"Kill the Dead Prop Traders!"

Obama's plan to limit proprietary trading in commercial banks sounds to me like he's shooting already dead guys in order to be able to claim "look! I shot down some bankers". Politically, it could be a smart (while a touch populist) move to get the support of Main street but it won't change that much the risks taken by the banks: the proprietary activities are already very limited there (and the crisis hasn't helped in the development of such activities...). Wait. Very limited??? What about for instance JPMorgan or Goldman that showed lately huge profits on prop trading? Well, the prop trading is just a glass window that allows the banks to show off and take higher margins on their Franchise. Roughly and in a few words, the banks are long and their prop is short and when there's a slump they highlight the performance of their prop activities. Christian Siva-Jothy, ex star prop trader and former head of proprietary trading at GS explains in an interview in the book "Inside the house of money":
"Certainly Goldman Sachs saw the prop group as a call option and hedge for when the franchise was doing poorly (the franchise is generally long inventory) [...] During the periods [of tightening cycles and credit events], a bank wants the prop group to make outsize returns, which will compensate for the lack of franchise income. [...] So in the years the franchise is doing well, they expect you to be between zero and up double digits, but in the years where there's a big dislocation, they'll expect you to knock the cover off the ball".

In the 1990s, there were actual prop trading banks and GS was definitely one of them but this dramatically changed. One reason was notably in 1994 after Siva-Jothy I quoted above lost a few hundreds million of Goldman's money on a GBPJPY deal and the prop activity was reduced (from hundreds of prop traders to 3, including Siva-Jothy). But the main reason is far more basic: taking positions is a too risky business for an investment bank... Those who speculate with us at TLofT know (and probably better than bank traders) how hard it is to put positions on and to make money from. Now, over 90% of the desks of the capital markets department of a bank are profitable, do you really think that's thanks to positions? I know it’s hard to believe as it’s a fallacy broadly fed by bank recruiters seeking for young talents that bank traders are prop traders, but the banks avoid position taking and speculation like the Black Death plague. To quote Gekko in the movie Wall Street, the banks don't throw darts at a board, they bet on "sure things". Gekko referred to inside trading, I won't mention the dark side stuffs the banks are able to do, but to bet on "sure things", they just do the oldest (well second oldest...) job in the world: buy and sell at a higher price to clients.

Let's come back to the pre-crisis times, why would a bank take any risk on positions when it's so easy to make money by buying products and selling them dearer to clients? The more complex the products (structured products, CDO, exotic options,...) the bigger the margins (arranger fees, structuring costs,… ) were, the more you stuffed your clients the more you made money. What such a business model required was a good sales force, not really guys able to put on the right positions. A trader’s job is not to speculate and he/she has strong risk limits not to do so but to hedge the risks implied by the sale of products and to be able to price and hedge any instrument that the client may desire in order to allow the sales guy to close the deal.

Now how come the banks took a hit during the crisis while they are not supposed to have big exposure? I can see 3 main reasons for that.

1-When the crisis came, the commercial flows vanished and the banks were left with what they hadn't managed to stuff to their clients with, mainly the "toxic" assets ramped up for the infamous CDO and other securitized products (ABS, CLO, …)

2 - The hedging strategies of complex products are driven by math models that determine the price (actually the cost of hedge) of the product (and consequently the margin earned on the sale), that’s the so called delta hedge. These models were not adapted to the extreme conditions seen during the crisis (should they be applied, they would just make the bank using them not competitive) and the crisis left the banks badly hedged and with consequent exposures.

3 – The risks were transferred though swaps and other derivatives to external counterparts that collapsed during the crisis, letting the exposure ultimately for the bank. Of course, the more leveraged the products traded with them were and that included mainly structured products, the more this appeared to be true.

Those points show the banks (and the whole financial system) got more hurt by the complex, leveraged  and structured products and other weapons of massive financial destruction rather than prop trading activities. The weird thing is should the banks more prop trading oriented and less client stuffing driven, we would probably be better off nowand even might have avoided such a crisis. On the one hand, everyone knows that speculation is risky and the prop activities are highly controlled and monitored. On the other hand, the feeling that selling products is free of risk (and greed) led to accumulate stockpiles of complex risks no one on earth is able to understand. Thus, the solution I suggest is definetely less populist than Obama's: "more speculation and more regulation on risk free business!"

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Hoodoo Child (Negative Return)

“Well I’m a Hoodoo chile,
Lord I’m hoodoo chile”

A “Hoodoo” in Wall Street’s folklore is a trader characterized by his/her excessive “bad luck”. A Hoodoo has what we call at TLofT the “Gift” or the ability to buy at the top and sell at the bottom.

I’ve to confess something to you, Fellow Traders: I lied to you in my previous post. I’ve been eaten alive by remorse and have not been able to sleep since, well actually I spent at least 15 minutes before I managed to feel asleep despite reading for the thousandth time “The Alchemy of Finance” (don’t worry, I still can’t understand it). In my previous post, I told you that I had a gut feeling that things will go really bad for Japan. False, it was not really a gut feeling, I used one of the most powerful indicator that I know: the Hoodoo.

