The Art of War a/k/a Competing on Wall Street

Three articles caught my eye over the weekend that touch on a common theme: how Wall Street functions (or doesn't function). In a nutshell, there are bits of interesting insight, wishful thinking and the usual conspiracy theories flying around. So what else is new?

1. It's Hard to Thaw a Frozen Market by Tyler Cowen in today's New York Times. Mr. Cowen is a smart guy. I've met him a few times and he is definitely on the ball. His article raises some essential points to deeply understanding today's locked markets and why they've become such a huge problem:

To understand the depths of the current crisis, let’s go back to an apparently unrelated episode in economic thought: the socialist calculation debate. Starting in the 1920s, Ludwig von Mises, the leader of the so-called Austrian School of Economics, charged that socialism was unable to engage in rational economic calculation. Without market prices, he reasoned, no one knows how much economic resources are worth.

The subsequent poor performance of planned economies bore out his point. For instance, the Soviet Union did a poor job of producing consumer goods and developing innovative industries. In the absence of well-functioning markets for capital goods, these mistakes festered, rather than being rectified by the independent judgments of individual entrepreneurs.

The irony is that the supercharged capital markets of the American economy are now — at least temporarily — in a somewhat comparable position. Starting in August, many asset markets lost their liquidity, as trading in many kinds of junk bonds, mortgage-backed securities and auction-rate securities has virtually vanished.

Market prices have been drained of their informational value and thus don’t much reflect the “wisdom of crowds,” as they would under normal circumstances. Investors are instead flocking to the safest of assets, like Treasury bills.

This last paragraph is a particularly important observation. I've been asked many times about "wisdom of crowds" and how they reconcile with company valuation, and my answer has always been "look at the stock price." Well, to Mr. Cowen's point, that isn't so helpful across a wide swath of the market right now. In the absence of a broad and deep market with a wide array of participants, price discovery is difficult if not impossible. Next, Mr. Cowen shines a light on why this problem is so acute for our financial institutions, and the answer, not surprisingly, is leverage:

This gridlock is especially harmful because leverage is so high, and financial institutions are so interconnected through swaps and loans. Institutions that rely so heavily on debt are precarious and need up-to-date information about valuations. When they don’t have it, markets freeze up. This is what has taken policymakers by surprise and turned a real estate crash into a much bigger financial problem.

The issue of leverage and interdependency is one about which I've written many times. This substantially ups the ante for all market participants, the Fed included. And the current gridlock and lack of real price discovery (given the absence of transactions) does not reflect well on the U.S. markets. And whether prices need to plummet to get activity going again or the Fed's massive liquidity party catalyzes a thaw in the markets, somethings got to give. Because the status quo reflects the utter non-functioning of a significant part of the U.S. financial markets.

2. Dimon Requests Freeze On Hiring Bear Advisers in yesterday's Wall Street Journal. Now I have quite a bit of respect for Jamie Dimon and how he's steered JP Morgan Chase, but this is mamby-pamby nonsense. This was part of the deal, Jamie. You got what you perceived to be a sweetheart but there were going to be some headaches.

Mr. Dimon is "basically saying, 'We're trying to help the system [with the Fed-backed takeover], and you're taking advantage of our gracious action. All is fair in love and war, but this is not a usual merger situation,' " said David Hendler, an analyst at CreditSights, a stock-research firm in New York.

Puh-leeze. This is no different than any other merger situation. Except that you've been given a $30 billion make-whole courtesy of the Fed and a few valuable options in the event you don't like how things are playing out (buying 20% at $2, option on the building). Part of what constitutes what I call "hard book value" is the ability to retain current staff and preserve franchise value within the key business units. This was a risk you supposedly priced in to the deal. And now you are asking your Wall Street brethren to back off because you want time to sign your own guys? Speed was a precursor to getting the package you got from the Fed, Jamie. You don't get to pick and choose what happens quickly and what happens slowly. If you are worried about losing key staff, sign them up. Now. Work 24/7, whatever it takes. But don't ask your pals to lay down their arms. You know the game. Play it right and play it fair. And no whining, please.

3. Making Sense of a Scared New World by Ben Stein in today's New York Times. I'd really like to see Nassim Taleb take a crack at de-bunking Mr. Stein's missive today. His logic is weak and pathetic even by Mr. Stein's not-so-lofty standards. Mr. Taleb would have a field day. One brief persual of The Black Swan is all one needs to understand why Mr. Stein's piece is intellectually bankrupt . This is the crux of Mr. Stein's argument that hedge funds are evil villains that have caused a goodly part of the current financial crisis:

The new part is the hedge funds and the changing of Wall Street from a financing entity to a market manipulation entity. The new part is hedge funds with (supposedly) $1.5 trillion in capital, immense hedge funds within banks and investment banks. The new part is that they have so much money and so much selling power that they can do what capitalists really want and love to do: to make money not by betting on the markets, but by controlling the markets, by putting so much sell side (and occasionally buy side) firepower in play that they know they will move the markets. This takes all that annoying uncertainty out of it.

