THE BEAR'S LAIR Was Enron right?
By Martin Hutchinson
The huge profits reported by Goldman Sachs and the investment banking end of JP
Morgan Chase last week surprised markets and demonstrated once again the power
of trading operations to earn spectacular returns for their protagonists and
even occasionally for investors.
It was of course the theory of Jeff Skilling and the late lamented Enron, of
which he was president and chief executive, that in the new wired world,
business would increasingly be done from trading platforms to the great benefit
of all. So was Enron not, in fact, an obviously malevolent scam that deserved
to get its top official a 25-year jail term, but a noble misunderstood pioneer
of 21st-century business?
The Enron thesis was an attractive one at first blush. Commodity
and energy distribution is an expensive business, but the advent of Internet
technology and efficient communications enabled costs to be taken out of it by
making each stage of the distribution process tradable, with price discovery
through open bidding rather than by wholesalers negotiating individually with
Similarly, financial services could be made more efficient by taking loans off
balance sheets through securitization, enabling home mortgages to be traded in
bulk across New York trading desks and packaged to investors in Dusseldorf.
Removing all those middlemen and shining the light of the market into obscure
local operations should both normalize prices and reduce costs.
It all sounded very plausible when I heard Skilling expound it at a conference
in April 2001, even as Enron's stock prices had gone into unexpected freefall.
Whatever the man's failings, he gave a hell of a presentation.
We now know the fate of Enron and the home mortgage securitization market,
which suggests there had to have been a flaw in Skilling's glossy presentation,
whether applied to energy or financial markets. Nevertheless, the most recent
earnings of Goldman, JP Morgan and indeed Bank of America (the last of which
rested largely on good results at Merrill Lynch) suggest that 25-year jail
sentences are not the inevitable outcome of practicing this theory; great
wealth may also eventuate, at least for traders.
Trading is among the most intellectually opaque of all ways of making money.
Modest analysis can uncover the secrets of profitability at almost all
businesses, at least post facto, but not those of trading. Traders seem no
cleverer than the rest of us, and rather less endowed with charm, although they
clearly have excellent nerves. They are also unable to explain how they make
money, or at least extremely unwilling to do so. Even books such as the
excellent if annoyingly arrogant best-sellers of successful ex-traders such as
Nassim Nicholas Taleb (The Black Swan) offer little further
enlightenment beyond massive helpings of rather dubious philosophy.
One can understand "buy low and sell high". But if it were as easy as that, why
couldn't everybody do it? Furthermore, why are the most successful traders
almost all concentrated in the same houses? There appears to the naked eye very
little difference between a trader at Goldman Sachs and a trader at a
second-tier European bank, yet only the Goldman guy is likely to become
There are two major secrets to success as a trader. One is to figure out a
methodology that works in the short term, even if it is likely to cause a
gigantic disaster later on. Most of the money made in trading mortgage bonds
resulted from this approach. The existence of fashionable, fallacious
risk-management models such as "Value at Risk", for example, enabled traders to
pile on debt and thereby achieve attractive returns through huge leveraging of
modest differentials between interest rates.
This strategy becomes particularly attractive if the US Federal Reserve is
forcing short-term interest rates down to levels far below long-term rates, as
it has since 1995. Indeed, since long-term interest rates declined steadily
from 1981 to December 2008, many traders in the debt area were able to spend
their entire careers in an arena in which a modest level of profit, year after
year, was built into the structure of their operations. Yes, there was the
occasional year in which short-term and long-term interest rates backed up, but
the last such year in which debt trading was economically unattractive was as
long ago as 1994.
That works for debt products, but not so well for stocks, which are less
attractive vehicles for leverage games because their prices bounce around too
much, so that even the doziest risk managers won't let you borrow too much
against them. However, during the glory years of 2003-07, trading desks found
an attractive alternative means of generating steady leveraged gains, through
their investments in privately held hedge funds and private equity funds, and
complex untraded securitization structures.
These investments were justified as asset diversification, though in reality
most were not "alternative" at all but heavily correlated to the stock or real
estate markets. Their true attraction was that their value could be assessed
only through the mathematical models of the trading desks themselves. Through
the fashionable "mark to market accounting", their book value could then be
marked up by a moderate amount each year, and profits taken into earnings on
which bonuses were based.
