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Thursday, May 13, 2010

Big Bank Perfect Trading Quarters - The Real Story

disclaimer/disclosure: 1) I am not an expert in bank balance sheets.  These 10Qs are not for the faint of heart, and yet I'm quite sure that there are readers in my audience who will be able to add value to this discussion and have more expertise in dissecting these than I do.   There is a mammoth story here, and I am probably not the guy to get to the bottom of it, but I hope to open up Pandora's box for others to dive into.  2) I am short XLF

You've probably heard by now that four of the biggest banks racked up "perfect quarters" in their trading businesses. Bloomberg:

"Bank of America, JP Morgan, and Goldman Sachs, the first, second and fifth-biggest U.S. banks by assets, all said in regulatory filings that they had zero days of trading losses in the first quarter. Citigroup,  the third-largest, doesn’t break out its daily trading revenue by quarter. It recorded a profit on each trading day, two people with knowledge of the results said"

From Dealbreaker: on JPM:

"JPMorgan had average daily trading revenue of $118 million for the quarter and never ended a day with a net loss, according to a filing on Monday. JPMorgan posted gains of between $60 million and $90 million on most trading days of the quarter with about half the days bringing in at least $90 million. On 10 days, Jamie & Co. had more than $180 million in net trading revenue."

on BAC:
"Bank of America scored positive net revenue on its trades every single day last quarter. Here’s the breakdown: Revenue was more than $25 million 95 percent of the trading days in the first quarter, with the firm chalking up gains of over $125 million on 16 trading days between $75 million and $100 million on another 16 days. BofA said the gains were due to “more effective positioning” and “market conditions.”


on GS:
"Goldman Sachs just revealed in an SEC filing that its traders made money on every single trading day last quarter, a record for the firm. Net revenue for trading was $25 million or higher in all of the first quarter’s 63 trading days with 35 of those days bringing in more $100 million, according to the filing."

The numbers reported by the banks are incredible indeed - amazing in both size and consistency, but I can't recall a story of more importance that the blogosphere has done a more miserable job of covering than this one.  While the financial blogosphere has put itself on the map by doing the analysis that mainstream media couldn't or wouldn't do, the lack of in depth analysis on this one has been striking.  Perhaps its because trying to navigate the 10Qs which were released, each nearly 200 pages, is extremely difficult and tedious. 

Still, its disappointing that the analysis to come out thus far has focused on irrelevant demonstrations of how impossible it is to have 63 consecutive winning days if your probability of winning on each day is 50%.  Or on how this means that the big boys must be "cheating" "fixing the game" or "frontrunning all of their orders."   See, the probability of winning when your cost of funds is near zero and you can invest at positive interest rates at assets which are already being supported by the Government is probably closer to 100% than 50%.  As for the complete misunderstanding of "frontrunning" and all that crap:  people have no clue that only roughly TWENTY PERCENT of these earnings that we're talking about are coming from equities businesses!  By focusing the anger on the wrong "causes," we guarantee that we won't change the patterns.  People have a right to be angry about these earnings - but not because of banks manipulating equity markets - it's because the Fed is feeding them with free money and asset price support.

The second paragraph of the Bloomberg article gets closer to the truth than anything else:

“The trading profits of the Street is just another way of measuring the subsidy the Fed is giving to the banks,” said Christopher Whalen, managing director of Torrance, California- based Institutional Risk Analytics. “It’s a transfer from savers to banks.”

See, there's a much larger travesty going on here.  Exactly as the Fed designed, the goal is to recapitalize the banks by allowing them, encouraging them, to earn back the losses they are "extending and pretending" away for now.  In fact, it's the only way extend and pretend works:  banks print money now by leveraging zero cost funds, which will then cover the writedowns they are presently avoiding taking.  By the time they take the writedowns, they'll have already "earned" back the capital they need.    Borrow from the Fed at zero or near zero, invest in positive yielding securities --> profit.  I could use some help quantifying that, though - which is where you bank balance sheet experts come in.