The task of the hedge funds is to find a weak spot in the market, and to put so much pressure on it that they can move it down, scare other players into selling (with the endless help of guileless journalists), wreak havoc with the markets’ indexes and then create that much more selling. Once the process starts rolling, it’s shooting fish in a barrel.

Making money by controlling the markets, huh? Hey now, Ben. Never really thought about it like that. I've always thought that markets generally reflected the value of a security, with the actual trading level oscillating around intrinsic value over time. But what you are implying is that hedge funds can push so hard in one direction as to bring a firm to its knees that doesn't fundamentally deserve to be there.

Consider this, Mr. Stein. What about George Soros, the Bank of England (BoE) and "Black Wednesday" in 1992? Mr. Soros couldn't unilaterally cause the pound to pull out of the ERM if it wasn't fundamentally mispriced. Sure, he pushed, and the market went with him because his actions reflected the true underlying value of the currency. Did the BoE deserve for this to happen? Yes. The ERM was a charade.

Did Bear Stearns deserve its fate, given how it was being managed, investor concerns about its portfolio risks and its liquidity profile? Yes. Was this due to those mean hedge funds ganging up and pushing it to the brink? No way. If the value was there buyers would have stepped in and pushed in the other direction, getting a mispriced security for cheap. But that's not what happened.

What about MBIA and Ambac? Bill Ackman of Pershing Square has been on a 5+ year jihad against the companies and the space in general, arguing that the business model was fundamentally flawed and the companies effectively bankrupt. He had to hold his short for a long time before it eventually paid off, and it paid off huge. If he and his peers were so powerful they would have driven the stock into the ground back in 2002-03. It didn't happen. Why? Because his hedge fund brethren and other institutional investors weren't convinced until the past year, when the stock began to tank and its problems fully came to light. People acting in their own self-interest. This is what makes markets function.

You see, Ben, there are two sides of a market that is functioning, the buy side and the sell side. Those on the sell side win if they sell at prices above what the franchise is truly worth. And in the case of Bear Stearns, as with most other financial institutions, there is a massive difference between short-term "give me my money now" value and long-term "let the value of my franchise play out" value. But the key thing for a financial institution, as with any bettor, is to have a bankroll large enough to let it live beyond the short-term. And in the case of Bear Stearns and perhaps some others, they didn't size their bets properly (in light of their leverage) and keep a sufficient amount of liquidity on hand. Is it the hedge fund industry's problem that they happened to recognize this and lean against its stock price? No. It was highly rational and it ended up doing what was perhaps necessary: getting a new group of better-qualified people to run the business. Because incumbent management had been doing a really, really bad job.

Next time, Ben, when you feel the urge to let conspiracy theories get the better of you, take a deep breath, drink some calming herbal tea and perhaps go for a run. Because you need to get out and see the real world. Because the world you are writing about exists only in your head.

 

Comments

[RBH]

Given his involvement with the Intelligent Design Creationist movement (see http://tinyurl.com/2n746b), Stein appears to have become a professional conspiracy theorist.

[Sam T]

'Did Bear Stearns deserve its fate, given how it was being managed, investor concerns about its portfolio risks and its liquidity profile? Yes. Was this due to those mean hedge funds ganging up and pushing it to the brink? No way. If the value was there buyers would have stepped in and pushed in the other direction, getting a mispriced security for cheap. But that's not what happened.'

The market never had a chance to step in and value BSC because the deal was closed behind locked doors outside business hours. I've asked again and again. Where were the SWFs when JPM was being given away?

[Timothy Post]

Roger:

I agree with your analysis in general but I would like to ask that you reexamine one fundamental assumption you make.

You wrote,

"I've always thought that markets generally reflected the value of a security, with the actual trading level oscillating around intrinsic value over time."

Actually, I would argue, based on my readings of George Soros' books, that there is actually no such thing a "intrinsic value." Sure, assets do often get ".... fundamentally mispriced.." but that is a very different concept from "intrinsic value."

Actually, it is the assumption of intrinsic value which has gotten so many modern investors in trouble.

The key two words in your above quote are "over time." Perhaps over time there may be intrinsic value but unfortunately that is of no value to us in the here and now.

Market prices move up and down along a spectrum and are determined by investors perception of reality. Since market prices themselves are one input variable into that perception of reality, the mechanism which moves prices is a feedback loop (i.e. Soros' reflexivity).