Leveraged with debt at low interest rates, those moderate returns were
sufficient to provide juicy bonuses to participants. Since many of these
investments eventually produced losses in 2008 (and many others will eventually
do so), the traders were essentially playing the same game as the Ponzi schemer
Bernard Madoff - the difference being that at least some of them may have been
unaware of the fundamental swindle of outside shareholders that was taking
While the intrinsic profitability of leveraged long bond positions in a secular
27-year bond bull market explains the sleek appearance of even regional bank
debt traders in the last couple of decades, it does not explain the
profitability of Goldman Sachs and JP Morgan today, as interest rates have been
rising in 2009. Private equity and hedge funds have had quite good years so
far, but that could not have been relied upon in advance. However, for the
largest participants in each market, there is another source of trading
products - the ability of dealers to profit from insider information.
Trading on insider information about the operations of client companies was a
major source of Pierpont Morgan's original fortune, and of those of many London
merchant bankers, but has been illegal since the 1930s and prosecuted with
gradually increasing ferocity by the Securities and Exchange Commission.
Presumably, investment banks today profit from this kind of information only
occasionally, although there will certainly be some leakage between the client
side of the largest banks and their trading arms (and most of them also have
research operations, whose information falls into a gray area).
However, there are many forms of inside information, in the sense of
information that the general universe of investors does not have. Probably the
most important, even more important than company operating information, is
information about large investors' moves into particular securities or markets.
Armed with this knowledge, a trader can manipulate the market so that his
positions always swim with the market current, never against it. In the less
transparent markets, such as those for options, credit default swaps and many
other derivatives, traders who are aware of a substantial portion of the money
flows can manipulate prices, let alone the parameters such as volatility that
serve as inputs to the ubiquitous mathematical valuation models.
This explains the recent sudden increase in the profitability of the largest
trading desks. Bear Stearns and Lehman Brothers have exited the market, and the
number of large non-US participants dabbling in US markets is way down from two
years ago. Hence the profitability of trading in general for the remaining
houses has jumped because their level of information on market activity has
jumped. I would expect that to have been particularly the case in markets such
as options and credit default swaps, in which prices are opaque and
manipulation relatively straightforward (apart from the possibility in CDS
markets of playing profitable games with actual defaults, the number of which
has risen in the recession far above the long-term average).
That's why Goldman and JP Morgan were particularly keen to get away from
Trouble Asset Relief Program funding, and reestablish their independence from
government interference. The existence of hobbled competitors, such as
Citigroup and Bank of America, who have not managed to escape from the
government and whose management is in turmoil, doubtless gives Goldman and JP
Morgan an additional advantage. A lengthy recession, with international banks
licking their wounds from losses in the US market, would be their ideal; in
such an environment their trading market shares will remain dominant.
Skilling of course understood the advantages of superior knowledge of market
flows; that's why he leveraged Enron to the hilt to gain market share (the
leverage eventually proved fatal - it proved to be impossible to run a huge
derivatives operation with a BBB credit rating). The supposed benefits to
society of distribution migrating to trading desks were mostly flim-flam. The
additional profits gained by such migration go almost entirely to the traders,
not to society as a whole. Likewise in the home mortgage market, the migration
from Jimmy Stewart making home mortgages directly to Wall Street securitizing
them added about 20 basis points (0.20%) to the cost of a home mortgage,
expressed as a margin over Treasury bond yields.
Both Enron's and Wall Street's trading operations were primarily rent-seeking
exercises, and extremely successful ones. The selective bailout of Wall Street,
by increasing market concentration, has increased the profitability of the
Goldmans and JP Morgans, as well as made it even more difficult for small and
even medium-sized finance providers to compete - I think it almost certain that
the juicy second quarters at Goldman and JP Morgan will prove NOT to have been
shared by the regional banks. (CIT's bankruptcy or near-bankruptcy is another
data item proving the same point; if credit provision itself had been
profitable in 2009, CIT would now be laughing).
For the rest of us, there are clear antitrust implications. "Too big to fail",
if it includes a trading operation, needs to be broken up to prevent the
rent-seeking of market dominance (which comes at the expense of the rest of
us). If President Barack Obama and Treasury Secretary Tim Geithner were not
getting their advice from Wall Street, they would already be preparing
legislation to achieve this. As it is, such legislation will have to come from
such anti-establishment figures as Rep Ron Paul (R-Texas), sponsor of a bill to
audit the Fed, and Rep Maxine Waters (D-Calif), sponsor of a bill to ban credit
Meanwhile, justice demands that they free poor Jeff Skilling, who was only a
far-sighted pioneer of the new Wall Street.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-09 David W Tice & Associates.)