“Sounds to me like you guys are a couple of bookies.”
--Billy Ray Valentine
You don't have to be an industry insider to see that Wall Street has changed. Since last summer, the average financial stock is off 30%, sending shock waves through the economy and corporate chieftains out the door.
To appreciate where we are, we must first understand how we got here. In the storied history of the financial markets, the rate of change has been nothing short of remarkable. The last ten years revolutionized an industry once known for clubby relationships and handshake agreements. The next ten years will forever alter the structural DNA.
When I started at Morgan Stanley
(MS) in 1991, I arrived at my turret while the skies were dark and transcribed derivative positions by hand. As ancient as it sounds, the risk management approach was that
arcane. We "paired" single stock positions into hand-written strategies in an attempt to manage the complex components of our collective risk puzzle.
That meticulous process was standard practice as traders relied on acquired acumen and T-accounts to base million dollar decisions. It was an innocent approach to an intricate machination, where inefficiencies were commonplace until arbitrage emerged to capture risk-free returns.
When we started pricing over-the-counter products in the early 90’s, we would "win" business by 30, 40 or 50 volatility points (a subjective assignment of valuation). Customers would "collar" stock and lay off risk without the requisite footprints and we gladly facilitated the orders.
This was the genesis of the Level III accounting conundrum
that is currently confounding the Street. Whenever engineered financial products are priced as a function of judgment, the risk of subjective valuation manifests and opens the door to human fallacy.
Technology companies awoke to write naked puts in lieu of stock buy-backs. If their short options were exercised, their cost basis was cheaper than it would have been if they simply bought stock in the open market. If not, the premium expired worthless and the income slipped through a tax-free loophole. Wall Street's ReinventionMicrosoft
(MSFT) did it. So did Dell
(INTC) too. They were happy campers and we were a profit machine as the wheels of capitalism greased a seamless coexistence. In time, as other sell-side players entered the market, relative edges rounded and fat dripped from the risk-free bone.
Market efficiency paved the way for new, more intricate risk management products and strategies. If Wall Street has proven anything, it’s an ability to continually reinvent itself, recreate risk and appeal to a customer segment eager to differentiate returns.
The information age democratized finance and paved the way for retail oriented order flow. This introduced a fertile audience to the street as desperate housewives flocked to stocks and the promises they held. We swallowed a bitter pill during the post-bubble spill but many of those lessons have since been forgotten.
During that time, brokerage talent migrated to the buy-side and chased the sexy sirens of hedge fund wealth. That shifted the structural chemistry of the marketplace as neophyte risk managers employed outsized leverage with hopes of capturing smaller moves. Paradoxically, that created compression in the marketplace that was once hidden by the docile tape, range-bound tape.
Due to the coordinated agenda to increase risk appetites following the dot.com implosion, over 60% of the U.S population now invests in the financial markets. That number will continue to appreciate as Wall Street reinvents the investment wheel and politicians identify ways to prolong the inevitable ramifications of our societal addictions. Banks Seek Fatter Payouts
We’ve spoken about the cumulative imbalances for a long time and last year, with the mortgage market acting as a catalyst and upwards of $500 trillion in derivatives tying the world together, that seismic shift seemingly came to bear. The proverbial pebble, as we’ve seen, has profound implications for the pond.
The relative edge of large cap brokers, once predicated on the promise of fat IPO's and advantageous execution, is a thing of the past. Further, once Reg-FD rounded the relative edges of information, customer business shifted to low-cost solutions and volume discounts. That crunched margins on traditional revenue generators and forced banks to again seek fatter payouts with outsized risk.
Financial institutions turned to opaque instruments such as collateralized debt obligations and exotic derivative baskets to generate income. That worked as long as the value of the underlying collateral—in this case, mortgages— appreciated during the real estate bubble. On the other side of that ride, as losses began to manifest in the off-balance sheet holdings, regulators recognized the need to increase transparency and quantify risk.
Thus began the arduous process of capitalizing bank balance sheets and recognizing losses. We’ve already seen more than $100 billion in write-downs by financial institutions as a function of sub-prime mortgage debt. The frightening aspect is that the other side of zero percent financing, be it credit card delinquencies or auto loans, looms large on the horizon.
The Federal Reserve and Treasury Department have been extremely aggressive in their attempt to stem the bleeding and there are nascent signs that their efforts will bear fruit
, if only for a spell.Lighten On The Upside
We’ve also seen the beginning
stages of the transfer of wealth as Citigroup
(C), Morgan Stanley
(MS), Bear Stearns
(BSC) and Merrill Lynch
(MER) open their doors to foreign investors. These infusions are a function of need rather than want but desperate times call for desperate measures.
To be sure, considering that we’ve sliced a third of the value from the world’s largest financial institutions, the potential for an oversold bounce is viable. If perception manifests that risk is contained, we could see a rally that shakes out the bears and emboldens the bulls. It remains my view that those with a longer-term lens would be wise to lighten when and if that upside arrives.
There will always be a Wall Street and a need for capital markets. The trick, for an industry mired in overcapacity and flush with risk, is to proactively adapt before they fall prey to poison they helped create.
And the sooner we take our medicine, the quicker we’ll be on the road to recovery.
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No positions in stocks mentioned.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
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