Risk Rap

Rapping About a World at Risk

Bernanke Bonds, Paulson Puts & Cox Calls

Marx made a wry observation in the opening lines to one of his historical tomes, “Men make their own history, but they do not make it as they please; they do not make it under self-selected circumstances, but under circumstances existing already, given and transmitted from the past. The tradition of all dead generations weighs like an nightmare on the brains of the living.”

So it is with us. We are experiencing a crisis that is the result of a decades long deconstruction of the United States economic, political and cultural infrastructure. It began with the dismantling of our manufacturing base. It continued with the transformation of our capital markets. The purpose of the stock markets was to facilitate capital formation for the creation of businesses and industries. Today the markets function principally for speculative investment and the enrichment purposes of monied interests. Our deconstruction accelerated with extreme political Rovian partisanship and the fear mongering and self serving righteous divisiveness incessantly screamed by the howling yodelers of Talk Radio. Finally our enlightened republic is threatened with extinction by the intentional dismantling of our public education system and the virulent attack on secular learning and civic participation.

During times like these weird things begin to happen. We need to be prepared for anything and everything. That said it is heartening to see the Fed, Treasury and SEC act with such dispatch to address the US role in the global banking crisis. An economic meltdown serves no one. The long term impact of these swift concerted actions will be profound. Undoubtedly these actions will add to the national debt. Some think it unfair to assign this burden onto the backs of future generations. Indeed this country started a revolution on the idea that taxation without representation is an intolerable injustice that cannot stand. Years from now the yet to be born will curse the long dead for their poor stewardship of our national wealth and resources and how it contributed to an extreme and unfair taxation they are forced to pay. That is of course if America does make good on its debt. Alexander Hamilton may be stirring in his grave. So this is a time out from the heat of a global market implosion. What is happening?

PROHIBITION ON SHORT SELLING: Shorting can now be considered a criminal enterprise. At present it only applies to large financial services firms. Lots of firms are clamoring to get on the you can’t short my stock list.

The new national slogan from the SEC should be “GO LONG ON AMERICA!”

REPO MAN:Global Repo Desk was created to facilitate liquidity amongst the global central banking system. London, Tokyo, Frankfurt and the other G8 central bankers are all counter parties to Bernanke’s $180 B liquidity infusion. Paulson’s putting on his old Goldman Sach’s trading cap and promises to trade us out of this bad position.

The Feds new slogan, “NO CENTRAL BANKER LEFT BEHIND!”

GOOD BANK / BAD BANK:Bernanke is using his infinite balance sheet to segregate all the bad debt from the good stuff. Its kind of like what ENRON did as it packaged all its poor debt obligations and parked them in offshore SIVs. Maybe it will work this time because unlike ENRON the Fed can print money. Lots of it.

New Slogan “BERNANKE AND PAULSON, SMARTEST GUYS IN THE ROOM.”

CORPORATE BAILOUTS: The US taxpayer is now the owner of the worlds largest insurance company. It’s $80 B capital infusion in AIG will keep this company solvent for the time being and keep the credit rating agencies from lowering AIG’s credit condition to junk. Cox has requested a copy of Lloyds of London Names List.

New Slogan: “PRAY FOR NO MORE HURRICANES, WE CAN”T AFFORD TO PAY OFF THE CLAIMS”

SHOTGUN WEDDINGS: First it was Bear Stearns and JP. Now its Merrill and B of A. Who’s next?

New Slogan: “WE DO MORE MARRIAGES THEN ELVIS AT A LAS VEGAS DRIVE THROUGH”

INFINITE BALANCE SHEET: That is what they keep saying. The Fed can do these financial gymnastics do to its access to an infinite balance sheet that can finally match infinite assets to cover infinite liabilities. Sounds like a tall order to me but i must admit it sounds pretty good from where I’m sitting today. Don’t know how it will go down with the future generations. From Bernanke’s lips to Gods ear.

New Slogan: “INFINITY, ITS MORE THEN ENOUGH TO GET IT DONE”

Bailout politics will sure to become a bloodsport. Every once in awhile you see the commentators on CNBC smugly ask about a threat to free markets and contemplating about the evolving form of capitalism. I can also hear Palin’s squeaking voice proclaiming she’s ready and offer some sage advise concerning our current plight. Palin would say that if she were so blessed to take the oath of office with her fellow Maverick John McCain, she would immediately put AIG up for sale on e-bay and return the proceeds of the sale to the American taxpayers.

