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Saturday, January 19, 2013

Too Big To Fail

The difference between commercial banking and investment banking is massive.Commercial banking is boring. You take deposits and make loans. You can swap risks through loan participations, but you manage your duration risks (the risk of rising rates over time) largely yourself by controlling loan terms and maturities. You manage your credit risks by careful underwriting. You manage your correlation risks by distribution and risk swapping with other banks. 

If you underwrite mortgages, you have to sell most of them, because you can't afford the duration risk on that much capital for that long. Or you can do adustable-rates, but current restrictions expose you to considerable duration risks. Only a three-year adustable gives you adequate coverage there, and now we have gone to five years. This leaves you with few options but adjustable seconds (much higher risk of loss) or to originate for Fannie, for example, and sell the mortgage. 

Investment banks are in the business of creating investment classes, and they take on a range of very complex risks that are accumulative, often correlated, and often quite obscure.

To understand why the taxpayer should not be insuring investment banking in any way, consider this article on structured notes
Here’s an investment that sounds just too good: You get 150 percent of the upside of the stock market but only 90 percent of the downside. That’s the promise of structured notes issued by companies including JPMorgan Chase & Co., Bank of America Corp. and Goldman Sachs Group Inc. 

Such hybrid securities, which have maturities like bonds but are linked to asset classes such as stocks, currencies and commodities, are increasingly popular. That’s especially true for notes linked to the stock market, which has risen 16.5 percent in the past year and 116 percent since the March 2009 bottom. Some $10.1 billion of structured notes tied to the S & P 500 were issued in 2012, the highest amount in three years, according to data compiled by Bloomberg.
The reason that such obligations exist is that pension-type savings funds have an acute need for more fixed income debt. The Fed's machinations make that need more acute as the desperate search for real returns becomes ever more desperate. Many of the major insurance companies in the world are now investing significant portions of their funds in more or less risky issues such as these and junkier corporate bonds, etc. 

Note that these instruments are also issued for commodities! These types of instruments are one of the ways that Fed buys of bonds move funds into the stock market and commodities. 

The problem is that the risk is hidden - if anything goes really bad, investors may not get the deal promised. If the implied principal loss guarantee is only 10%, it's less risky, but less of a good deal. If the market is down 20%, you only lose 10% of your principal, but you are giving up a chunk of potential returns.

The real "pull" of these is that they hide the risk. There is intense correlation in these types of issues - if one set of them goes bad, they all pretty much go bad in a big downturn. The normal hedge for this type of risk would be Treasuries, because when the stock market collapses Treasuries should go up. But it now costs you money to be in Treasuries at these maturities, so that hedge is breaking down by being too expensive for a real hedge. Further, with the Fed buying so MUCH, it's pretty obvious that as soon as it stops the internal pressures will be for Treasuries to lose value (rates to rise) and also for commodities and stocks to lose value in tandem.

To me it looks like there is too much risk out there. Subprime auto loans have breached the pre-crash levels, these types of instruments keep accumulating at much higher levels, newer mortgage issues have real risks (should rates even rise to 4.5%, you are looking at house price declines which cause higher defaults and higher principal losses plus a market value loss, i.e. you lose if you hold 'em and you lose if you fold 'em).

Now combining commercial banking and investment banking creates a degree of economic correlation that is impossible to bear. Therefore no matter what they say, these large bank holding companies will be insured by the taxpayer or the Fed, because if the investment banking side goes down, it takes down the commercial side as well.

Gramm-Leach-Bliley, which eliminated the statutory separation between commercial banking and investment banking existent since the Great Depression, has created a giant pile of correlations. The only thing the Fed's intervention and Dodd-Frank have created is to put the Fed at risk as well. And you know what happens when you bust your central bank and your banking system and your government is insolvent! A panic, and a 20 year depression. 

Dodd-Frank is disastrous, and the only way to begin to unwind this terrific heap of risk is to break up these companies. Failure to do so will simply produce more and more hidden risk and ensure calamity. "Too big to fail" = will absolutely fail. 

We're still in the land of "let's pretend", and time is getting short to emerge. We will get a bit battered if we try to back away from the abyss, but if we don't back away we are destined to end up at the bottom of the abyss WITHIN FIVE YEARS. 

Seriously.

Comments:
I read this, and immediately thought it' time for a Vegas trip. Because there's no way the elites are going to back away from the abyss, and you might as well enjoy the moment before the long dark begins.
 
There are more time bombs out there than anyone can count; I don't give us anywhere near five years.

That said, I'm amazed we've made it this long.
 
WSJ - there is that mood among the small businessmen. I'd describe it as "fear".
 
They're not going to back away. It's going to crumble in five years or less, I feel fairly certain. What should people holding long-term debt like a mortgage do given this very likely probability of financial crashing?
 
The crash doesn't scare me as much as the schemes that will come after it.
 
Well you can sleep easy MOM as I can assure you no Investment or Commercial bank will lose money selling these notes. Primarily a retail product the only one who loses is the investor. And even then the math is not as bad as it looks. It's beyond the level of a comments discourse but if you value the time value of money, the spread between put and call volatility, the cap on the upside and some other Greek letters they're pretty much fair value. If you're tired of running to Victoria's secret to get stuff to fire up the Chief I can send you some info describing the math on these things and that will give you 2 something to get really worked up over.

N.B. Just beware last week the CFO of a major investment bank said I couldn't handle 5th grade math.
 
"You’re not going to like what comes after America" Leonard Cohen
 
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