Spero Consulting

Archive for October 11th, 2008

Today, Octo­ber 11, we’ve been orga­niz­ing our thoughts about the ongo­ing finan­cial cri­sis. We’ll have more to say about ways to rem­edy the imme­di­ate cri­sis, but this post con­tains a spe­cific rec­om­men­da­tion for when the cri­sis ends, which today may seem to be far, far off. We’re sure that – whether jus­ti­fied or not – many laws and reg­u­la­tions will be revised and tough­ened, and this should be one of them.

We make this rec­om­men­da­tion because from our expe­ri­ence and from the infer­ences that we’ve made about firms through­out this cri­sis, it seems that nei­ther many senior man­agers nor reg­u­la­tors fully under­stand many prop trad­ing activ­i­ties although, of course, neither set of indi­vid­u­als would ever admit as much. 

With gov­ern­ment sup­port comes oblig­a­tions, includ­ing the com­mit­ment not to take out­sized risks or ones that are par­tic­u­larly dif­fi­cult to mea­sure or approx­i­mate, and that seems rea­son­able to us.

In that regard, it seems very likely that the fed­eral gov­ern­ment will con­tinue to pro­vide higher lev­els of deposit insur­ance above the past limit of $100,000. Already that limit has been increased to $250,000, and there is talk of, at least tem­porar­ily, guar­an­tee­ing all deposits. (The guar­an­tee of all deposits is stu­pid and coun­ter­pro­duc­tive, and if it goes into effect, it will elim­i­nate a use­ful dis­ci­plin­ing and warn­ing mechanism. Having large, unin­sured depos­i­tors flee risky finan­cial insti­tu­tions warns man­age­ments to change and informs reg­u­la­tors of impend­ing prob­lems. We plan a sep­a­rate post on that topic in the near future.)

Now, how­ever, along with the indem­nity that insur­ance pro­vides should come the oblig­a­tions of the insured – a quid pro quo if you will. It seems that the gov­ern­ment has done a very poor job of set­ting risk-​sharing mech­a­nisms, i.e., the equiv­a­lent of deductibles, i.e., inflicting finan­cial pain on the senior man­age­ment when a bank fails – beyond the loss of share value.

We won’t com­ment on that aspect today; instead, we pro­pose a lim­i­ta­tion on insured-​institution trad­ing activ­i­ties. Insured banks should not be per­mit­ted to have pro­pri­etary trad­ing desks in their cap­i­tal mar­kets departments.

Note that this will not stop banks from harm­ing them­selves by (1) lend­ing or (2) mak­ing bad invest­ments or trades in their trea­sury depart­ments or (3) mis­man­ag­ing cus­tomer trad­ing desks. 

It will how­ever, allow reg­u­la­tors to focus their atten­tion on where the major risks are taken within the firms. With­out going into details, we real­ize that their is a cer­tain fun­gi­bil­ity between trea­sury trades and prop trades in cap­i­tal mar­kets depart­ments and to a cer­tain degree between prop desks and cus­tomer desks in said depart­ments, but it would seem to be more dif­fi­cult to jus­tify cer­tain trades and strate­gies if the desks were within typ­i­cal, bank-​related busi­ness activ­i­ties. (When could write much about this but it likely wouldn’t change minds; so, we defer.)

We’re com­pletely for the free-​market–more so than most bank man­agers – but until such insti­tu­tions for­sake their gov­ern­ment insur­ance, we’ll insist that they have an oblig­a­tion to the cit­i­zenry – through the gov­ern­ment – to behave in a respon­si­ble, low risk man­ner. If that gen­er­ates lower returns for them on aver­age, then so be it. That’s the nature of the risk-​return spec­trum and their legal and fidu­ciary responsibilities.

By the way, if an all-​in, full-​accounting were ever per­formed, we’d be doubt­ful that such prop trad­ing oper­a­tions were prof­itable or value-​creating, espe­cially at the com­mer­cial banks. From what we’ve observed, trading PnL (profit and loss) is con­sid­ered and some­times trading-​related PnL is con­sid­ered for per­for­mance eval­u­a­tion, but rarely an all-​in account­ing is per­formed. The mar­ginal over­head costs risk-​management, back-​office oper­a­tions, audit­ing, account­ing, etc., asso­ci­ated with such activ­i­ties are often ignored. Moreover, on a risk-​adjusted basis, it is sub­stan­tially less likely that over­all, net returns are positive.