And it all gets funneled through Fannie and Freddie.  How much agency mortgage backed securities does JP Morgan hold?  Take a guess...  on  page 97 of their 10Q, you can see $30.6 Billion in the trading account, and another $160 Billion classified as "available for sale."  And you wonder why Fannie and Freddie are getting a bottomless pit of Government aid?  Oh - in case you were wondering, Bank of America owns $153 Billion of Agency MBS classified as available for sale, and another $43Billion of agency collateralized mortgage obligations (BAC 10q, page 21). {I do want to clarify that I don't think these available for sale securities are impacting the income statement, though - at least not in terms of the change in their fair value. I'm not sure about any interest revenue they are throwing off.}

The real bank subsidy is sneaking around the corner largely unnoticed, while the angry mob in the street rants and raves about equity markets, which are a relative odd-lot in the profit numbers.  The 10Qs are here:  GS, C, JPM, BAC, and I've pulled out the trading revenues for each:

Goldman (page 106):
FICC (Fixed Income, Currency, Commodities): $ 7.386Billion
Equity Trading:  $1.473 Billion
Equity Commissions:  $881MM

Citigroup (page 100):
Interest Rates: $1.309Billion
FX: $241MM
Equity: $565MM
Commodity: $109MM
Credit Derivatives: $1.827 Billion

BankAmerica (page 108)
FICC: $5.515 Billion
Equities:  $1.530 Billion

JPMorgan (pg 18)
Fixed Income: $5.464 Billion
Equities: $1.462 Billion

So there you go - we've proved that these profits are not largely derived from computerized trading frontrunning equity orders - and now we can get down to the real nitty gritty. 

Remember what happened at the end of Q1 2010 - the quarter in question?  The Fed wrapped up its purchases of $1.25 TRILLION dollars of Agency MBS.  There very well may have been some "frontrunning" involved in those outsized profits - but it wasn't the banks frontrunning your purchase of 500 AAPL - it may have been frontrunning of the Fed's purchases of assets.    Load up on the stuff you know the Fed is going to be buying, sit back, wait, collect coupon as the Treasury continues to funnel money into the bankrupt entities, and rack up trading gains as the Fed drives the prices higher.  Bill Gross at PIMCO even gave us this playbook last year - he advised, "Shake hands with the Government."

What, then, is the exit plan?  I guess for the Agency paper it's easy - the Government has your back anyway, so you can't lose.  But are the banks really borrowing short (from the Fed, and in the CP market) and lending long (buying treasuries, and Agency paper) ?  If so, the Fed won't be raising rates to substantial levels anytime in the foreseeable future - they CAN'T - or the banks would get hosed by their funding maturity gap (see: CIT!)...  Perhaps some bank balance sheet experts can weigh in here.

Finally, there's a simple explanation for a chunk of the trading profits:  values on the paper held by the big banks continues to improve.  Now, it's my opinion that a large reason that these values are improving is again a direct result of the Fed's policies of mandating re-risking: (yeah, this is where you can throw the word PONZI in)  forcing re-investment into risky assets by offering the alternative of zero returns in cash accounts - but we will have to wait and see on that one...

Anyway, there is a big, deep, story here (which I've barely scratched the surface of in this post), but it's sad to watch commentators divert attention from the real problem - knowing that they already have an easy target which the public is confused and angry about:  electronic trading.  This post is in no means a defense of electronic trading (although I've made my position clear on that in the past) - the point is that inciting people to ignorantly scream and yell about the wrong thing does nothing except guarantee that the REAL problem won't get recognized and solved.

-KD

EDIT:  interestingly, a former colleague of mine told me after reading this that I sounded "like a socialist," which I thought was interesting, since I think my views are pretty purely capitalistic.  I countered that my point was that these hidden subsidies ARE socialistic in nature, and on the contrary, being against them is the opposite of socialist... 

51 comments:

Andrew said...

KD,

You may be on to the "real" story, but the "saddest" story has to be Morgan Stanley's inability to join the 63/63 club. Even when it's tee'd up with the FED's ZIRP and highly orchestrated MBS buying, they swing and miss. Sad indeed.

Kid Dynamite said...

andrew - ha - right - i forgot to even mention them...

Ken said...

KD,

The anger does not derive from electronic trading, it derives from the privilege enjoyed by a select group of Wall Street titans.

No offense, but those on Wall Street or those who make their living on Wall Street, suffer from severe myopia in their belief that what is good for Wall Street and the big banks is good for Main Street.

Unfortunately, many of the media outlets (CNBS) perpetuate that myth.

If we grant what you are saying is correct and the Fed is accomplishing what it hoped to accomplish, it still amounts to a select group of large privileged banks and pseudo banks on Wall Street being given free money while the rest of America continues to suffer.

You just know this same "free money" they are making right now is going to be the impetus for record bonuses come end of the year as well.

I own a small business. I am sure Wall Street is not even aware they exist, but talk to some of your small community banks who do lending in the communities and to small businesses in their communities.

Access to credit and capital is non-existent today, yet the big boys on Wall St continue to enjoy a bonanza on a daily basis due to Uncle Ben's largesse.

