Wednesday, September 30, 2009

Network lock down

Tim Harford has a good overview of the network lock down.

Not everyone buys the story of QWERTY lock-in. The American economists Stan Liebowitz and Stephen Margolis call it “The Fable of the Keys” – pointing out that the evidence for Dvorak’s superiority is sketchy. (That Navy test? Conducted by a certain Lieutenant Commander August Dvorak, who owned the patent…) For Liebowitz and Margolis, network lock-in is an interesting theoretical possibility, but in practice they argue that people find a way to move to the new standard.
An intriguing new experiment supports that idea. Tanjim Hossain and John Morgan recruited Hong Kong students and paid them money if they were successfully able to coordinate on the same “platform” – an abstract representation of the choice between standards such as a Blu-Ray or an HD-DVD. What really mattered was to choose the most popular platform, and the students did that – but they also managed to coordinate a move to the higher-quality choice, even if they had started off on the low-quality platform.

The loss of the Bund contract from LIFFE to the DTB is a good example of this change over. There is an interesting paper to be written there. Some background in an Independent story.

Sunday, September 27, 2009

Banking compensation (part 2)

The NYT has an article on compensation in the banking sector.

PROFESSOR STULZ also notes that bank C.E.O.’s lost a lot of their own money during the credit crisis.

He and Professor Fahlenbrach studied 98 banks that were part of the Standard & Poor’s 1500-stock index at the end of 2006, relying on the government’s Standard Industrial Classification system to determine which companies to consider as banks.

They found that the C.E.O.’s of these banks lost more than $30 million, on average, of their investments in their own banks in 2007 and 2008, and that the executives who headed Bear Stearns and Lehman at the onset of the crisis lost close to $1 billion each.

“If the prospect of losing those amounts was insufficient to induce the firms’ C.E.O.’s to pursue different policies,” Professor Stulz says, “it’s extremely difficult to imagine any compensation reform package that contains incentives that would do the trick.”

Saturday, September 26, 2009

Bank bonus

The pitchforks are out and the mob is off and running. Amidst the green-eyed hysteria over bank bonus payments, there has been little evidence to suggest that 'excessive' bonus payments are responsible for the recent crisis. Indeed, amidst it all, there are a couple of counter-points. First, The Epicurean Dealmaker gives us an overview of investment banking compensation. The highlight.

There are a lot of knocks you can legitimately put on Wall Street, but claiming investment bankers take crazy risks just so they can walk out the door December 31st with pockets full of cash, free and clear of future effects on their employer, is not one of them. Unlike the public shareholders in their firms, who are mostly highly diversified and therefore have far lower relative exposure to the health and survival of any one bank, investment bank employees can't yank their accumulated years of compensation out of their employer when the shit hits the fan. They are stuck, and they have a hell of a lot bigger personal stake in the future health and survival of their firm than any public shareholder.

The second is a filling by the late-great Lehman Brothers on their stock incentive plan and a WSJ article outlining the exposure of Lehman employees to the firm.

Tuesday, September 22, 2009


Following up the comments by Gillian Tett, Lex offers a slightly less Machiavellian view of the Barclays disposal.

“The transaction is, if you like, a way of swapping the fair value adjustment that would otherwise be taken on a monoline downgrade over a longer period of time through reduced net interest income,” said analysts at Credit Suisse.

But the analysts note the danger is that the market will continue to view the exposures as before and that any monoline downgrade will be taken badly.

Other analysts are concerned that, in return for stability, Barclays is giving too much away to Protium’s backers and managers.

Cayman Islands-based Protium is providing $450m of funding for the assets, mostly from two unnamed substantial US and UK investors.

The investors will be entitled to fixed payments of 7 per cent a year for 10 years on their initial investment. Any excess cash flow after repayment of the loan to Barclays will also be taken by the investors.

C12, a US asset management company that runs Protium and is mostly made up of former Barclays Capital executives, will also see some of the benefits. C12 will receive a $40m annual management fee to administer the assets.

And while Barclays is transferring a chunk of the risk, it is also handing away some of the potential upside to Protium and C12 if the values of these assets recover.

If assets of $12bn went up in value by just 1 per cent, the Protium investors could have made $120m on their original $450m investment – a return of 25 per cent.

Not only that but Barclays could be exposed to any downside if the assets fall in value. Protium has working capital but does not have an equity cushion to burn through before taking losses.

The cash flows come from assets that were once valued at far more than $12bn and so Barclays believes that even if some of the assets fell in value it would not disrupt the cash flows to the extent that its loan is impaired.

The structure of the deal also means that Protium and C12 receive payments from the cash flow ahead of any interest payments made on the Barclays loan.

“This structure is unusual as it implies Barclays’ loan is subordinate to the management fees,” said one analyst.

Another oddity is the fact that Barclays has derecognised the assets on its balance sheet for accounting purposes but has kept them on its balance sheet for regulatory reasons.

Nevertheless, Barclays’ move could be the first in a series of these types of deals as investors seek to make a return on these toxic assets – particularly if the banks involved are prepared to offer juicy returns.

Friday, September 18, 2009

The cellar

Gillian Tett re-uses the cellar analogy to look at Barclays' disposal of sour assets. What is not clear, however, is whether the separate legal entity means that the fund can fail without doing damage to Barclays.

In theory, regulators could preventjavascript:void(0) that outflow, if they were willing to clamp down on the unregulated world in a co-ordinated way. In practice, though, western leaders are finding it so tough to agree on how to reform the front rooms of finance that I seriously doubt they will have the energy to attack the cellars too.

Thus far, few banks have had the political chutzpah to exploit that situation too brazenly. Barclays, however, now appears to be blazing a trail of sorts – and I would hazard a bet that plenty more banks will be tempted to follow suit. So stand by to see more Protium-style deals emerge in the coming months. After all, financial cellars can come in numerous forms – and, it would seem, ever more weird names.

Thursday, September 10, 2009

John Kay discusses Lord Turner's view on the social wealth of financial services. He says:

But more explanation is required. If my guess about the MPC decision is correct, someone on the other side of the trade gets it wrong. This activity may be very profitable for particular individuals and firms, but the gains and losses should net out for the financial sector as a whole. How can proprietary trading have been a very large source of earnings and profits for a large industry?

I find it hard to believe that this proprietary trading is really the main source of revenue. Kay goes on to suggest explanations:

Explanations fall into three broad groups. First, the profits arise from government-created distortions, particularly state guarantees of the liabilities of financial institutions and opportunities for regulatory arbitrage. Second, profits are made at the expense of the customers of financial institutions. Corporate treasurers, pension fund managers and individuals mistakenly believe they can outwit dealers at investment banks. Trading firms that are also marketmakers use knowledge gained from one activity to profit in the other. Third, the profits are illusory; the reported gains are either borrowed from the future or from other segments of conglomerate financial institutions.

There are a few government distortions - obviously the GBP exit from the ERM was a classic example of that. Breaking of pegs is a big earner, but it does not happen very often and money is also lost when the peg is not broken. Some profits come at the expense of customers. However, this is mostly a high volume low margin business that is not really proprietary but serving customers. The larger firms have experienced treasury staffed by ex-industry people; the smaller firms pay but are also expensive to service because of the odd lots and small volumes. True proprietary profits probably are illusory: the come in the good times and disappear in the bad times. The carry trade and its unwind is a great example.

This also helps to explain the cyclical nature of the proprietary game: others are making money, it looks so attractive, we get into the game and then it blows up and we vow to keep out of this business until the next time.