By assuming that there is something called intrinsic value many modern investors (i.e. neo-classical economics) believe that market prices have some invisible ballast.

I would suggest that there is no ballast. rather the fact that market prices "normally" move within 1 or 2 standard deviations of the mean gives one the perception of self-correction.

But as we now know so well, market prices sometimes move very far to one end or the other of that spectrum.

None of these ideas are original. They're just my interpretation of Soros' concepts. I think we would all be wise to go to audible.com and re-listen to some of his books while working out over the next couple weeks.

[Yaser Anwar]

"Hedge funds controlling the markets to remove uncertainty." I don't think I've ever heard something more ridiculous with regards to market action than that. Ben Stein is definitely on crack. Next thing you'll know he'll start a non-profit organization called 'Anti-Hedge Funds' (in his mind he has already started one).

While Ben Stein didn't quote the uptick rule, a coincident that the markets have been weak (plus in terms of Dow's money flow) since the SEC's repealing of the uptick rule in July 07.

This has led to increase volatility and more dramatic declines (though the uptick rule/dramatic declines is probably just causation thanks to credit/subprime woes).

H, interesting question. I don't think there can be a predetermined number one can save for a rainy day.

I-banks, unlike normal businesses, face a lot more uncertainties (especially with SIV/offshore vehicles, increasing leverage and derivatives that allow exposure without holding tieing up capital i.e. Total Return Swaps) which make it tough to judge the cash horde needed during turbulent times (especially if a firm takes proprietary risk with their own capital for which they would need the cash to meet margin requirements).

This is proved by recent comments of Alan Shwartz, according to whom, BSC has "a lot of cash" one day, and next few days "sudden cash shortages".

This problem reminds me of the VaR issue. During normal times, a firm's total risk was being judged by their daily VaRs but when things get volatile as they did, pretty much every bank/fund (in banks MS especially) lost several 100 mns over their VaR.

Goldman always had a higher VaR vs. comps which is why they traded at a lower multiple with the general misconception that they would loose more when markets went south. With the leverage smoke somewhat cleared now, seems to have been the contrary case, or that GS was just smart enough to hedge themselves in the right manner.

[Roger]

Rob, I understand where you are coming from, but I think you are asking the wrong question. "Yes, BS might have been a mess, and the hedge funds may have been acting rationally and in their own self-interest, but is the meltdown of a major investment bank really the best thing for the economy?"

Whether the meltdown of Bear Stearns is the best thing for the economy isn't the point. I can think of lots of cases where business failures weren't the best thing for the economy. But in a capitalist system where there are public stockholders, public and private debt-holders and managers who are stewards of these funds, the capital allocation process has to be allowed to happen.

It is bad enough that the Fed stepped in and did unnatural (and fundamentally non-free market) things it believed were required to stave off a systemic crisis; if it had bailed out the public stockholders as well that would be been an incalculable breach of fiduciary duty to the U.S. taxpayer. One could easily argue that they breached this duty and overstepped their bounds by providing the $30 billion backstop and facilitating the transaction in the first place.

I know it is painful and I know it is hard, but if the Fed steps in and provide a de-facto guarantee of some or all of our financial institutions, then we might as well nationalize the entire sector and call it for what it is: a government appendage. Stockholders can't stand to benefit in the good times and have their losses covered in the bad. So it isn't really question of what's best for the economy in the short run. It's a question of what's best for our economy and the social and economic fabric of our country in the long run.

[alex morrow]

I think your comments on Bear employees and Dimon are on the money. He stole the business with the help of the FED. He shouldn't expect the employees to be restricted free agents. They can take their book and move to the highest bidder. He got a bargain on their equity, why should he be able to tie up their future.

[Rob]

So are you saying that because BS was vulnerable, they deserved to fail? That it was a house of cards, and all the hedge funds are guilty of was providing a bit of wind?

Yes, BS might have been a mess, and the hedge funds may have been acting rationally and in their own self-interest, but is the meltdown of a major investment bank really the best thing for the economy?

I know you argue that we need to hurry up and reach bottom, and let all of these major failures occur along the way in the name of expediency, but isn't there a way to have a softer landing? For instance, could BS have corrected their horrible bets without self-destructing? Would that have had a better net result for the economy?

[H]

The question I would ask in about the impact of hedge funds is: because of the amount of money the bring to bare coupled with leverage they use, what is the impact on the amount of "rainy day" money a firm like Bear would have to keep around to survive a short term ambush type attack (sorry for the great white shark analogy -- it just seemed to fit)? Are hedge funds changing the game? And if so, by how much?