I guess it is the Feds version of "Trickle Down Economics". The belief if you give enough money to the large firms, eventually is will trickle down to little people below.

That is why people are angry.

James said...

8 out 8 times the media gets in wrong and sometimes very wrong. If you want to blame anyone for market malfunctions blame the governments manipulations. What was the world Neo lived in? The same one we live in. The Matrix

Kid Dynamite said...

Ken - what I meant is that if you look at the comment thread on any blog that has written about this topic, you will INEVITABLY read people ranting about high frequency trading and front running - which is NOT the problem and NOT the source of these outsized profits.

Damian said...

It'd be interesting to see the breakout of winning/losing days just for the equity business. It's also interesting that equity trading is now a bigger business than either IB ($1.1b) or asset management ($978m). Clients?! We don't need no stinkin' clients!

But you are right about most of the business (65%) comes from FICC right now - and no doubt where most of the Fed money flows through so it is likely, as you state, the main source of profits and therefore profitable days.

Also interesting that $1.4b is earned just on interest (so interest is now a bigger business than asset management).

I do find it amazing that GS was able to pull $1.4b out of the market in 3 months - but that doesn't mean they've done anything nefarious.

I think you are right that we should be mad at the Fed and not necessarily GS - the idea that GS is a "bank" that is allowed access to the Fed window is what I take issue with - in what sense are they a bank? I suppose they are lending that free money to someone, but whom? I haven't seen credit availability for businesses improve that greatly - so it makes me wonder if that money if flowing into the trading operations. I'm sure it is some of each.

I'd really like to know where that money that GS is getting so cheap is going - is that too much to ask?

But What do I Know? said...

Any broker will tell you that the retail bond traders for the big firms have a license to print money, and I've always assumed that it was much the same for institutional. The vig on a bond trade is so big (and the market so opaque) that you simply can't trade them as a retail client--you have to buy and hold to maturity to avoid getting screwed twice.

So I'm with you KD: there's a lot of kicking and moaning about HFT, but the real crooks are on the bond desks. It's hard for me to see how they haven't always made money every day. . .

Sean McLaughlin said...

I've got to think that the banks must be making some sizable profits by creating algos that are always positioning themselves to be simultaneously best bid and best offer. They do this a million times a day - and probably breakeven at worse, or maybe even make a little of the spread. But the real gravy comes from the liquidity rebates the exchanges provide.

Does this sound feasible? Or am I spouting the obvious? Or am I completely clueless?

Kid Dynamite said...

Sean - it all depends on what your definition of "sizable money" is... but as I explained in the post - the vast majority of the earnings that are the topic of discussion here are NOT from equities businesses.

scharfy said...

For whats it worth, the American public can opt out of the HFT, capital and equity markets if they don't want to play with the big boys and their levered free money. However, the average person is unwittingly sucked into the scam that is - abusive monetary policy. In that sense, this is much more nefarious.

And the fact that they are borrowing subsidized short-term money at .25% - and reinvesting that money into subsidized longer duration bonds (yes- both legs of the trade have explicit government guarantees!) - That is called trading?

That is an insult to traders everywhere.

RMH said...

I just found your blog the other day and it's quickly becoming a favorite. Nice work!

Something I've been thinking about...derivatives markets are zero-sum and all of the major banks killed it the past quarter. What percentage of the trading volumes do the TBTF banks trade? Who are their counter parties and how can they tolerate getting hosed so badly quarter after quarter? I have no problem whatsoever with the concept of traders getting paid to accept risk and commit capital their capital making a market - I trade for a living. It just seems odd that a.) The large banks are THAT much better than the rest of the market and b.) the rest of the market continues to trade with TBTFs, given the lopsided results. I guess extremely expensive hedges are better than none at all...

Kid Dynamite said...

RMH - i'm not sure that logic works. I would assume that, in general, the big banks net make money on their derivatives desks - but that doesn't mean that they hold the other side of every trade their customers do... they get paid commissions, and they trade out of the positions that they facilitate their customers on...

so if the banks net make money, it doesn't have to mean that the customers are losing money - but someone is definitely losing money somewhere. of course, FISCAL zero sum doesn't mean that the customers don't still want this... if they didn't, they wouldn't trade derivs!

Anonymous said...

The business model of Wall Street?

Kid Dynamite said...

yes anon - here's another decent article on the subject (last several paragraphs are best)

http://www.bloomberg.com/apps/news?pid=20601039&sid=ax0kTsl0dBXw

"So let’s forget about the how and focus on the why. Why were these banks able to make so much money with such uncanny consistency? One logical answer is that America’s political leaders obviously want it this way.

