down stock prices and destroy public companies. They hire thugs to stalk and threaten corporate executives and their families. They pay small armies of “bashers” to flood the Internet with scurrilous rumors and lies. They engage in extortion and blackmail. And they collude with crooked law firms to saddle corporations with bogus class-action lawsuits. They also conspire to cut off companies’ access to credit. They finance dubious market indexes and credit rating agencies that spread false information about the prospects of companies and the economy. They pay shady financial research shops to publish false, negative information, disguised as “independent” analysis. And they manipulate credit default swaps and derivatives, the prices of which are considered indicators of corporate health."

You get the picture.

Matt Taibbi, a writer for Rolling Stone, who gained notoriety for a conspiracy-esque article about Goldman Sachs, now writes on his blog about Golman's lobbying efforts to head off curbs on short selling. The blog entry alleges, but by no means proves, that Goldman is also trying to defend the practice naked short selling. According to the New York Times, in public filings Goldman has argued that new short-selling rules adopted last year have worked to curb abuses and “fails to deliver” — the term for problems associated with naked shorting — and that further restrictions are not needed.

Here's my own conspiracy theory about the conspiracy theory: the people behind Deep Capture are working to influence journalists like Taibbi to do their bidding and get their ideas into the "mainstream" media.

I myself have no idea about whether new curbs on short selling are sufficient nor about the true market impact of naked short selling. I do know that questions about short selling, transparency and efficient market function are immensely complex, that that the causes behind the collapse of Bear and Lehman are widely misunderstood, and that neither the government nor the banking industry has been clear about what went wrong and how to prevent future shocks to the financial system.

The confluence of these unknows is the condition that gives rise to conspiracy theories and hedge funds, which already have the stigma of being opaque, private and secretive, now more than ever need to avoid being the subject of conspiracy theories.