Finally, we actu­ally think that many senior man­agers of com­mer­cial banks would wel­come the ban. We sus­pect that many of them are sus­pi­cious of such activ­i­ties but don’t feel qual­i­fied to eval­u­ate and elim­i­nate them. We think it is true of most reg­u­la­tors, too. They don’t object because they don’t want to seem unso­phis­ti­cated; pride goeth before the fall.

When will they ever learn?

Peggy Noo­nan has another excel­lent opin­ion col­umn in today’s The Wall Street Jour­nal. It is enti­tled, Play­ing Fris­bee on a Precipice. The title and the column’s blurb say it all: “Our polit­i­cal class lacks the seri­ous­ness this moment demands.” Clearly, her essay is about the small­ness of our present day politi­cians and their advisers.

She has per­fected the abil­ity to lament, yet simul­ta­ne­ously expect, the fallen nature of man.

We’ve writ­ten about our admi­ra­tion for Ms. Noo­nan on a num­ber of occa­sions, and once again she strikes the metaphor­i­cal nail directly on the head. There is an over­whelm­ing small­ness of the cur­rent polit­i­cal class where every­thing, regard­less of the cri­sis, is attempted to be used for short-​term polit­i­cal gain. What small, small peo­ple in both parties.

It’s obvi­ous from her title that she uses the metaphor of play­ing Fris­bee on a cliff to show their utter lack of seri­ous­ness, pri­mar­ily within the two Pres­i­den­tial cam­paigns and with can­di­dates. Per­haps deep down inside, our polit­i­cal actors real­ize that they are not up to the task and there­fore con­tinue to play games as the fel­low cit­i­zens lose tril­lions of dollars. 

In that sense our politi­cians are like young sib­lings or friends mak­ing out­ra­geous claims against each other know­ing full well that their par­ents would step-​in and never per­mit such events to tran­spire. Unfor­tu­nately, the grownups are gone, and the noise down­stairs isn’t an older sib­ling try­ing to scare via a the equiv­a­lent of a Hal­loween prank.

It’s worth men­tion­ing that a month ago we used some­what sim­i­lar imagery to Ms. Noonan’s about the mort­gage cri­sis in Our Poster Boy for the Credit Cri­sis.

In that post we com­pared many Wall Street firms to our hun­gri­est Basenji, Boots. As the photo shows, Bootsy had his head buried so far in the food bag that he had no idea where he was. To his good for­tune he was in the kitchen, and not near the base­ment steps as he pushed on. 

Due to lax man­age­ment, poorly designed incen­tives, and the result­ing exces­sive risk-​taking, Wall Street’s metaphoric head was buried just as far in the food bag seek­ing ever smaller and smaller morsels as it pushed closer and closer to the precipice of the Grand Canyon – located in to hous­ing bust of the South­west, no less.

We still pre­fer our graphic to the one in her column:

By the way, Ms. Noo­nan and Sarah Palin share that trait that seems to be fem­i­nine but which Ronald Rea­gan also pos­sessed. It per­mits a severe scold­ing but in a gen­tle, humor­ous way. 

We don’t know of Mrs. Palin well enough to include her, but we’d argue that it worked for Mr. Rea­gan and works for Ms. Noo­nan because their cen­tral core was/​is so per­ma­nent, solid, and robust that one knows exactly their posi­tion before they speak. That inner sense of com­plete­ness, com­bined with the con­fi­dence that nat­u­rally fol­lows from such maturity, means that lis­tener or the reader knows the words are from the heart, the essence, the core and not just cheap rhetoric. That depth of con­vic­tion per­mits the humor and irony to be appre­ci­ated for what it is, and also what it is not: it is not mean­ness or cheap tactic.

Enough about peo­ple big­ger than us. Out of our own small­ness, we couldn’t help link­ing the failed lead­er­ship of the nation’s old­est baby­boomers, who are now in charge of many gov­ern­ment func­tions and large cor­po­ra­tions, to one of their favorite, Pete Seeger protest songs from the six­ties. It was about gov­ern­ment mis­steps, too. “When will they ever learn? When will they ever learn?”