Otherwise, for example, the government already would have begun to liquidate Fannie Mae and Freddie Mac and let the crash in housing prices and mortgage-backed securities run its course. To encourage personal savings, the Federal Reserve would have raised interest rates and turned off the banking industry’s easy-money spigot. And the White House would be throwing a fit over the International Monetary Fund’s use of U.S. taxpayer dollars to help bail out Greece and its ilk, along with the European banks that own their debt.

Americans don’t want the immediate pain such steps would bring, though. So our government keeps trying to stretch it out through massive subsidies for the financial-services industry, which means traders at America’s largest too-big-to-fail banks get to keep making their killings and bonuses, for now. What nobody knows yet is how long the government can keep up the rig. "

MR said...

KD - Agree with you on how poor the coverage in the MSM and the blogosphere has been on this issue. If I read another article on the statistical impossibility of 63 consecutive winning days, I will tear my hair out!

As you point out, the dominant proportion of bank profits come from their fixed income divisions. The profits in fixed income depend on two things: the amount of new business flowing in (on which the bank earns bid-offer) and the performance of the book of legacy positions.

Bid-offer and new business in the first quarter was reasonable, especially given that a lot of clients trade more in Q1 than they do in other quarters (annual asset allocation etc). Obviously by earning this spread on a daily basis, the median expectation of the daily profit is a positive number. For e.g. if bid-offer earns $30 mio each day, then the book has to lose $30 mio for it to be a losing day.

In most quarters, banks have losing days because the size of the book is usually magnitudes higher than the incremental new business. Bank books have two characteristics: they are long credit carry (though not usually interest rate carry as I'll explain later) and they are short tail risk. Q1 was great for being long credit and it was also free of any tail events such as the 2:45 pm crash we had last week or the Eurozone explosion.

Also importantly, banks do not usually load up on naked interest rate carry trades - they may fund short and lend long (even this is exaggerated) but they almost always hedge their interest rate risk to negligible levels. In fact, some of the banks are positioned to make money if rates rise. I explain it in more detail here with an example from BAC's investor presentation on their interest rate risk positioning http://www.macroresilience.com/2010/04/04/maturity-transformation-and-the-yield-curve/ in the middle of a more general discussion on maturity transformation - the only carry game they play is the credit carry game and even then they usually only invest in extremely "safe" highly-rated credit such as Fannie/Freddie right now. For most firms, this is not very profitable but it can be incredibly lucrative to lever up a 30 bps spread on an effective leverage of 30-1.

In fact, the initial motivation and many of the initial posts on my blog were an attempt to explain how the real moral hazard problem in banking is not how banks lever up and take on crazy risks on the back of cheap funding, but how they lever up and take on tail risks ( such as super-senior tranches of CDOs) which are likely to pay off in most scenarios and blow up every once in a while. Even better if the risk is so deemed to be "safe" that the govt and CB will likely come and bail your investment out e.g. the implicit bailout of the European banking sector that's going on right now via the PIIGs bailout.

Let me give you another example of the kind of "tail risk" business that does well in benign environments such as Q1 - dynamically hedged derivatives books. The dynamic hedges work well in most situations except when tail scenarios are realised, when higher-order risks and discontinuities mean that the book goes out of control - if liquidity vanishes, things get even worse. Again nothing of this sort happened in Q1 for even a day.



getyourselfconnected said...

KD,
I hear you and I do get the point you are getting across. I think the issue here is that many people are internalizing the banks "edges" mostly in the trading end of things. I think many traders and avarage joe personal brokerage account users read many blogs and they see the HFT angle (and others) and get very mad. They know getting one winning day can seem hard most of the time so they fail to see where most of the real money is being made. I get that. Myself, and I imagine almost everyone else on earth, cannot borrow from the FED and lend back to them (love how this makes sense) for a spread so that does not resonate quite as hard. You are correct that the offloading of crap paper into the hole of FNM, FRE, FHA is the real outrage here.

getyourselfconnected said...

Ok, I'll start trouble:

Edward Harrison does an MMT overview:
http://tinyurl.com/29n4o8a

Sorry!

TZ said...

Does Harry Markopoulos read financial blogs? He's just the kind of guy we need to help sort this 10q stuff out.

Kid Dynamite said...

GYC - the nexus of this post was pretty much that people internalize as you described because they are ignorant and need to be presented with the FACTS instead of the hysteria.

and i'm NOT getting into another MMT discussion. NO!

Kid Dynamite said...

