Thursday, June 7, 2012

The Rewards to Getting Fired

One of the best things about getting fired typically is that you have no ties and no obligations left to the employer who canned you. But, recent trading losses at JP Morgan and trading gains--on the opposite side, at Saba Capital Management, suggest that public policy require employees who lose big, to stay on the hook for trading losses to former employers.

In the first half of 2012, the JP Morgan Chief Investment Office, established short positions in credit derivatives--the Investment Grade Series 9 10-year Index CDS--that were hedges to credit swaps--themselves hedges to JPM's huge loan portfolio. These positions were so large that the trading community interested in such things began calling the anonymous trader behind the trade, Bruno Iksil in the JPM London office, the Whale. The trade was presumably legal (though there are ongoing investigations), but was highly illiquid, and because it was on the short side, vulnerable to limitless loss on the upside.

From offices on the 58th floor of the Chrysler Building in Midtown Manhattan, Boaz Weinstein runs a $5.5 billion hedge fund firm called Saba Capital Management. Before starting Saba, he was responsible for a team at Deutsche Bank that lost nearly $2 billion, in the depths of the financial crisis, in 2008 almost causing the Bank's collapse. He founded Saba with 14 other members of the team at he supervised at the Bank. Assuming the trading loss was the result of completely legal acts, then SABA has no legal liability. But, the optics were terrible.
As Bruno Iksil was diving deep into the Series 9 10-year Index CDS, Weinstein detected the size and vulnerability of the JPM position. At a conference earlier this year, he recommended going long the Series 9 10-year Index CDS. It was, as the Times, wrote, specific and direct and aroused attention in the hedge fund community. From then on, it was whale against whale and also a massive short squeeze.

In April, the trade moved against JPM and, at first, the bank minimized any potential losses, but by early May JPM indicated that the losses would in the $2 billion range, even though the trade had not been closed out. Because it was not, losses could be larger still. Presumably, that meant that Saba and Weinstein, with others, were huge winners on the long side of the short squeeze. So, Saba Capital and Weinstein, who had a reputation for beating casinos by counting cards, won big and JPM lost big.

Normally, public interest over the distribution of any trade would seem unusual--one guy wins, the other loses, so what? But as the size of the loss suggests that the implications are bigger than a battle between whales. It has become clear that if the trade had been large enough, losses from it could have imperiled the solvency of JPM and possibly required a taxpayer bailout. Now, perhaps this trade could never have gotten so big before the JPM risk management apparatus kicked into gear, but perhaps not--the Long Term Capital Management fiasco clearly demonstrates that a highly capitalized firm full of brilliant analysts and traders could squander its entire equity very rapidly-- in LTCM's case less than a week.

One can argue that Iksil was simply a rogue trader and he will get fired and go to jail; but what if everything was, as it seems to be, entirely legal? How could such a thing happen and could it happen in the future? The point is that there are huge systemic incentives to individual traders (like Bruno Iksil and as there was to Boaz Weinstein) to bet the bank because the penalties to losing are non existent and rewards huge. Indeed if Weinstein's career is an example, the rewards to losing a lot of money --"getting fired" and then establishing a hedge fund--may be greater than the rewards to winning as bank employee. And, equally scary, it is clear that the greater the bet, the greater is the market recognition of the trader--win or lose. Even more disturbing, the larger the trade, in sheer size, not in terms of risk but in size alone, the greater the incentives between bank and trader/employee diverge. The bank's risks increase dramatically with the size of the bet, while the employee value gains in the market. You would think that such a trader would be toxic as toxic as the trade but not so. This sounds perverse--and is.

So, Boaz Weinstein, who almost buried Deutsche Bank in 2008, benefited tremendously from bringing his employers to the edge. Should Bruno Iksil, who may have buried JPM in 2012, set up his own hedge fund he would be positioned to benefit also? Is this good public policy to allow these incentives to stay in place? Of course not. Why shouldn't shareholders of Deutsche Bank seek to recoup losses that Weinstein generated in 2008 from his profits in 2012? And, why shouldn't Iksil be obligated to pay JP Morgan back from any win fall profits he makes if hedge fund succeeds?

Finally, why shouldn't there be equal claw back provisions to executives and board members of banks if the losses are so great that a taxpayer bailout is required?
There are no such provisions in the law and public policy, and there should be or this kind thing can and will happen again and again.

Anybody say moral hazard?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
This article is tagged with: Economy

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