Thursday, September 22, 2011

How Do You Lose $2 Billion, Part II

News has continued to trickle out regarding the UBS rogue trader in London who lost $2 billion of the bank’s money. But not much news. It has dropped completely off the top stories on my Google news feed. There is plenty of speculation out there, however.

One piece of the story that has been out from the beginning is that the trader in question worked at the “Delta 1 trading desk” in UBS’s London office. This is a standard department in all of the big global investment banks. What these trading desks do is engage in trades for securities that are supposed to move up and down in lockstep. A change (or delta) in one stock of 1%, should be matched by a 1% change in other stocks. Of course, with any actively traded security, the correlation is never perfect, which opens up opportunities to make money.

The Delta 1 desk is supposed to engage in arbitrage, not speculation. Speculation involves swinging for the fences. Bigger risks, but correspondingly bigger rewards. Arbitrage, on the other hand, is about engaging in risk-free transactions that still provide a positive return.

Let’s say you are speculating on the price of wheat. Based on your analysis of global weather patterns, you think the harvest will be bad, and wheat prices will be higher a year from now. You can go into the futures markets and contract to buy (a long position) 10,000 bushels of wheat a year from now, with a price of $1.60 per bushel. A year from now, if you are right, the spot price of wheat goes up to $1.90 per bushel. But your contract says you can buy at $1.60. Your contract is now worth 1.90-1.60, 30 cents a bushel. But there is no guarantee. If the price of wheat actually falls, you can lose money. That’s speculation.

Now change the situation. Imagine that someone will sell you 10,000 bushels of wheat today for $1.50 per bushel. They’ll store it for a year for $200. Your cost of capital to buy the wheat is 5%. You buy the wheat, and then you go into the futures market and contract to sell (a short position) the wheat a year from now at the same $1.60 per bushel. Your costs for wheat, storage, and interest are $15000+200+750, for a total of $15950. A year from now you deliver your wheat and collect $16000. You make a small profit of $50. But by buying and selling simultaneously, you have eliminated any risk. The weather can be good, bad, or indifferent. You are insulated from movements in the spot price. That’s arbitrage.

What Delta 1 traders are supposed to be doing is arbitrage. The net total of your buy positions and the net total of your sell positions are always supposed to be close together. That way your bets are hedged. You can’t make much money on any individual trade, but if something unexpected happens, you won’t lose a lot of money either.

What UBS’s rogue trader was doing was faking one half of the equation. He was placing large speculative bets, and then falsifying the paperwork on the offsetting hedges. Eventually, someone noticed that things weren’t lining up properly, and he was caught.

But $2.3 billion is a lot of misalignment.

Sunday, September 18, 2011

UBS Loses $2 Billion: Part I

The financial world was rocked by a scandal last week. UBS, the giant Swiss bank, announced losses of over $2 billion in unauthorized trades. The losses were generated by one trader in their London office.

The obvious reaction is "Two billion dollars! How does one guy lose two billion dollars?"

We don't know yet, and the details will only trickle out over the next few weeks. Already this weekend, UBS has revealed that the trades that generated the losses occurred over a period of about three months, and that the total losses came to about $2.3 billion.

"Two point three billion dollars! How does one guy lose two point three billion dollars?"

We have now seen enough of these "rogue trader" cases to make a few predictions about the story that will emerge as the investigation continues.

1. It started out much smaller. These guys don't start out placing $2 billion bets in the giant global casino known as our modern capital markets. Far more likely is that he screwed up some trades, maybe from something as mundane as a keystroke error. "Sell a million euros at the preset price. At most I'll lose a million. Holy crap, how did that extra zero get in there!" You lose a big enough chunk of money, and you will get fired. So now the thought process runs "I can't tell my boss about losing $10 million; I'll get fired. And my swanky bachelor pad costs $10 grand a month in rent. I have to earn that money back."

2. Risk controls were defeated. In the giant global casino known as our modern capital markets, the senior management of the investment banks is aware that it might not be the best idea to hand company credit cards with no limit out to a bunch of testosterone fueled 25-30 year olds who are amped up on Red Bull. So instead, they give them cards with credit limits. Essentially, every bank has systems in place to measure how much the bank could potentially lose from each trader's positions. In every case of a "rogue trader" those systems have been circumvented. Part of the problem here is that the big money is made by trading, and coming up with newer, ever more exotic financials instruments. The small money is made by working in risk management. The best and the brightest aren't clamoring to work in the field.

3. The problem got much bigger quickly. Once you've lost a bunch of money, decided to try and make it back, and figured out how to make bigger and bigger trades without senior management catching on, you start doubling down on your trading positions. Trading positions are what ordinary people would call betting, but we don't work in the giant global casino known as our modern capital markets. Let's say you start by losing $10 million. You place another $10 million bet to get it back. Once you lose that, now you've got to make $20 million back. The losses can grow geometrically at this point. If you double down and lose it all every time, it only takes 8 trades to get to the level of losses experienced by UBS.

The rest of this story will eventually emerge. When it does, I'm going to try and put the details into plain English.

Thursday, September 8, 2011

Unemployment: We're On Our Own

The President is scheduled to make a major address on jobs and job creation this evening. He is going to unveil his plan for reducing the unemployment rate below the 9% level where it seems to be stuck. I plan to be doing something else during the speech, maintaining my near unbroken, bipartisan record of skipping presidential addresses.

President Obama will probably propose a bold new program of infrastructure rebuilding. This will be combined with tax credits for companies that hire new employees and maybe a request for money to retrain displaced workers. This will be combined with lines like “let’s get this country moving again.”

The problem is that almost none of what he proposes is going to work. Tax credits have been tried before, and failed miserably, during the Carter administration. A $500 credit, or even a $1000 credit, simply is not enough incentive to convince employers to add on employees they don’t need. Conversely, if you do need to hire someone, you are going to do it whether tax credits are available or not.

Retraining sounds like a good idea, but community colleges are set up to produce entry level employees with no experience. Taking a couple of classes for six months to a year will not lead to a new career.

As for a massive Federal jobs program, that is going to run into fiscal realities. The government is spending 40% more than it is taking in tax revenue. A bipartisan super committee of Congressmen and Senators is currently doing the planning for a major round of spending cuts.

Besides, what does an infrastructure rebuilding program really consist of? A bunch of work crews filling potholes and painting bridges. Does anybody really think that an unemployed office worker who’s a hundred pounds overweight is going to take a job on a road crew? Those positions would probably be filled by illegal immigrants with fake social security numbers.

Nope, a big jobs program is an idea that would be dead on arrival. All that’s left is a bunch of high sounding phrases about how the government is no going to abandon the people who need help in this crisis.

Now, it is easy for me to be blasé about the unemployment rate. After all, I still have a job. But it seems to me that the best thing the President can do about jobs in this country is tell the truth: we’re on our own. It is not the Federal government’s responsibility to provide jobs. Even if it was, deficit spending has reached its limit and beyond.

Anybody who is waiting for the Feds to ride in like the cavalry and create a bunch of jobs is going to be sorely disappointed. The first step to solving a problem is to admit that the problem exists. Everybody agrees that high unemployment is a problem. But the second step towards solving a problem is taking ownership of the problem. As long as we think it is the President’s, or Congress’s, or the Federal government problem to solve unemployment, people will not take whatever necessary steps to reinvent themselves and find work.

You see, it is up to us, to get this country moving again.