Banks: The coming storm
Enviado: 21/2/2004 22:17Banks
The coming storm
Feb 19th 2004
From The Economist print edition
With markets apparently safer, banks are trading ever-greater amounts in search of higher returns. Expect trouble
IN THE autumn of 1998, at a conference organised by Credit Suisse First Boston in—appropriately enough—Monte Carlo, Allen Wheat, then head of the investment bank, stood up after dinner and delivered a breathtaking mea culpa. Some sort of apology certainly seemed in order given the huge sums the bank had just lost from extravagant gambles on the Russian economy in particular and financial markets in general. The bets went spectacularly wrong after Russia defaulted, financial markets went berserk, and Long-Term Capital Management (LTCM), a very large hedge fund, had to be rescued by its bankers at the behest of the Federal Reserve. CSFB eventually admitted to losses of $1.3 billion. Before the end of this year, the bosses of many big banks may face the same unpalatable task which confronted Mr Wheat if, like him, they have the courage to admit their mistakes.
The reason is simple: the size of banks' bets is rising rapidly. This is because returns have fallen as fast as markets have risen. Yields on corporate debt of all types, for example, have fallen dramatically, and commissions for all sorts of businesses have also dropped. So banks are having to bet more of their own money to continue generating huge profits. But the amount that they have put on the table in recent months has become worryingly large.
So large, indeed, that the present situation “is not dissimilar” to the one that preceded the collapse of LTCM, says Michael Thompson, a strategist at RiskMetrics, a consultancy that specialises in the kind of risk-management models employed by the banks themselves. Like LTCM, banks are building up huge positions in the expectation that markets will remain stable. They are, says Mr Thompson, “walking themselves to the edge of the cliff”. This is because—as all past financial crises have shown—the risk-management models they use woefully underestimate the savage effects of big shocks, when everybody is trying to get out of their positions at the same time.
Even the banks themselves admit that they are taking bigger risks. Though they do not divulge the size of their positions, or in which markets they are concentrated, how much those positions have grown can partly be gleaned from what they have to report in their financial statements.
So-called value-at-risk (VAR) models determine the amount of capital that banks must set aside against their trading positions, and purport to show how many millions of dollars a bank might lose should markets turn against it. Banks report this figure. If a bank's VAR is rising, it is taking more risk—and VARs have been climbing for nearly every bank active in financial markets (see chart). The VAR at Goldman Sachs, which these days is widely viewed on Wall Street more as a hedge fund than a bank, has more than doubled in recent years. One of the bank's senior traders was even told recently that he must take still more risk.
Rest assured that he is far from the only one being told this at Goldman Sachs, or anywhere else for that matter, even though it was only a few years ago that many banks specifically eschewed higher-risk trading as a good way to make money. Earlier this month UBS, a big Swiss bank, said that “with markets and investor sentiment starting to improve” it would gradually increase credit and trading risks.
Even Citigroup, which stopped explicitly trading for its own account a few years back, and HSBC, a bank that used to think of trading as rather beneath its dignity, both announced recently that they too are increasing the amount of trading they do with their own money. And Credit Suisse First Boston, having scaled back its own trading after its 1998 debacle, is also now increasing the amount it devotes to trading, though it claims that it will no longer “bet the ranch”. Allied Irish Banks, which has had more than its fair share of trading fiascos—losing nearly $700m in 2002 thanks to the activities of John Rusnak, one of its foreign-exchange traders—is trying to hire another 20 traders in Dublin.
VAR crash
Of itself, VAR provides a conservative guide to the huge size of banks' current positions. In simple terms, these models assess the amount of risk that a bank is taking by looking at the volatility of the assets it holds and the correlation between them (the less correlation the better). In that way, banks can see how much they might lose were these bets to sour. Crucially, if markets become less volatile, banks can pile on more positions and still have the same VAR. With the exception of Treasuries, markets have indeed become much less volatile—volatility has halved at least in many markets in the past year-and-a-half. Equity markets are now less volatile than they have been for almost a decade. Roughly speaking, if markets are half as volatile, banks' positions can be twice as large for the same amount of capital. But since VARs have in fact risen, some banks' positions are probably three times what they were in the autumn of 2002.
In fact the situation could be still worse. For banks have been increasing their trading exposures in other ways, too. The most notable is via direct investments in hedge funds, often those set up by traders who used to work for the banks themselves. Chemical Bank, now part of J.P. Morgan Chase, started the trend 15 years ago. Now, almost all big banks invest their own capital in hedge funds.
