You can read the Jamie Dimon “Don’t gloat about how bad Goldman is. Did you hear me? Don’t gloat about how BAD GOLDMAN IS. The fact that GOLDMAN is BAD is of no interest to our clients. Or the press. Don’t leak this to the press!” memo two ways. One is, y’know, what it sounds like: Dimon gets to score some easy/meta points by spreading it around that his business practices are so superior that he doesn’t even need to spread it around that his business practices are superior. The other is that making money off of clients isn’t something invented at Goldman Sachs and anyone at JPMorgan who throws stones is likely to be clonked on the forehead by a ricochet. (Or possibly by a deranged fictional whistleblower!*)
Greek Debt Management Guy Thought His Partners In Obscuring The National Debt Would Be The Last People To Rip Him OffBy Matt Levine
I can’t even comprehend Bloomberg’s story about the Greece-Goldman swap-debt-whatever kaboodle, so let’s talk about the philosophy of derivatives for a minute. First the story:
Greece’s secret loan from Goldman Sachs Group Inc. (GS) was a costly mistake from the start. On the day the 2001 deal was struck, the government owed the bank about 600 million euros ($793 million) more than the 2.8 billion euros it borrowed, said Spyros Papanicolaou, who took over the country’s debt-management agency in 2005. By then, the price of the transaction, a derivative that disguised the loan and that Goldman Sachs persuaded Greece not to test with competitors, had almost doubled to 5.1 billion euros, he said.
There are at least three reasons to use derivatives. First you could be into some actual informed shifting of risks from those who want to pay to get rid of them to those willing to be paid to bear them, or from those who have Risk X and want Risk Y to those who etc. Boy are there a lot of textbooks that talk about this. And I suppose it even happens sometimes. You could imagine that a vanilla interest rate swap entered into by a corporation on its bonds or credit facility could qualify as this. I guess people who trade listed options to do covered-write strategies or speculate on takeovers or whatever fall in this category, maybe modulo the “informed.” (Sometimes!)
Then there’s tax and regulatory arbitrage. This is time-honored and much of it, particularly the stuff with the best names, is focused on tax dodging, but there are also various other regimes – securities laws, accounting, whatever – that you might want to get around with derivatives. Paying $10 for CDS with a maximum payout of $10 purely to lower your capital requirements is a recent amusing/egregious example.
The thing that wasn’t mentioned in the CFA Level I derivatives primer is principal-agent arbitrage. This is … first of all, let’s say this isn’t a derivatives issue, or a financial-industry issue, it’s like a life issue. (Some would say it’s why there’s an M&A business, for instance.*) Read more »
The gnomes at the Bank for International Settlements have produced a particularly gnomish paper called “Collateral requirements for mandatory central clearing of over-the-counter derivatives.” Wait! It might be important! Hear them out. (There’ll be charts …)
Their goal is to measure how much more cash collateral the big dealer banks will need to encumber to make the transition to central clearing of derivatives (specifically interest rate swaps and CDS) under various forms of central counterparty regime. If you’re interested in that sort of thing, and some people are, then this provides you with much fodder for chewing ruminatively. It sort of reads like an econometrics final exam that, speaking only for myself here, I would fail, so I can’t really say how ruminatively you should chew it. You could clearly make different choices at many, many different points, and while each individual choice seems thoughtful enough you wonder whether the accumulation leaves you with a toy paper at the end.*
Now, if you’re not particularly into the constraints on cash that would be driven by central clearing of derivatives, you can still get something from this paper. Specifically, this gives you a sensible look at how much damage the Financial Weapons Of Mass DestructionTM can do at any one time. Because “margin” is a proxy for something else, specifically likelihood of a big loss. Here’s how they do their math: Read more »
Paying Bankers In Derivatives Worked Out So Well For Credit Suisse That They’re Going To Do It AgainBy Matt Levine
Dealbreaker has long admired Credit Suisse for being on the cutting edge of creative approaches to compensation. In 2008, they gave bankers bonuses consisting of “toxic assets” to (1) incentivize the risk-takers to stick around and (2) remind people that “toxic assets” is a meaningless term if you don’t consider price. That worked out okay. This year, they’re giving junior mistmakers bonuses consisting of nothing, as a gentle reminder that there are other, similarly nonremunerative careers that might be better suited to their interests and talents. That also seems to be working. And now there’s this piece of magic:
Credit Suisse Group AG, Switzerland’s second-biggest bank, plans to pay a portion of senior employees’ 2011 bonuses in bonds packaged from derivatives linked to about 800 entities.
