Sunday, March 17, 2013

Mark, Marks and Marked...

The funny thing about theoretical finance is that it really does not exist at all with the exception of the leaching effects it has when employed in a non-theoretical environment. JP Morgan and Goldman Sachs (and most central bankers) epitomize the effects directly. Neither institution has a net positive effect on our economy but rather, in my opinion, ultimately a very negative one. This is because the compensation they require and receive is larger not only than they deserve but than reality has the capability to deliver. Why does this occur? Why has it continued for so long? Why did Rubin and Greenspan fight so hard for these new financial models?

We can answer all those questions in that they are rooted in a simple problem people accepting obligations that they are unable to meet and people providing said opportunities to people knowing that they will not meet them. GreenSPIN, BURNanke, BlankFIEND, DRUGhi, BarBOOMo, Jamie DEAMONd have made their legacies and their fortunes selling concepts that they know don’t really exist, can not work and are doomed to fail. They prey on a social and economic structure based on destruction rather than creation.

What we saw at the “Whale Trade Testimony” was a veritable disaster and much worse than the Goldman Sachs episode from a few years ago. At least Goldman had a kind of complex and arbitrary breach. JP Morgan on the other hand in this case (though Goldman has the same issues and possibly worse) had a very simple breach…lies about prices, lies about losses and gains, lies about assets and lies about their process. If each one of these issues were not a very clear issue it would at least give them cover. But its absolutely clear what someone’s intentions are when then show derivatives priced on one side of  the book as gains or break even and in reality they know to show huge losses. This is very different than an opinion or even directional bet on some sub prime security. This is the simplest deception aimed purely at compensation (forget even speculation)…and the most egregious kind of deception.

It is my view, that Jamie DEMONd will have been found to have received most of his compensation based on derivatives transactions (ironically not banking) and that when those transaction are all ultimately unwound - they will finally show gargantuan losses. Certainly we have the impetus for people to lie because everyone involved could receive much better compensation by attempting to move a price around a little bit. Ironically, it should also be well understood that there is no regulation that can really solve the pricing issue with illiquid theoretical securities. The entire enticement for using these securities lies in their vague pricing and flexible marks. With out those characteristics they are not worth the paper they are not written on to a company such as JPM of GS. Fancy having to earn money by really making a real profit - that’s much too boring for companies at the cutting edge. Moreover, JPM is a big player in a small pond. It only takes a few players to move a price, bid or offer in a systematic way that shifts a market with few participants and non-transparent pricing. For these reasons, I do not believe that pricing service will do the trick. We supposedly have all sorts of rules to prevent quote stuffing, yet if you trade in a dark pool and buy collocated servers on the exchange you apparently can send as many quotes as you would like. If that is the case with simple securities like stocks and futures, it opens up Pandora's box with derivatives.

Have you ever traded leap options contracts? If you have you can easily manipulate the market yourself by placing offers and bids for single contracts at prices that shift the mid point in your favor because there are very few other serious participants willing to operate at those prices and the spreads are wide. You can even execute a trade at a less than high quality price for a single contract just to show that your marks were good. How can someone fight infrastructure like that? Options are simple and they operate on an exchange yet the prices of leaps are easily manipulated. If you are trading JPM style derivatives the terms of the contracts are long and their behaviour is very similar to leaps but with out the public exchange or standards of execution. Even if an exchange would be designed and clearing rules and process be enforced, these prices would still be highly malleable. Not only that, but in periods of severe liquidity constraints these prices can distend to levels that make absolutely no sense to any model because liquidity needs not to have the slightest respect for any model…it is rather quite the reverse. In my algorithms, for example, I respect liquidity before I respect theoretical outcomes. This is an art and not a science which is why Phd’s in my opinion are so bad at it. JPM and GS are two examples of banks trading at very very high leverage between 60 and 400 to 1 and doing so primarily based on the theories and supposed market efficiencies and inefficiencies identified by theoretical financial modeller phd’s with little practical understanding of human behavior at all - especially in markets.

I believe that JPM’s testimony in Washington this week was a total disaster. I believe that charges of some kind will be coming (they will probably promptly be settled of course) and perjury and obstruction will probably be reduced to some minor infraction with the ability to neither admit or deny guilt. But needless to say, what ever happens, it will be risky for the individuals involved but certainly mostly for the bank(s) that really really need people to believe in their confidence game in order to payout bonuses and be believable regarding being viable counter-parties on derivative securities of nearly $80 trillion - as well managing and executing safely. As we can see from their testimony, we have nothing but full risk controls and perfect. hedging by these large institutions - right?

The reality is that in 2008 and 2009 JPM had HUGE discrepancies in their derivatives books, some of which led partially to the bankrupting of Lehman but also that, without belief in and acceptance of their confidence game, would have led to JPM”s bankruptcy too. Please remember that Fannie Mae and FredieMac both had books of derivatives that in one moment reflect huge profits/bonuses and then when evaluated by people not receiving those huge bonuses showed disastrous losses. This is exactly what has been able to happen at JPM, BAC, GS, C and a host of other large players…as long as the music plays and there are bonuses to be had why not move a few marks around, or play with LIBOR between friends to engineer the desired result, especially when it can be done with other peoples money!

© 2009 m3, ltd. All rights reserved.