Music: Temptations, Ball of Confusion

Risk: economy, market, future generations

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September 19, 2008 Posted by | banking, Bernanke, Bush, Cox, credit crisis, Paulson, pop, TARP | , , , , , , , , , , , , , , , , | Leave a comment

Hedge Funds Flight to Quality

Volatility in the equity markets, credit market dislocations and continued concerns about market liquidity are prompting hedge funds to seek out prime brokerage and custodial relationships with investment banks that boast healthy balance sheets.

JP Morgan’s acquisition of Bear Stearns has given hedge fund mangers pause to think about the financial health and balance sheet condition of their principal counterparties. The potential insolvency of first tier investment banks was once unimaginable. But the near bankruptcy of Bear Stearns due to losses in mortgage derivative and financing businesses, the persistent rumors concerning Lehman Brothers financial condition and the continued quest of Merrill Lynch, Citibank, UBS, AIG and Morgan Stanley to seek funding from Sovereign Wealth Funds to bolster capital adequacy is driving hedge funds to secure relationships with bank’s that have healthy balance sheets.

Risk aversion is a strong theme for all providers of credit. Hedge funds have a voracious appetite for credit. Many hedge funds require generous lines of credit to support highly leveraged and short selling trading strategies. If their prime broker becomes capital constrained these funds will not be able to execute their strategies. So the need to maintain relationships with healthy banks that provide consistent access to large lines of credit is critical.

The potential effect of market contagion in the event of Bear Stearns’ insolvency was the primary issue of concern that prompted the Federal Reserve to take its unprecedented action. Had Bear Stearns become insolvent the levered positions of its substantial hedge fund and correspondent broker clientele would create a wave of defaults that would cascade throughout the global capital market industry. Extreme market volatility and the negative effect on market liquidity in equity, futures, debt and foreign exchange markets could have been dramatic.

Hedge fund managers also require that banks have a product set, support infrastructure and market presence they require as trading strategies become more sophisticated to include numerous asset classes trading on multiple global exchanges. Cross-netting of product set positions and margin account requirements are important for hedge funds as well as the bank. Cross-netting of all positions helps fund mangers to gain preferential finance rates and transaction fees. Cross-netting for bank’s is a critical risk management tool to determine its aggregated exposure to the numerous investment positions of large sophisticated hedge fund complexes.

As the large money center banks struggle to integrate their global capital markets and investment banking businesses, capital adequacy in line with the requirements of the Basel II initiative heighten the need to measure and fund sufficient regulatory capital levels. The temptation of banks to arbitrage their regulatory and economic capital balances will certainly be put to the test as they seek to woo lucrative hedge fund business. The continually expanding global hedge fund industry may pose a competitive threat to the commercial credit side of these banking institutions as liquidity in the credit markets continue to be a pressing concern. It bears watching and it will be interesting to monitor developments to see if community banks can take advantage of its larger competitors capital constraints posed by its focus on capital markets business.

I can hear the frenzied flying now.

You Tube Video: Flight of the Bumblebee

Risk: capital markets, hedge funds, credit, commercial banking, regulatory, Basel II

June 5, 2008 Posted by | banking, Basel II, Bear Stearns, hedge funds, investments, regulatory | , , , , , , , , , , | Leave a comment

FAS 157: Allegory of the Cave

In Plato’s magnum opus, The Republic, he devotes a chapter to Socrates’ discourse with his young student Glaucon. Socrates uses an allegory to explain the difference between truth and appearances. The Allegory of the Cave has remained a powerful philosophical metaphor and cornerstone of metaphysics. It outlines how the human perception of reality can be at odds with and diverge widely from what actually is true and good.

The cave is a controlled environment where humans are held captive. The only light they are allowed to see is from a dimly lit fire that casts shadows of images on a far wall. Enclosed in darkness save the faint projections, their inability to see the source or understand how those images appear to their senses gives them the perception that the shadows of things that they see are in fact the real things themselves. It’s not until the cave’s captives are brought out into the light of day that they are able to see that the shadows are only a poor reflection of a manipulated truth.

Socrates’ lesson to young Glaucon, whose name is very close to glaucoma, serves as a proper metaphor to understand the debate concerning FAS 157 and the concept of Fair Value.  For the uninitiated, the issue of Fair Value under FAS 157 addresses how to determine the “value” of securities held in investment portfolios. FAS 157 provide guidelines for three categories of valuation methodologies. Large banks and brokerage firms are increasing the reclassification of their assets using Level 3 methods. The valuation and projected cash flows from assets such as CMOs, CDOs, CLO, and Credit Default Swaps are being derived by sophisticated computer models developed by each firms in-house risk management group. Many of these risk models failed to perceive and detect the melt down in the credit markets that so far has led to $100 billion in balance sheet write downs for the large investment and money center banks. Socrates allegory is similar to the models developed by bank risk managers. These “black box proprietary applications” shines light on the Level 3 assets to determine an approximation of market value. It’s a self created reality of a risk manager’s perception of an assets value.