Citigroup may have shut down its “proprietary” trading operations five years ago (temporarily, it now transpires) but it invested a few hundred million dollars of its money in a hedge fund set up by the traders that ran the bank's proprietary trading. Earlier this month, Deutsche Bank leaked that it was also investing $1 billion in a hedge fund run by its erstwhile traders. J.P. Morgan Chase is thought to be the most generous in doling out its cash, but Credit Suisse, Goldman Sachs, Lehman Brothers, and BNP Paribas together invest hundreds of millions of their shareholders' money in hedge funds.
In total, banks have invested many billions of dollars in such funds. The reason, apart from an understandable desire to invest money with good traders, is that the money that is invested in this way is counted as an investment not as a trading position, and so is not included in the banks' own trading books. Most of the money that banks invest has gone into hedge funds that specialise in bonds and other sorts of fixed-income instruments. Like the banks, hedge funds have been leveraging up their exposures to markets.
This activity is splendidly profitable, as long as markets behave themselves. But the strategy puts banks and hedge funds alike at huge risk if markets suffer a severe shock—a far more common occurrence than banks allow for. Their models (and, yes, hedge funds use VAR models as well) assume a certain level of losses for moves of a given magnitude. The problem comes for the tiny number of crises when markets move much more and, to add insult to injury, banks' assumptions about the diversity of their portfolios are shown to be wrong. In other words, the models, says one regulator with a chuckle, are of least use when they are most needed.
By regulatory fiat, when banks' positions sour they must either stump up more capital or reduce their exposures. Invariably, when markets are panicking, they do the latter. Since everyone else is heading for the exits at the same time, these become crowded, moving prices against those trying to get out, and requiring still more unwinding of positions. It has happened many times before with more or less calamitous consequences.
It could well happen again. There are any number of potential flashpoints: a rout in the dollar, say, or a spike in the oil price, or a big emerging market getting into trouble again. If it does happen, the chain reaction could be particularly devastating this time. Banks and hedge funds have increased their exposures most to those markets that they are least able to withdraw from. Think, if you will, of the extraordinary rise in the price of emerging-market debt and junk bonds. “I used to sleep easy at night with my VAR model,” said Mr Wheat in his speech more than five years ago in Monte Carlo. Suffice to say that he suffered a sleepless night or two when that model was found wanting—and that many a bank boss could be in for the same.
Um abraço,
MozHawk
The coming storm
Feb 19th 2004
From The Economist print edition
With markets apparently safer, banks are trading ever-greater amounts in search of higher returns. Expect trouble
IN THE autumn of 1998, at a conference organised by Credit Suisse First Boston in—appropriately enough—Monte Carlo, Allen Wheat, then head of the investment bank, stood up after dinner and delivered a breathtaking mea culpa. Some sort of apology certainly seemed in order given the huge sums the bank had just lost from extravagant gambles on the Russian economy in particular and financial markets in general. The bets went spectacularly wrong after Russia defaulted, financial markets went berserk, and Long-Term Capital Management (LTCM), a very large hedge fund, had to be rescued by its bankers at the behest of the Federal Reserve. CSFB eventually admitted to losses of $1.3 billion. Before the end of this year, the bosses of many big banks may face the same unpalatable task which confronted Mr Wheat if, like him, they have the courage to admit their mistakes.
The reason is simple: the size of banks' bets is rising rapidly. This is because returns have fallen as fast as markets have risen. Yields on corporate debt of all types, for example, have fallen dramatically, and commissions for all sorts of businesses have also dropped. So banks are having to bet more of their own money to continue generating huge profits. But the amount that they have put on the table in recent months has become worryingly large.
So large, indeed, that the present situation “is not dissimilar” to the one that preceded the collapse of LTCM, says Michael Thompson, a strategist at RiskMetrics, a consultancy that specialises in the kind of risk-management models employed by the banks themselves. Like LTCM, banks are building up huge positions in the expectation that markets will remain stable. They are, says Mr Thompson, “walking themselves to the edge of the cliff”. This is because—as all past financial crises have shown—the risk-management models they use woefully underestimate the savage effects of big shocks, when everybody is trying to get out of their positions at the same time.
Even the banks themselves admit that they are taking bigger risks. Though they do not divulge the size of their positions, or in which markets they are concentrated, how much those positions have grown can partly be gleaned from what they have to report in their financial statements.
So-called value-at-risk (VAR) models determine the amount of capital that banks must set aside against their trading positions, and purport to show how many millions of dollars a bank might lose should markets turn against it. Banks report this figure. If a bank's VAR is rising, it is taking more risk—and VARs have been climbing for nearly every bank active in financial markets (see chart). The VAR at Goldman Sachs, which these days is widely viewed on Wall Street more as a hedge fund than a bank, has more than doubled in recent years. One of the bank's senior traders was even told recently that he must take still more risk.
