- After the Fed bailed out Bear Stearns and arranged for its sale to JP Morgan, I blogged saying that the Fed hadn’t done the right thing, and was now creating a situation of moral hazard.
- When Lehman was in trouble, I said that this was a good time for the Fed to make amends for not allowing Bear to fail. Reputed commentors such as Michael Lewis backed up my claims (sorry, i’m too lazy to find links). And the Fed seemed to take our suggestion. And Lehman was allowed to fail
- Now, following Lehman’s collapse (and I’m not sure if there’s a causality here), the entire global financial system is in trouble. No one is lending to each other (remember that in my original post I had said that the point of removing the moral hazard is that no one will lend to bad banks. Based on that it’s like as if all banks are bad now). The remaining banks are going down one by one.
- It seems like the Lehman collapse is just a small part of the larger picture, and if things continue to go bad the way they’ve been, it’s even likely that the impact of the Lehman collapse will not be major compared to the total size of the crisis.
- So the real danger is that by the time the crisis is over and everyone has recovered (it’ll take a long time indeed for this to happen), people would’ve forgotten about Lehman. Forgotten that banks are not necessarily too big to fail (and given how bad things have got, the Fed cannot allow more banks to fail). Forgotten that no one will bail out the creditors if someone in the system tells jai. And people will go back to their old bad habits
- Important question to ask here is the role of the Lehman collapse in the magnitude of the current crisis. There definitely has been some impact, but it would be interesting to see exactly how much. Would this collapse have been as bad had Bear been allowed to fail when it was about to fail? How much incremental damage was done to the system in the six months between the two major ibank failures?
- In hindsight it seems like the Fed might have done better in letting Bear fail rather than letting Lehman fail; actually we aren’t even sure of this.
- The question remains as to how discipline will be ensured in the system, without too many restrictions, once the system is back up on its feet (it’s going to take a long time, mind you). Maybe we will see smaller banks. Large networks of smaller banks, with none too big to fail. Yes, there will be continuous churn, wiht banks failing continuously and new banks coming up to replace them. Banks will be more ruthless in dealing with each other.
- But how does one ensure that the system goes into this particular steady state, and not any other, once it’s back up?
Category: investment banking
Following up on my masterplan
In my earlier post on this subject, I had written that I might possibly put the contents of the letter I wrote on this blog. On second thoughts, however, I decided that those contents were mostly a private matter between me and the person the letter was intended for, and so it won’t be a good idea to post it on the blog. However, there are a few lines which I came up with which I think I’m fairly proud of. So as to not to disappoint you readers completely, here is one of those:
There is no point in my narrating the Ramayana for a year and then you saying that you thought I was narrating the Mahabharata.
To compensate for not putting the full letter as promised, I am putting here Rahul RG’s excellent commentary on the issue. RG was 3 years my junior at NPS Indiranagar, IIT Madras and IIM Bangalore. It’s in the form of a GTalk conversation. It’s slightly longish so I’ll put it under the fold.
On Alonso and Delta Hedging and Creating Positive Black Swans (and louvvu of course)
Yesterday, on the Twisted Shout blog, I had blogged about Xabi Alonso, and his methods for scoring goals. Complete with videos of a few of his goals, and incomplete because I couldn’t find a few other videos, I explained how he goes about the entire process. He takes long shots, I had explained. From a distance. Hoping to catch the goalkeeper off guard. And accurate enough to get the ball in the net most of the time.
Towards the end of The Black Swan, Nassim Taleb talks about how you can make black swans work for you. He talks about industries such as moviemaking and book publishing, and he says they traditionally thrive on positive black swans. They lose a little money on most projects – books or movies, but make significantly more money when one of them succeeds.
The book industry, Taleb argues, has now lost its traditional revenue model. Nowadays, the norm for publishers is to dole out huge advances to authors who will potentially write blockbusters. This, Taleb says, now exposes the publishers to huge negative black swans. The advances are so huge that if a book sells well they recover their investments. If not, they are prone to losing a huge amount.
I notice a similar problem in the romance industry. Suppose you have been hitting on, or even seeing, a girl for a long time, and it’s now time for measurement. By conducting the measurement experiment now, you are exposing yourself to a huge negative black swan. You have already made considerable investment in the relationship, mostly emotional but also monetary and temporal. And what if the measurement doesn’t go the way you want it to go? You are already in the D (desire) of Kotler’s AIDA. It will take a long time for you to recover from it, and this could even be career threatening, as I had discovered the hard way a couple of days years back.
Now, my theory with relationships (I don’t know how much you want to trust this – since I’ve never been in a relationship) is that in order to succeed, both parties should be at least in the I (interest) zone. And one of the parties has to be in D zone. This is a necessary but not sufficient condition for the relationship to go thorugh.