MR - thanks for the comment. So, if i read you right, you are suggesting that the banks are NOT borrowing at 25bps from the fed and buying 30 year treasuries at 4.5%... is that what you're saying? i can certainly believe that... it would make no sense to me if they did do that (although one reason i suspect that some banks definitely ARE doing this, is that the WFC CEO spoke up several months ago and said that they were NOT buying 30 year bonds because he foresaw higher rates ahead... i don't think that was a macro research call he was making, it seemed like a balance sheet management call...)

in other words, are you suggesting that this is false?:

http://pragcap.com/three-things-i-think-i-think-11

"These big banks are borrowing from the Fed for nothing and can effectively sell low risk bonds back to the government for a 3%+ annualized gain."

i can certainly believe that... and the travesty of the Fed marking up the banks's assets (like Agency MBS) is no less magnificent.

John said...

Wow, great story, too bad no one's noticing...

getyourselfconnected said...

KD,
I was going to use that Prag Cap snippet this evening, mean!

I agree, NO MMT!

Kid Dynamite said...

GYC - Blodgett wrote the same thing over at Clusterstock./.. the question is - is it TRUE? i kinda doubt it... the Treasury positions aren't really big enough - as shown in the 10Qs. maybe combined with the Agency positions, it could be almost big enough - but i'm still not sure if the Agency interest (marked AVAILABLE FOR SALE) is even included in those earnings numbers. i tend to think NOT.

what does all this mean? that the profits are likely coming from increases in the marks... which is also a direct result of Fed manipulation (buying MBS)), so the point still holds.

Anonymous said...

Without detracting at all from the thrust of what KD is trying to get at in this post, I also want to point out that there is nothing particularly shocking statistically if a large bank had equity trading profits in all 63 days of a quarter.

When the average Joe reads that GS traded equities profitably for 63 days in a row (which may or may not have happened!!! since you need to see the entire universe of products traded), they think that is prima facie evidence of a rigged system with front-running. Some even go so far as to calculate the odds of flipping a coin heads 63 times in a row.

In reality, the big banks perform millions of equity trades per day, and these are done with a winning percentage that is slightly larger than 50% for each trade.

So, rather than trying to flip 63 heads in a row, they are flipping the coin say 1 million times per day with a coin weighted ever so slightly towards heads, and then having 63 days with more than 500K heads.

This is just the law of large numbers at work. It is not evidence of any wrong-doing.

-PeterPeter

getyourselfconnected said...

The edge the banks have due to ALL the subsidies means they have the best hand going into the river card and also have redraws with 16 outs to a better hand. This is NOT a 50% coin flip but a freeroll!

I like this analogy!

Sam said...

What about "flow trading" aka market making? Each time a client transacts with them, they skim a little off with the b/a spread. That's the explanation GS always gives when asked about their profits. "Our clients drive our revenues", "spreads were wide", "client volumes were high" etc.

I would not call it "front running" per se but it is "piggybacking" on client order flow in liquid instruments like equity futures, fx, rates and these were volatile and well-traded in this Q.

With no big write downs, it may just be possible that they made money the old-fashioned way by leeching pension funds, hedgies, retail, and not necessarily making big prop bets anywhere.

Onlooker said...

KD

I should have known that you would be amongst the few to get this story right. As I wrote in the comments over at PragCap earlier:

I’ve really been confounded by the lack of any critical thinking and analysis regarding this latest revelations about the big banks’ “trading” success. I guess it’s just easier, and a lot more fun, to think that they have ultimate control over the stock market and can’t lose there. While the real truth continues to be that the fed govt and the Fed have rigged the whole market and economy to funnel easy money and profits to these banks; just as you point out.

Don’t misunderstand me, believe me I’m outraged. But let’s be outraged at the proper thing. That we’ve bent over (or been bent over, is more like it) to bail out banks and their bondholders.

getyourselfconnected said...

Onlooker,
saw your comments over at PragCap. Good stuff.

HT said...

Sorry KD, I know you're working hard to understand the mechanics of the situation here, but isn't the real problem the inappropriately low Fed interest rate, not the banks that are able to benefit from a unusually tilted FICC environment?

And the low Fed interest rates are primarily due to the political desire to dampen the socio-economic impacts from many years of accumulated bad consumer borrowing behavior.

And that Tim and Ben know this policy is just giving money to the banks, even if that may not their direct intent? They might even be as troubled about this as you are?