Rest assured that he is far from the only one being told this at Goldman Sachs, or anywhere else for that matter, even though it was only a few years ago that many banks specifically eschewed higher-risk trading as a good way to make money. Earlier this month UBS, a big Swiss bank, said that “with markets and investor sentiment starting to improve” it would gradually increase credit and trading risks.
Even Citigroup, which stopped explicitly trading for its own account a few years back, and HSBC, a bank that used to think of trading as rather beneath its dignity, both announced recently that they too are increasing the amount of trading they do with their own money. And Credit Suisse First Boston, having scaled back its own trading after its 1998 debacle, is also now increasing the amount it devotes to trading, though it claims that it will no longer “bet the ranch”. Allied Irish Banks, which has had more than its fair share of trading fiascos—losing nearly $700m in 2002 thanks to the activities of John Rusnak, one of its foreign-exchange traders—is trying to hire another 20 traders in Dublin.
VAR crash
Of itself, VAR provides a conservative guide to the huge size of banks' current positions. In simple terms, these models assess the amount of risk that a bank is taking by looking at the volatility of the assets it holds and the correlation between them (the less correlation the better). In that way, banks can see how much they might lose were these bets to sour. Crucially, if markets become less volatile, banks can pile on more positions and still have the same VAR. With the exception of Treasuries, markets have indeed become much less volatile—volatility has halved at least in many markets in the past year-and-a-half. Equity markets are now less volatile than they have been for almost a decade. Roughly speaking, if markets are half as volatile, banks' positions can be twice as large for the same amount of capital. But since VARs have in fact risen, some banks' positions are probably three times what they were in the autumn of 2002.
In fact the situation could be still worse. For banks have been increasing their trading exposures in other ways, too. The most notable is via direct investments in hedge funds, often those set up by traders who used to work for the banks themselves. Chemical Bank, now part of J.P. Morgan Chase, started the trend 15 years ago. Now, almost all big banks invest their own capital in hedge funds.
Citigroup may have shut down its “proprietary” trading operations five years ago (temporarily, it now transpires) but it invested a few hundred million dollars of its money in a hedge fund set up by the traders that ran the bank's proprietary trading. Earlier this month, Deutsche Bank leaked that it was also investing $1 billion in a hedge fund run by its erstwhile traders. J.P. Morgan Chase is thought to be the most generous in doling out its cash, but Credit Suisse, Goldman Sachs, Lehman Brothers, and BNP Paribas together invest hundreds of millions of their shareholders' money in hedge funds.
In total, banks have invested many billions of dollars in such funds. The reason, apart from an understandable desire to invest money with good traders, is that the money that is invested in this way is counted as an investment not as a trading position, and so is not included in the banks' own trading books. Most of the money that banks invest has gone into hedge funds that specialise in bonds and other sorts of fixed-income instruments. Like the banks, hedge funds have been leveraging up their exposures to markets.
This activity is splendidly profitable, as long as markets behave themselves. But the strategy puts banks and hedge funds alike at huge risk if markets suffer a severe shock—a far more common occurrence than banks allow for. Their models (and, yes, hedge funds use VAR models as well) assume a certain level of losses for moves of a given magnitude. The problem comes for the tiny number of crises when markets move much more and, to add insult to injury, banks' assumptions about the diversity of their portfolios are shown to be wrong. In other words, the models, says one regulator with a chuckle, are of least use when they are most needed.
By regulatory fiat, when banks' positions sour they must either stump up more capital or reduce their exposures. Invariably, when markets are panicking, they do the latter. Since everyone else is heading for the exits at the same time, these become crowded, moving prices against those trying to get out, and requiring still more unwinding of positions. It has happened many times before with more or less calamitous consequences.
It could well happen again. There are any number of potential flashpoints: a rout in the dollar, say, or a spike in the oil price, or a big emerging market getting into trouble again. If it does happen, the chain reaction could be particularly devastating this time. Banks and hedge funds have increased their exposures most to those markets that they are least able to withdraw from. Think, if you will, of the extraordinary rise in the price of emerging-market debt and junk bonds. “I used to sleep easy at night with my VAR model,” said Mr Wheat in his speech more than five years ago in Monte Carlo. Suffice to say that he suffered a sleepless night or two when that model was found wanting—and that many a bank boss could be in for the same.
Um abraço,
MozHawk