fixed income

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Double or Nothing: How Wall Street is Destroying Itself

There’s nothing controversial about the claim— reported on by Slate, Bloomberg and Harvard Magazine — that in the last 20 years Wall Street has moved away from an investment-led model, to a gambling-led model.

This was exemplified by the failure of LTCM which blew up unsuccessfully making huge interest rate bets for tiny profits, or “picking up nickels in front of a streamroller”, and by Jon Corzine’s MF Global doing practically the same thing with European debt (while at the same time stealing from clients).

As Nassim Taleb described in The Black Swan this strategy — betting large amounts for small frequent profits — is extremely fragile because eventually (and probably sooner in the real world than in a model) losses will happen (and, of course, if you are betting big, losses will be big). If you are running your business on the basis of leverage, this is especially dangerous, because facing a margin call or a downgrade you may be left in a fire sale to raise collateral.

This fragile business model is in fact descended from the Martingale roulette betting system. Martingale is the perfect example of the failure of theory, because in theory, Martingale is a system of guaranteed profit, which I think is probably what makes these kinds of practices so attractive to the arbitrageurs of Wall Street (and of course Wall Street often selects for this by recruiting and promoting the most wild-eyed and risk-hungry). Martingale works by betting, and then doubling your bet until you win. This — in theory, and given enough capital — delivers a profit of your initial stake every time. Historically, the problem has been that bettors run out of capital eventually, simply because they don’t have an infinite stock (of course, thanks to Ben Bernanke, that is no longer a problem). The key feature of this system— and the attribute which many institutions have copied — is that it delivers frequent small-to-moderate profits, and occasional huge losses (when the bettor runs out of money).

The key difference between modern business models, and the traditional roulette betting system is that today the focus is on betting multiple times on a single outcome. By this method (and given enough capital) it is in theory possible to win whichever way an event goes. If things are going your way, it is possible to insure your position by betting against your initial bet, and so produce a position that profits no matter what the eventual outcome. If things are not going your way, it is possible to throw larger and larger chunks of capital into a position or counter-position again and again and again —mirroring the Martingale strategy — to try to compensate for earlier bets that have gone awry (this, of course, is so often the downfall of rogue traders like Nick Leeson and Kweku Adoboli).

This brings up a key issue: there is a second problem with the Martingale strategy in the real world beyond the obvious problem of running out of capital. You can have all the capital in the world (and thanks to the Fed, the TBTF banks now have a printing-press backstop) but if you do not have a counter-party to take your bets  (and as your bets and counter-bets get bigger and bigger it by definition becomes harder and harder to find suitable counter-parties) then you are Corzined, and you will be left sitting on top of a very large load of pain (sound familiar, Bruno Iksil?)

The obvious real world example takes us back to the casino table — if you are trying to execute a Martingale strategy starting at $100, and have lost 10 times in a row, your 11th bet would have to be for $204,800 to win back your initial stake of $100. That might well exceed the casino table limits — in other words you have lost your counter-party, and are left facing a loss far huger than any expected gains.

Similarly (as Jamie Dimon and Bruno Iksil have now learned to their discredit) if you have built up a whale-sized market-dominating gross position of bets and counter-bets on the CDX IG9 index (or any such market) which turns heavily negative, it is exceedingly difficult to find a counter-party to continue increasing your bets against, and your Martingale game will probably be over, and you will be forced to face up to the (now exceedingly huge) loss. (And this recklessness is what Dimon refers to as “hedging portfolio risk“?)

The really sickening thing is that I know that these kinds of activities are going on far more than is widely recognised; every time a Wall Street bank announces a perfect trading quarter it sets off an alarm bell ringing in my head, because it means that the arbitrageurs are chasing losses and picking up nickels in front of streamrollers again, and emboldened by confidence will eventually will get crushed under the wheel, and our hyper-connected hyper-leveraged system will be thrown into shock once again by downgrades, margin calls and fire sales.

The obvious conclusion is that if the loss-chasing Martingale traders cannot resist blowing up even with the zero-interest rate policy and an unfettered fiat liquidity backstop, then perhaps this system is fundamentally weak. Alas, no. I think that the conclusion that the clueless schmucks at the Fed have reached is that poor Wall Street needs not only a lender-of-last-resort, but a counter-party-of-last-resort. If you broke your trading book doubling or quadrupling down on horseshit and are sitting on top of a colossal mark-to-market loss, why not have the Fed step in and take it off your hands at a price floor in exchange for newly “printed” digital currency? That’s what the 2008 bailouts did.