According to Victor Niederhoffer’s “Education of a Speculator", a Hoodoo’s bad luck is highly contagious and one needs to run away from him/her as fast as possible to avoid to be personally hit by a financial disaster. While it is probably the highest of the risk I take in my trading, I like to play with fire and happen to be in contact with Hoodoos trying to profit myself from their Gift and hoping that I won’t be contaminated.

I met my first Hoodoo almost 10 years ago, while I was a young trader running the “Orc race” with Investment Banks and absolutely no idea about the Hoodoo concept. As my Master trader and his padawan (myself) were about to trade the hedge of an interest rate position, a Senior Prop trader from NY, in Paris for the day, came and ordered : "Wait this afternoon before hedging your position, the FED will speak" then left. The FED talked later but inevitably said the very opposite of what he said and the loss for not hedging was quite consequent. Well, it happens to be wrong and that doesn't make you a hoodoo so far but years after I found more about this guy: historically, ALL the desks he worked with collapsed when he was there. That's a signal that rings (I should write "sings") "Hoodoo, Hoodoo chile…". That story also shows that in the investment bank world, one can be a Hoodoo, lead on a regular basis to financial disasters and lose constantly money and have a senior position and accountabilities within the bank...

I've been told about a Hoodoo legend, a senior Forex trader. The old chap was losing money so constantly and trading the wrong side of a deal so systematically that he became a legend in his bank. He was so "Gifted" that he was well known and the matter of endless jokes even among the support functions of the bank: middle offices, IT, back offices,... But one day, he surprised the whole bank with a huge winner, finally! And all those guys joking at him in his back (of course he wasn’t aware of his legend status), stood the mouth wide open, amazed and just couldn't believe it. Well, actually they were right not to believe it… The trader actually had the wrong position as usual but what happened was pretty rare: his back-office confirmed mistakenly the other side of the position and the back office of his counterpart did a mistake as well and confirmed the wrong side too, so at the end the tickets matched and the deal was booked on the wrong side for the both counterparts… "Hoodoo, Hoodoo chile…"

During the past few years, I’ve met loads of Hoodoo candidates. The thing is guys who got a front office position in an investment bank after years of high education, years of slavery in internships and training programmes at the very precise moment the banking system went to the brink of a collapse clearly demonstrate a high Hoodoo potential… One of those guys is to me a confirmed Hoodoo: he had his personal record of being involved in companies he was working with that bankrupted, purchasing shares or assets at the top when he joined the front office in the booming business of CDOs. The CDO desk hadn’t known one single negative month since its inception, it hadn’t seen a positive one since he joined… In 2007 when he joined, the traders received record bonuses (to date) rewarding the previous year, since they (well, he at least) have received zero or so… So no doubt on the Hoodoo status of the guy… You know the song…

The thing is that guy recently moved to Japan. Our first reaction along with a few fellow traders also aware about his Gift was immediate: “We must short Japan” and that explains what I referred to as a “gut feeling”. Lately, in order to remove the bias on that conclusion, I’ve been re-thinking the interpretation we did about the move to Japan of our local Hoodoo. Maybe it doesn’t mean that the Japanese Economy will slump and Japan will be pushed in a double dip recession. It can alternatively mean that the Yen will dive: our Hoodoo is now paid in Yen.

Unfortunately, the Hoodoo indicator in that case doesn’t give us any clue what side we should trade. We need to do our homework to find out and monitor the situation in Japan very closely as a big move is likely to be there: you’ll see, the Gift is just the most reliable indicator ever.

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Don't short the Sheriff

First things first: Happy new year, Fellow Traders!

In 2010, trade with the Lord… of Trading and don’t short the sheriff, I mean the Market sheriffs of course: the governments worldwide, the treasury departments, the FED, the BCE, the BOE and the other Central Banks. It’s not that I turned into a Bull, the thing is just that I’m a coward and scared of the Sheriffs. They showed us in 2009 how fast, big and powerful their guns are and how wide their arsenal is: interest rates slashes, Credit/Quantitative Easing and other money printing presses, banks bail-out, accounting changes, government fiscal stimuli and loads of programs: the TARP, the TARP strikes back, the return of the TARP, the TALF Episode I, the P-PIP, the HAMP and maybe the use of a few weapons that’s better not to mention, the kind of that can send a guy in jail for a few hundreds years, but no sheriff would send another sheriff who saved the world in jail. Here we go: the sheriffs saved the world. Remember one year ago as 2009 began, a few months after Lehman the markets were close to collapse and the end of the world seemed inevitable. Here came the sheriffs, they fired their weapons and shot in the Economy (well on the banks mainly) a few trillions (hey Sheriff would you shoot me a bit please?), supported the global rally from March as the injected money seemed to be used to a large extent to buy stocks and killed a lot of markets outlaws, namely shorters.