But maybe they've played the scenarios and this is the best of the possible outcomes. That raising interest rates and increasing socio-economic stress at this moment would possibly result in public and congressional outrage directed at the Fed. That a congress that has not been strong in demonstrating its competency in understanding complexities of modern financial markets or macroeconomics may then take legistative action to cut back Fed independence and enact further restrictive policy measures on the US financial system.

And this endgame may be more damaging to the US in the long run than allowing the dynamic that you're appropriatly critical of to just play out?

The banks are capitalizing on an unusual situation, but one that is rooted in the American citizen that is still relatively ignorant of their own role in causing the economic environment thats been created, and still has not faced up to their own personal accountability in taking on the pain required to restore health to our financial system.

Kid Dynamite said...

yes HT - i think that's a very accurate description of the problem. although you forgot about actual asset price support too - the Fed buying MBS, Treasuries, etc...

In this post, my goal was to draw attention to the actual problem - which is the willful subsidies by the Fed and Treasury, and not necessarily to condemn the banks. It again comes back to the "don't hate the playa hate the game" analogy, and relates to my colleague who called me socialist: the FED is being socialist, the BANKS are being capitalists... I don't like it, but it's hard to fault them for that.

summing up - yeah - my point wasn't that you should call Jamie Dimon at JPM and tell him how much he sucks - you should call your congressman and tell them what you think of the Fed's policies - but as you noted, we might not like the alternatives as much as we think we would! and thus the Law of Unintended Consequences arises again...

getyourselfconnected said...

I think all the ladies should protest JPM and Dimon by disrobing:
http://tinyurl.com/2bzpuz8

I told you this would catch on!

Kid Dynamite said...

GYC - i read about that Dimon protest earlier. it wasn't clear if they would have clothes under their robes...

MR said...

What I'm saying is that if they do invest in 30y treasuries after borrowing at 25 bps from the Fed, they then hedge the interest rate risk out by entering into a 30y fixed-floating swap where they pay 30y fixed and receive floating - thus removing the interest rate carry/risk component.

So yes the TPC article like most others on this subject is wrong - if the above trade is not hedged with a swap, it is nothing like riskless. A small rise in rates will bankrupt the entire industry - in fact the Fed was able to do exactly that 50 yrs ago when banks primarily had fixed rate govt bonds and could not hedge. But none of this analysis incorporates the impact of hedging via swaps/options etc that almost any bank with an asset-liability management desk undertakes.

The WFC quote you mention is on these lines and the only publicly available "proof" on this subject is in almost every BAC investor report which has the interest rate risk profile showing a positive sensitivity to interest rates, just like WFC claims and I suspect most banks are currently positioned similarly except maybe the smaller banks. Again its in the middle of this post http://www.macroresilience.com/2010/04/04/maturity-transformation-and-the-yield-curve/ .

Kid Dynamite said...

MR - yes - i understand that interest rate exposure can be hedged, but, well, there's no way that the banks can possibly be doing that: borrowing short, lending long, and swapping out their interest rate exposure. it's impossible - isn't it? for a simple reason: WHO WOULD BE ON THE OTHER SIDE OF THAT TRADE? someone has to take the other side of the swap! If all the big boys are the same way, there's no one to take that exposure from them. remember, Swap counterparties aren't just some magic blip on the screen - they are real institutions.

and I think that your second point is precisely the problem, and it's exactly why the Fed's hands are tied: they cannot raise rates!

that's why i wondered what the exit plan is, especially since the Fed is done with its MBS purchases...

in short, i think that the carry trade is certainly part of the explanation, but that it's definitely NOT riskless, and that the interest rate exposure has not been hedged out. but if someone disagrees, i'm listening...

Onlooker said...

KD said:
"WHO WOULD BE ON THE OTHER SIDE OF THAT TRADE?"

I am but a layman in this area, and far from sophisticated in my knowledge of the minutia here, but that was also my thought on this.

I realize that there could be some counterparties out there willing to do this kind of swap, for various reasons. But enough to take on all the interest rate exposure of all these big banks? I doesn't seem plausible, but I'm open to learning too.

It does seem crazy for all these banks to take on this kind of interest rate exposure by doing the simple borrow short-buy long carry trade, but we've seen dumber things before. And they're desperate to recapitalize, and the Fed and Treasury are their willing accomplices.

The fact that they haven't thought this out 5 moves ahead and are just hoping that it will somehow all work out wouldn't surprise me too terribly; unfortunately.

Kid Dynamite said...

onlooker - of course there are natural counterparties to that swap, but, as you noted, not in the size that the big boys would have to do.

as david Merkel on Aleph blog said : "rule 1: there is no net hedging in the system"

http://alephblog.com/2010/03/06/the-rules-part-i/

Onlooker said...

