Monday, April 28, 2008

Come back Glass Steagall all is forgiven!

Q: What do we know, what do we really know?

A: Well we know that a 50lb poodle is a pretty big poodle

And we know that once the foxes get into the henhouse there is only one outcome.

So in all this talk about (lack of) risk management and due diligence and forethought, we shouldn’t lose sight of some pretty obvious lessons from history and the human condition.

It’s not so long ago that the merger/takeovers of the investment banks by the major financial centre commercial banks was hailed as the inevitable way forward. The story was that the only way that investment banks could play in the new world of M&A and prop trading was by having the massive balance sheets of the big retail players at their disposal [how right they were! (Unfortunately)] And so Citi ended up with Salomon and Schroders, UBS ended up with Dillon Read and SG Warburg, Barclays bought some crowd and were BZW for a while; Deutsche got Morgan Grenfell, Credit Suisse and First Boston shacked up too, etc. etc.

Ironically the only natural marriage that didn’t happen was JPMorgan and Morgan Stanley – the old House of Morgan (and perhaps the main catalyst of the Glass Steagall regulation) has not been reconstructed. Maybe they were smart or maybe the tribal memory saved them from the madness.

Thus the foxes got into the henhouse.

Traders with the instincts for the long term of a great white shark got their hands on an all-you-can-eat buffet of capital and gorged [don’t take my word for this see ]. These guys are coin operated risk-reward junkies -- your risk, their reward. In a microsecond they worked out that they had a call option on the assets of the firm. The maximising strategy was to gamble all the way to the high rollers table and then collaborate at that table to up the stakes. so that the pots just got bigger and bigger (using a variety of forms of leverage, misrated financial instruments and pass the parcel strategies).

Who should be surprised?

In the old days the risk takers played with their own capital and maybe that’s why they used to be quite good at it. Now they are crap. Management of other people’s money, (whether as bank capital or in hedge funds) has coincided with a period of disastrous returns to investors. Some of this is explained by the outrageous fees ( annual fees + 20% or more of the upside – what a deal! ) which wipe out returns (ask Warren Buffet -: ) but most of it is explained by human nature and our response to incentives.

But here’s the thought -- the more they are paid the worse they will be!

Come back Glass Steagall all is forgiven.

Pat Brazel discusses topics around portfolio optimization, wealth management and investment strategies for Zignals