Dow Jones: 1/1/9 - 1/1/10

Firstly, this indicates that the lessons of the Financial History have been learned, particularly the chapter on the "Great Depression": the "laissez-faire" liberalism doesn't work and the markets are not able to recover on their own and need massive interventions and money injections. I read a book "The return of Depression Economics" written on this by Paul Krugman, winner of the Nobel Prize in Economics which I have found highly interesting and clear, for me not an economist (thanks to the Lord of Trading) and that I'd recommend in order to have an idea of the Economic school that has an important influence on the Sheriffs decisions.

Secondly, this suggests that the Sheriffs will keep on doing everything they can (and I do mean Everything) to support the recovery they initiated and avoid we fall back in a Recession. My opinion is while the stock market may take a breath after that rally, the sheriffs have still enough ammunition to avoid a deep correction and prevent us from the announced double dip recession, at least during this coming year. I also think they have enough ammo to exit their stimuli not before they are 100% sure the Economy can fly without them. Lehman was shot down for some obscure reasons probably by Sheriffs who underestimated the impact of its collapse, it was a mistake and I'm pretty sure we won’t see so soon this kind of mistake. The forecasts and talks about a double dip recession including by President Obama, appear to me like an extra safety net to ensure that it won't occur. The very same thing can be said for the anticipated crash in the Commercial Real Estate. This contrarian view here is based on a simple thing: when most of the participants are bearish, they just make the short positions expensive and the long ones cheap... That's what I tried to explain (in vain) to my former Master Bossy when I was happily running the "Orc race" (which is a TLofT variant of the "rat race"): as long as most of the market participants are bearish and expect the imminent end of the world, the rally will sustain... This said, I have the feeling this opinion faded lately (the "Double Dip recession" was the topic of many articles a few months ago, it is much less now) but there are still plenty of good reasons to feed the Bearish sentiment: I won't tell you anything you don't know if I say the recovery is fragile, that the past year the economic issues worsened, the unemployment soared to reach in some countries unbearable levels and doubled in the US, the US big banks recent profits seems to come only from cheap funding (1.4% last year according to The Economist) and their balance-sheet is still loaded with tox... legacy assets no one on earth seems to be able to properly price yet and which value is still highly dependent on the US government programs and their impact on the ultimate default rates and recovery values, it looks like the house prices according to Banks research have not bottomed yet and so on, and so on and so on. OK, you know these songs... In my humble opinion if there's a crash in 2010, it's unlikely to come from one of the listed above as the Sheriffs veil too closely on them. If I was required to give a guess, I’d say that the inflation will ultimately creep in and that’s the fight against it by the very same Sheriffs using the very same type of weapons that will bring us to the next crash but I think we still have some time before we see this. Another thing to make the game more difficult: a cataclysm often comes from where it is not expected, at least by the Crowd.

This said, after the systemic shock triggered by Lehman's collapse all the markets became highly correlated, as basically everything moved down then. During the most of 2009, all the markets seem to move up and down in tune with the 30 of the Dow Jones. We discussed in an earlier post the break of the correlation between the EURUSD and the SPX, but actually during the last months of 2009, the break in the correlation between the different markets could be observed more broadly (stock, bond, credit, interest rate, commodities markets). For instance the chart above shows the correlation between (the log returns of) the S&P500 and  the Nikkei 225 since Sept 08. It suggests that in 2010 the prices could reflect back the relative value between the different markets as they used to. In such a market environment, the strategy is simple: go long the best and/or short the worst. To be back to our metaphor: we could be in a situation where the Sheriffs after they saved the world together will more focus on their own ranch, even letting the outlaws steal the cows in their neighbourhood provided that those don't steal theirs. It might be the case if troubles get serious in the Euro-area (a Greek default? Ireland and Spain are not really healthy neither) or in the Middle East (bye bye Dubai?): things might go really bad there without any Sheriff intervention if the risk of global contagion of a slump looks limited and the initiated global recovery is not at stake.

Don’t short the Sheriffs until they run out of ammunition... and to me one sheriff that might run out of it shortly is the BoJ. I'm doing my homework on Japan as I've a beginning of bearish view for now motivated by pure gut feeling rather than anything else and I will post the fruits of my investigation (if any) later this year here. But at first sight and in a few words, the Japan has been using the Quantitative Easing weapon for a decade now and it didn't work. They may need to use it again and again as the current absence of interest rates differential led the currency to levels which are hardly sustainable for the Japan to stay competitive. If negative economic news in the US or in Europe hit the screens, the prospects will be that  the FED, the ECB or the BoE will keep longer their rates low and this will affect Japan as it would then expected that the absence of differential is to sustain longer. That were just a few thoughts at that stage, to be continued...

To end this post once again on my trading, last summer when I understood the commitment of the Sheriffs to do whatever the recovery requires, I "traded the FED" going long stocks and long EURUSD mainly and that paid off. For now, I will keep on trading this side, mainly adding on the long stock position with S&P500 names (let's trust Sheriff Ben to protect it) as the EURUSD direction in a few weeks is very uncertain to me. At the beginning of last year, I had the very opposite view, I was dead wrong, I reversed and managed to make money. In a very similar way, if it appears that I'm wrong this year, I will reverse. Then I definitely won't be the first to reverse to be on the right side but it's still OK as the trick with trading is not to be the last to do it...

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