So, how about testing whether the other person is in the I zone when you are also in I zone? If she is, then well and good – you can start the process of figuring out if you want to get into D, etc. If she isn’t you can quickly cut your losses and move on. If she does admit to being interested in you, it’s great. It’s a positive black swan. And if she tells K, you haven’t really invested much in the relationship so it shouldn’t be hard. Right? So that’s how my mind ran when I thought about this problem yesterday.
I sent her a mail asking her for permission to put blade on her. I explained to her in the mail (i’ll probably blog the mail at a later date – I’m quite proud of my efforts on second thoughts I won’t blog the mail. I think she deserves exclusivity to that masterpiece) that I ever since I met her a few days back I have gotten really interested in her, and am considering the possibility of blading her. That if she is not interested in getting bladed by me, then there is no point in my continuing and wasting both our times and energies, and so she should tell me that right now. I sent this mail to her earlier this evening and I’m still awaiting her reply.
So where does delta hedging fit into this? It is like the road to Ithaca as this poem mentions. It is about the journey being more enjoyable than the destination. It is about the process of doing something being more enjoyable than the results. It is from the excitement you get just by doing something for the heck of it. These are all what I call as second order effects. They are, in effect, derivatives. First order derivatives of something you are doing, which is effectively the underlying.
As I had mentioned in my previous post, by going ahead with the blading, the only thing I had to lose was my confidence. My form. And if I had gone about blading the conventional way, poking and probing, and making small inroads, the process too would’ve been excruciating, and would’ve added to the pain of the blade not succeeding. So was there a way in which I could hedge out the loss of form and confidence?
I think I’ve been fairly ingenious in going for my long shot. I’m doing something unusual by going about it the unconventional way. Add to this the joy of sitting and drafting that letter to her (yes, it’s a masterpiece). And the possibility of the insights I might gain from this process. And of blogging it, as I am doing now. As soon as I had hit upon this method, i realized that the second order advantages from this were huge. And would easily hedge away any blues that failure in my attempt would bring. It was like getting a put option along with a stock. You knew that your losses were capped.
On the other hand – if she accepted – the returns would be huge. It would be a positive black swan. Capped losses and uncapped gains! Once I had figured this out it was a no brainer that I should go for it. And I have gone for it. A long shot a la Alonso. And I’m waiting for the result. Wish me luck.
The IITM Open Quiz and LTCM
Yesterday, I lamented about the fact that the IITM Open Quiz is no more, because the quizzers at IITM decided to default on their obligation to take the great tradition forward. I then called for volunteers to contribute questions so that we can hold the quiz at a different date.
I’m reminded of the collapse of Long Term Capital Management. There, when the company was about to default, different ibanks all (all except Bear Stearns) pitched in with a little bit of money each to resurect it. Similarly, this time we can expect us old quizmasters of the quiz to contribute a few questions each in order to bail it out.
However, we should remember that the LTCM bailout couldn’t have been done by the ibanks alone. The most important player back then was the US government. Similarly we need a government-like player here who can facilitate the resurrection of the quiz, and assure all “creditors” (people who “lend” questions) that their efforts won’t go in vain (for the record, creditors to LTCM encashed their bailout money at a substantial profit a few years later).
I had also mentioned yesterday that there is no point if the IITM Open is held at a place other than IITM. The government, we thus think, should be IITM. However, it won’t be as easy to get buy-in from the IITM Student Community (who are critical to doing all the GA work, etc.) as it would be to get buy-in from the profs/admin (who have been sympathetic to this quiz throughout its existence). It’s like the US president agrees to orchestrate the bailout but the treasury department employees who have to actually do the work become hostile.
I wonder what steps we can take in order to turn this situation around, and get the people to organize the quiz. As I had mentioned earlier, getting volunteers on the quizmaster front won’t be fight.
parts of lehman
neuberger berman: $ 2 * 10^9
lehman NY: $ 2 * 10^8
lehman Asia: $ 2 * 10^8
lehman fixed income europe: $ 2 * 10^0
Dear Lehman Employees
Or should I say ex-Lehman employees? Assuming that most of you haven’t been fired yet, I’ll drop the ex. I know that a couple of days back, I wished for your company’s demise. That had nothing to do with you. I wished for that because I thought that was the right thing to be done. And the right thing has been done.
I know that you are out of a job, or will soon be without one. And that there are millions of Lehman people out on the street now, looking for a job. You may soon be joined by some people from Merrill, so you may not be alone. However, this is not the kind of thing where one appreciates company – after all that would reduce your chances of getting a job early.
I’m told that a number of you are desperate to quickly get into other jobs. I even heard that some of you are willing to take fantastic pay cuts in order to get employed again. I also heard that some of you are planning to apply to jobs that have nothing remotely to do with banking. i would advise you against doing things like this.