The move “is a risk transfer from the firm to employees,” Chief Executive Officer Brady Dougan, 52, wrote in a memo to the firm’s staff and obtained by Bloomberg News. “We are trying to strike the right balance and align employees with shareholders. These measures help to put us in a good place and to perform well in 2012.” …
The bonds mature in nine years and will pay a coupon of 5 percent for Swiss franc holders and 6.5 percent in U.S. dollars “for holders elsewhere,” Dougan wrote. Credit Suisse will absorb the first $500 million of losses on the portfolio, according to the memo.
How can you not love this? My favorite part is that shareholders eat the first tranche of losses. OOOH NO BANKSTERS ROBBING SHAREHOLDERS, you think – well, not you, but someone thinks – except no. Read more »
Sometimes it’s useful to be reminded that not all financial structuring is designed to get around capital requirements or defraud customers. Some is designed to get around taxes and defraud the treasury! One group of people who like to think about that kind of thing is the Congressional Joint Committee on Taxation, who took some time out from shouting about payroll taxes yesterday to have a geeky hearing about the state of financial instrument taxation. Short version is, they’re not all that happy about it.
The JCT staff generally say pretty smart stuff about tax policy, and they get that shit is fucked up and bullshit. Or as they put it more diplomatically:
The timing, character, and source rules apply differently to (and are sometimes uncertain for) equity, debt, options, forward contracts, and notional principal contracts. These five basic instruments can be combined in various ways to replicate the economic returns of any underlying asset. … The flexibility of financial instruments also creates great difficulties in the taxation of financial instruments. This report provides examples of taxpayers’ uses of financial instruments to achieve desired timing, character, and source outcomes and describes how the tax laws have or have not addressed this tax planning.
There are two useful takeaways here. One is kind of weird: there are a bunch of fairly basic things (exchange-traded notes, CDS) where nobody – not the IRS, not the JCT, nobody – knows how they’re supposed to be taxed. That … seems like a bad thing. And, I’m going to guess, not so much the fault of evil financial innovators.
I have a hazy memory of those exciting days in 2008 and 2009 when the world was going to be remade, shiny and new, with all of the risk gone from the financial system. The way we were going to get rid of all the risk, as I recall, was with the Volcker Rule and transparency around derivatives trading. That way, no shady prop trading of derivatives could blow up our financial system again, as long as you don’t think too hard about the word “again.”
Anyway, how’d it work out? Well, the New York Fed, who you’d think would have something to say about all of that, put up a note today about transparency in CDS trading. Their feelings about transparency in CDS trading can be summed up as “meh, we could take or leave transparency in CDS trading.” Specifically:
Data on trading activity in the CDS market paint a mixed picture of the likely impact of trade reporting rules. The high levels of standardization of trading and contractual terms are apt to enhance the ability of market participants and policymakers to interpret the reported transactions. However, the low frequency of trading diminishes the potential price discovery benefits of real-time trade reporting.
So real-time trade reporting won’t cause undue problems for dealers because most CDS is in fact a pretty standardized product that can be reported on a comparable basis. There’s “an impressively high level of standardization of contract terms and market conventions” in single-name CDS, including things like standardized coupons, payment dates, and the fact that “47 percent of single-name transactions and 84 percent of index trades … are in the five-year tenor.”
But no one will care about that reporting, because there just isn’t that much trading. This is based on a longer New York Fed paper from earlier this year, which we’ve mentioned before, but this graph is worthy of another look:
You could quibble with the data design (next graph I do will have three color-coded categories, “big numbers,” “medium numbers,” and “small numbers,” and they will be interspersed randomly across the graph!) but let. it. go. Instead let’s talk about the fact that for something like 1,200 of the 1,500-ish corporate CDS reference entities, the average trading frequency is less than once per day. Read more »
Bank of New York Mellon is back in the news for offering a special promotion to its valued FX customers: if you act now, instead of screwing you with the worst possible price for your FX trades, they will not do that. OWS is working!
The thing about that is … well, wait, let’s start with something more important: I don’t really think that Gretchen Morgenson understands anything about derivatives. That would be ridiculous. Good to have that off my chest.
What I meant to say yesterday was not that she did, or that anything she’s said about derivatives was technically correct. It was that getting all excited about how she mislabeled a repo a swap misses the point. If a repo and a swap have substantially the same cash flows and achieve substantially the same economic effect – here, letting MF Global leverage a position by separating funding from credit risk – then there’s nothing substantive about calling one thing a “repo” and another a “swap.”
BoNY Mellon, though, shows that what you call a thing actually can matter. Thinking that everything is a derivative may lead to confusion and anger if you’re, say, Gretchen. Because Derivatives Are Bad. But, if you’re me, thinking that everything is a derivative might make you a little bit more sympathetic to BoNY. Because I don’t think that what they were doing was – or was only – screwing their customers by secretly giving them the worst price of the day. I think that they were “long a floating-strike, intra-day option on their FX transaction.” Read more »