"rule 1: there is no net hedging in the system"

Yes, and that is the fallacy of too many of the arguments for the extensive array of derivatives that have been created and traded. The idea that all (or most) of the risk can be hedged away in the whole system is absurd. And so when it implodes it falls on govts to patch the sinking boat.

Someday that will fail too; spectacularly. It's just horrifying to see us continue to build the house of cards (i.e. ponzi).

Anonymous said...

Who takes the other side of the swap? Some munis will take a swap where they are paid fixed but they pay floating.

It would be interesting how many state and local issuers (whether municipal or quasi-municipal) have entered into unhedged swaps with the IBs thus transfering all of the risk.

Kid Dynamite said...

yes, anon - we all agree that there are potential counterparties who might want the other side of this trade, but there is absolutely no way that the counterparties to this swap are naturally as big as the banks would need to be.

MR said...

Regarding proof that most of the interest rate risk is hedged out, most banks don't give out detailed disclosures on this. But some do and the best out there is in the Bank of America investor presentations. Just take a look at slide 35 of this presentation here http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9MzY1Mjg0fENoaWxkSUQ9MzU5ODE3fFR5cGU9MQ==&t=1 . Apart from the direction of the interest rate exposure i.e. BAC makes money if rates go up and curve steepens (which is the exact opposite of what their exposure would be if they were borrowing short and lending long at a fixed rate), what's more relevant is how small the absolute risk is given the size of their balance sheet. Therefore if I assume that they're not lying, they're essentially more or less hedged.

Regarding natural counterparties, there are two. The smaller one is corporates who want to swap their long-maturity fixed rate bond issuances into floating rates. The larger one which somehow never comes up in any discussion is the pension fund and life insurance industry who have a huge demand for long-dated assets to match their long tenor liabilities. Let me give you an example - in the UK, traditionally the curve has been inverted between the 10y and 30y just solely because of the demand from pension funds to buy 30y fixed rate assets (curve is no longer inverted given how low rates are now). There's not enough govt bond issuance in this sector so they need to create it synthetically via the swaps market.

Just to clarify, I am not claiming that no banks play the carry trade, just that the big banks don't play it to anywhere near the extent the mainstream media likes to believe they do. This is primarily because they don't need to - the fact that they get funding from the central bank free of any credit cost means that they just need to find some "safe" asset with a small credit spread. The leverage they are afforded due to the TBTF guarantee means that even this small spread can be turned into a very attractive ROE.

Anyway, there isn't much more evidence I can offer and if you're still not convinced, then we'll just have to agree to disagree!

Kid Dynamite said...

MR - i hear you. the takeaway is that the carry trade attributed by the mainstream media is NOT what's happening.

it's not that i disagree with you, it's that i'm saying there's no way that they're putting on a huge carry trade with a term mismatch and then hedging out the rate exposure (which defeats the main point of the carry trade). and i think you're saying the same thing.

oddlot said...

MR - what you're saying is interesting, but the various fixed income product desks run by various traders are not hedging all their rate exposure. Holding inventory helps the customer business. If the spread was not positive, it might be minimized. But the spread is positive, so it is maximized. You would be long as much as you can stand such that you don't get killed if rates back up. Nothing prevents this from being wound down before quarter-end, and then built back up. And nothing prevents top management at BAC from saying what people want to hear (we are hedged homie!)while their traders try to make some dough. Say you earn 250 over funding, long treasuries. For every $1B you are long Friday afternoon, you come in Monday up about $200K. Somebody has to own those securites. Makes sense it would be someone who can fund them at 25bps.

Anonymous said...

There's a much simpler, non-tinfoil-hat explanation -- maybe the banks have scaled down prop trading and have more customer flow. Would you be surprised to learn that your stockbroker made money every single day of the last quarter, if he charges you 5c/share on every trade?

Kid Dynamite said...

anon, there's no tin foil hat stuff here at all. if you know anything about the business at all, you'll know that banks can't do $100mm a day in commissions (or bid/ask market making), even globally across all products.

GS even gave you the equity commissions: $881MM...

ps - no one pays 5c a share anymore.

QuantPlus said...

No offense, KD, but you obviously do not trade for a living. You blog. Out of 500 trades/day in listed stocks... I probably get cheated one way or another 100 times/day. It's always some form of "backing away"... either the Bot move the price by a penny denying me a fill... or the Bot short-changes me on size... giving me 100 shares instead of 500 or whatever. It's all a spoof to get me to pay more... but I just buy something else.