I know some of you have mortgages to pay. Some of you have families to take care of. And by embracing the American culture, you don’t have enough stowed away to take care of this. Some of you may not be allowed to legally live where you are currently leaving unless you find another job soon. Yes, if you are in this kind of a situation, you would do well to find a job early. However, keep in mind that whenever you are looking out, all that matters is your last paycheque. I figured out the hard way a few months back that the job market is Markovian. It doesn’t care for what you used to do. So if you end up taking a pay cut now, you might have to live on a different salary scale for the rest of your life.
However, a large number of you may not belong to the above category. You might have some savings stashed away, or you wont’ have mortgages to repay, and you aren’t really desperate to retain your visa. If you fit this category, I would advise you to hold out. I know you are upset now, but don’t panic. Don’t be in a hurry to find a job. Don’t sell out. Unless there are more large-scale layoffs in the near future – with Merrill having been sold, the chances of this aren’t too high – the job situation is going to get better with time.
Remember that once you are in a job, you will never get a break. You might get your statutory three weeks of privileged leave, but you will never find an opportunity to take a longish break. You will never get an opportunity for a sabbatical. To take some time off and do what you want. Yes, personal experience tells me that it’s really tough to chill when you don’t know where your next cash flow will come from. But given your experience in what was considered to be the best bond house in the world, it shouldn’t be that tough to find another job, when the supply in the market isn’t as bad as it is now. I would still advise you to take a short break, and breathe, and introspect, and ask yourself all the questions you haven’t been able to ask because you didn’t have the time.
You might think I’m crazy to be telling you this, but I think this is what will work best for you. Yes, there is a small chance you might get a good enough job paying well enough soon enough. If you hit upon this, then, you must count yourself lucky, and take it. However, there is a good chance that you may not be able to do this. All I’m saying is that in that situation you shouldn’t panic.
Just one last thing. If you are from Lehman, and are interested in working for a quant-based algorithmic trading hedge fund trading in Indian equity and equity derivatives markets, and based out of in Gurgaon, let me know. Drop in a comment with your email ID. Look up on this page, and you find a tab saying “Contact”. Click on that and you’ll get a form. fill it up including your email id and submit it. You might find someone responding to you in a few days.
Thanks and reegards,
SKimpy
Sorry Vennai. Sorry MJ. Sorry Baal
But Lehman has to go. In the “larger interests” of continuing a vibrant, risktaking and efficient worldwide financial system, it is best that the Fed does not bail out Lehman.
I had written about this a few months back, in hindsight, after Bear was bailed out by Fed who arranged for a hurried takeover by JP Morgan. Given that Lehman is still alive, though just, I think it’s time to revisit the arguments that I had made there. Quoting from the earlier post:
However, I think the easiest method of regulating these banks would have been to convince them that they are not too big to fail. Yes, they allowed Bear to almost fail, and its shareholders almost got wiped out. However, my belief is that this episode will be quickly forgotten and people will be back to the same old risky practices once the current crisis is over.
Most wall street banks used to function under the assumption that they are “too big to fail” and that if they make huge losses, the US Taxpayer would somehow bail them out. This led to the oft-repeated unhealthy scenario of “private profits, socialized losses” and encouraged extremely risky behaviour. The Bear bailout has set a bad precedent in this regard, and might lead banks to go back to their bad habits once they are out of the current crisis.
Then, I had written that
What if Bear would have been allowed to fail? People with whom it transacted would have all lost tonnes of money. So how would that have helped? Basically, in future, banks would become more wary of counterparty risk. They would be continuously monitoring each other. If one guy behaved badly, other banks would stop talking to him. Which would push up the level of everyone’s behaviour. I think being boycotted by your friends is a bigger punishment by being caned by the teacher.
The near-failure of Lehman has presented the Fed with an opportunity of setting right the mistakes that it did when it arranged the Bear bailout. They are lucky that there is an investment bank, not too large, which is on the brink of failure, and whose complete failure can change the way wall street functions.
I hope Lehman doesn’t fail. I hope they manage to do something on their own, or arrange some sort of funding, to pick themselves up from this crisis. However, if these efforts fail, they should be allowed to fail, however ungracefully. A bailout can only worsen the way major investment banks function.
Letting Bear fail
This is a tubelight post. Was supposed to have written this two months back.
I sometimes wonder if the US Fed did the right thing by encouraging JP Morgan to buy out Bear Stearns rather than to just let the latter fail. I know letting it fail would have had significant negative impact on the already struggling financial sector. But wouldn’t it have sent out a nice message for the longer term? That nobody was too big to fail? Wouldn’t this have significantly improved the quality of derivatives contracts in the long term?
interest rates derivatives revisited…
so my favorite topic of interest rate swaps has made front page news today (in the Business Standard). apparently the food corporation of india (FCI) entered into a swap with Barclays in which FCI received fixed and paid an interest rate linked to the yield on Indian GSecs. now it so happens that reverse repo rates have gone up by much more than Barclays had projected (thus driving up yields on GSecs), and poor FCI is now getting mothered.