Only one problem: eventually, this approach will destroy the currency. Would you want your wealth stored in dollars that Bernanke can just duplicate and pony up to the latest TBTF Martingale catastrophe artist? I thought not: that’s one reason why Eurasian creditor nations are all quickly and purposefully going about ditching the dollar for bilateral trade.

The bottom line for Wall Street is that either the bailouts will stop and anyone practising this crazy behaviour will end up bust — ending the moral hazard of adrenaline junkie coke-and-hookers traders and 21-year-old PhD-wielding quants playing the Martingale game risk free thanks to the Fed — or the Fed will destroy the currency. I don’t know how long that will take, but the fact that the dollar is effectively no longer the global reserve currency says everything I need to know about where we are going.

The bigger point here is whatever happened to banking as banking, instead of banking as a game of roulette? You know, where investment banks make the majority of their profits and spend the majority of their efforts lending to people who need the money to create products and make ideas reality?

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Get Bullish, Muppets!

Sounds like Goldman has some equities (AAPL?) to dump on its muppet clients.

From Business Insider:

Goldman portfolio strategists Peter Oppenheimer and Matthieu Walterspiler are out with a doozy of report, basically presenting a big bullish case for stocks, relative to bonds.

From Goldman:

In 1956, George Ross Goobey, the general manager of the Imperial Tobacco pension fund in the UK made a controversial speech to the Association of Superannuation and Pension Funds (ASPF) arguing the merits of investing in equities to generate inflation linked growth for pension funds.  He became famous for allocating the entirety of the funds investments to equities, a move that is often associated with the start of the so-called ‘cult of the equity’.

Prior to this, equities were largely seen as volatile assets that achieved lower risk adjusted returns than government bonds and, consequently, required a higher yield. As more institutions warmed to the idea of shifting funds into equities, partly as a hedge against inflation, the yield on equities declined and the so-called ‘reverse yield gap’ was born. This refers to the fall in dividend yields to below government bond yields; a pattern that has continued, in most developed economies, until recently.

In his speech to the ASPF, Ross Goobey talked about the long-run historical evidence that the ex-post equity risk premium was positive and that investors ignored this at their own peril.

The long-run performance of equities was much greater than for bonds having adjusted for inflation. As he said: ‘I know that people will say: ‘Well, things are never going to be the same again’, but … it has happened again, and again. I say to you that my views are that it is still going to happen yet again even though it may not be the steep rises which we have had in the past.’ Over the 50 years that followed Mr. Ross Goobey’s pitch, his predictions proved very successful. The annualized real return to US equities (as a proxy)  between 1956 and 2000 were 7.4%.

But things have changed since the start of this century and the collapse of equity markets following the bursting of the technology bubble. In this post bubble world valuations fell from unrealistically high levels. But the decline of equity markets continued well after most equity markets returned to more ‘normal’ valuations. The onset of the credit crunch, and the deleveraging of balance sheets in many developed economies that followed this have punctured the confidence that once surrounded equities, and the pre-1960s skepticism about equity returns has returned. Dividend yields are once again above bond yields and both historical, and expected future returns have collapsed.

That’s right muppets, time to get bullish and hoover up all the equities we want to offload! This is a once in a generation opportunity to own equities!

Or not. Let’s just say that prices aren’t exactly being supported by a surge in manufacturing:

That’s right: manufacturing is just about where it was at the turn of the millennium, and unsurprisingly so is the S&P.

However there is a sliver of a superficial hint that the muppet masters may be right.

Here’s the S&P500 priced in gold:


Looks cheap next to where we were ten years ago. But in the long run I don’t really think where we were ten years ago tells us much about the fundamentals; it tells us more about Greenspan’s propensity to grease markets with shitloads of liquidity and watch stocks soar. The deeper I dig into the data, the more I tend to conclude that we really need to throw all recent historical trends out of the window.

Here’s a choice data set:


Does that look like a normal recovery? It looks like a complete paradigm shift to me. I’ve already covered my underlying reasons for believing that we live in unprecedented times. But this chart from Zero Hedge speaks as much as anything else:


So, if you have money to burn and a gullible nature go ahead and throw your money at the muppet masters. In the long run, equities and other productive assets have proven themselves superior to any other asset class, because they tend to produce a tangible return.

But right now? The real problem is that the global economic system is a mesh of interconnected fragility where one failed party can take the entire system down. Well run companies can be dragged down by badly-run counter-parties, and badly run companies can just be bailed out, totally obliterating the market mechanism. This is not an environment conducive to organic growth. It’s a cancerous environment, juiced up on (priced in) central bank interventions. It is the very definition of iatrogenesis: when “medicine” causes deeper and worse sickness.