So what.

Esoteric stuff to be sure but the debate concerning this issue is most relevant to understanding how the current credit crisis evolved, how banks, brokerage firms and hedge funds value and trade securities, how risk mangers make informed decisions concerning risk tolerance and how industry and governmental regulators determine weather a bank is sufficiently capitalized to remain solvent.

The political fallout from the Bear Stearns shotgun wedding is yet to be played out. Main Street wants some relief for mortgage defaults and Wall Street feels that the Fed reacted too quickly and is resisting additional regulation and market intervention into the workings of the capital markets.

Pervasive credit and macroeconomic risks are still present in the global capital and debt markets. Mortgages, municipal finance and commercial paper markets were the first wave of credit market dislocations. Credit card receivables, student loans and other securitized asset classes may pose some acute challenges for our central bankers, accountants, regulators and risk managers in the not to distant future.

Once we emerge from our caves Socrates’ quote to young Glaucon become most prescient. Said Socrates, “And if they were in the habit of conferring honors among themselves on those who were quickest to observe the passing shadows and to remark which of them went before, and which followed after, and which were together; and who were therefore best able to draw conclusions as to the future, do you think that he would care for such honors and glories, or envy the possessors of them? Would he not say with Homer, Better to be the poor servant of a poor master, and to endure anything, rather than think as they do and live after their manner?”

Thank you Socrates. I waited 30 years to use this knowledge that Dr. Choi excitedly taught me in Introduction to Western Philosophy as a freshman at William Paterson College in 1974. Now that we have experienced the light may we never have to slip into darkness again?

Music Video: War, Slippin Into Darkness

Risk: credit, regulatory, accounting, banking, market, risk management

May 18, 2008 Posted by | banking, credit crisis, FASB, hedge funds, jazz, movie, philosophy | , , , , , , , , , , , , , , , , , , , , | 1 Comment

Paulson Carries the Olympic Torch

During last weeks US Senate Banking Committee hearings on the Bear Stearns bailout Treasury Secretary Henry Paulson had to send a deputy because he was in Beijing tutoring them on the finer points of high finance.

Paulson could probably call China his second home. He is reputably an avid bird watcher and China has some of the best displays of avian pomposity in the world. I have read estimates that he has visited China over 50 times under the guise of eco tourist, investment banker and now head of treasury.

I surmise that most of his trips these days concern how to manage the relationship between the largest economic superpower and the world’s fastest growing economic superpower. Mundane subjects like the sinking dollar, letting the Yuan float and reinforcing the message of America’s and China’s symbiotic dependency are topics of mutual concern.

You Tube Music Video: Olympic Theme

Risk: Political, Moral, Currency

April 13, 2008 Posted by | Bear Stearns, China, Paulson | , , , | Leave a comment

Too Big to Fail

Mini Me is Big Time

Last weeks Senate Hearings on the credit market crisis and the role of the Fed in the bailout of Bear Stearns produced some dramatic headlines, noteworthy quotes and an opportunity for politicians, regulators and big swinging bankers to come together to shed some much needed transparency on the situation.

People are confused, uncertain and fearful. How can the boom go bust so quickly and how can the American economic colossus be brought to its knees in such a pedestrian fashion? The talk on Main Street is big banks vs. sub prime mortgage holders and the political calculus of which class of debtors in default pose the greatest threat to the economic prosperity and political stability of the nation.

The emerging economic environment will reify a new political landscape that can potentially broaden the divisions of a divided nation. The to big to fail rationalization of opening the Federal coffers to bailout failing capitalist enterprises is perceived by many taxpayers as the rich and powerful taking care of the rich and powerful by robbing the poor to pay the rich.

To paraphrase Senator Dodd, “we can’t be perceived as if we are privatizing profit and socializing risk.” It is dangerous to arbitrage the nations economic and political default probabilities. Who is too big to fail? That will be a question that the voters should have some say on come November but the discourse thus far has been confined to Senate chambers and the hard to locate CSPAN channel. It has yet to come to the fore in any meaningful way in the campaigns of the political candidates running for office in this year’s election.

Give the Fed high marks for acting. Give some of the Senators credit for understanding that the actions of the Fed help both large institutional banking interests and the little guy concerned about the reset rate on his ARM.

Shame on the politicians that are trying to make hay by sowing divisions among interest groups for political gain.

Risk: Political, Banking, Class, Market

You Tube Video: Peter Gabriel, Big Time

April 10, 2008 Posted by | Bear Stearns, credit crisis, pop | , , , , , , , , , , | Leave a comment