10 years ago this kind of behavior was illegal and extremely rare. Your broker had an audit trail and you could often get justice with a phone call. Today the laws are the same... but are openly ignored and no one cares.

It's as if you walked into Walmart or 7-11 and they tried to short-change you by one dollar... every single time. That level of petty crime.

Your defense of what is de facto organized crime by the Securities Industry is ill advised. Defending all manner of Bot Spoofing as OK... because it's only 20% of revenues or whatever is no defense at all.

Anonymous said...

Jon Stewart chimes in

http://www.thedailyshow.com/watch/thu-may-13-2010/hoarders

Kid Dynamite said...

oh quantplus... i blog "for a living" because i already made my money TRADING for a living...

you can list all the ways you get out-traded on a daily basis, but what it means is that you have inferior technology, technique and access, not that you're being "cheated"

and yet - that's all irrelevant - again. the entire point of this post is that you can shut down the equity markets entirely, and the big banks will STILL earn $100mm a day.

never mind the fact that there is no defense of anything in this post, other than a goal to put the focus on the real issues, and not the ones the media gets ignorant bystanders all fired up about.

Anonymous said...

Kid, 5c/share was just a random number. People may not pay that kind of commission to their stockbroker any more, but they do routinely pay bid/ask spreads like that to fixed income market makers (5c on a $50 share is 10bp -- pretty standard for a 10y interest rate swap or a commodity derivative).

I don't know what the commission number exactly counts, but I'm assuming it probably doesn't include bid/ask spreads on OTC equity derivatives. Even taking that number for what its worth, its $15mm/day in commissions, and equities is what, like 25% of GS trading revenues? So that's $60mm/day in commission or commission equivalents (they aren't strictly commissions in the fixed income world) -- lots of cushion to blow through before you have a loss-making day.

najdorf said...

KD, I'm with you: highly skeptical of the proposition that banks can actually hedge their interest rate risk, other than by buying politicians to produce the desired interest rate policy and bailouts of insolvent institutions. In order to hedge the massive amount of interest rate risk in a system with so much short-term funding and long-term fixed-rate debt, you need to find someone in the system who is willing to pay floating rates. "Someone" usually is:

1. An idiot (see muni issuers, people who take floating rate mortgages to save tiny amounts).

2. A fiduciary paying himself a fat salary every week while exposing his idiot clients to interest rate risk that hasn't reared its head in 30 years and therefore is ignored.

3. Someone greedy who wants a free lunch and thinks he can trade fast enough not to be a bagholder (many of these people are wrong).

All of the big players in our economy claim to hedge interest rate risk. Are categories 1-3 above going to be able to pay them what they owe in a rising rate environment? At the start of the crisis we were worried about ARMs, but actually anyone who took an ARM with reasonable terms (fair spread to LIBOR/short-term Treasuries/bank funding costs) has done fine so far. If the Fed ever takes away the punchbowl and it's no longer possible to get a 4-5%mortgage, are ARM borrowers going to be able to pay their mortgages? Are pension funds and muni issuers going to raise taxes/contributions in order to pay out on swaps to big banks?

At the same time, the interest rate carry trade is really, really profitable for now and the Fed shows no real signs of taking it apart. Look at how much money agency mortgage REITs (AGNC, NLY) have been making on exactly the carry trade you describe, even with much higher funding costs than TBTF banks. 15-20% ROE with no credit risk and a very simple strategy. I think it's very smart to short the low-quality banks with lots of credit risk and dubiously hedged interest rate risk (especially regionals and internationals), but the costs of doing so are very high and you have no idea if governments are ever going to get tough. As a result, I think any short positions in financials ought to be funded with long positions in TBTF institutions or the carry trade. In a long/short option book you can also profit off an increase in volatility.

Anonymous said...

So many people have it backwards in thinking that politicians are the ones in control, when in fact they are puppets controlled by Big Banking. The job of politicians (according to Big Banking) is to accept million$ in lobbyist bribes in exchange for billion$ worth of contracts, favors, subsidies, bailouts, banker-friendly laws, convenient loopholes, and lax enforcement of regulations.
It's the same story around the world: governments are now controlled by the Financial Industry, and there's nothing you and I can do to stop it.

Howard Lothrop said...

Focus here seems to be on banks, and yes banks generally want to pay fixed and receive float as they need to shorten assets to match with their short and quickly repricing deposit liabilities. Other types of institutions have the exact opposite problem. For example, life insurance companies and pension funds have very long liabilities so they need to swap in longer assets. So you can see they are natural receivers of fixed and natural payers of float.