Volcker Rule: Point of No Return

Volcker's rules: Any day now

Three years have elapsed since regulators proposed new regulation to restrict proprietary trading at banks (more specifically, depositary financial institutions).  Three years of discussion, debate, rule-writing and re-writing, dissension, lobbying, and procrastination. 

And now the new rule, better known as the Volcker Rule and named for former Federal Reserve chairman Paul Volcker, who first proposed limits on bank trading during the crisis, has reached a point of no return.  Regulators--the SEC, FDIC, OCC, CFTC and the Federal Reserve--have promised to sign off before mid-December.

Banks aren't surprised. They aren't caught off guard. They knew an old era of gun-slinging, wild, volatile, frantic, but overwhelmingly profitable proprietary trading at the major banks was coming to an end.  While regulators and their lawyers sequestered themselves for years to write hundreds and hundreds of pages of rules, banks tried to push back and soften the blow. But they knew they wouldn't win much of this tuggle, although they poured resources and time into the effort.  They had already begun to scale down prop-trading activity. 

New rules will prohibit outright proprietary trading (trading for banks' own accounts using their own capital), but will permit trading for clients, trading for hedging purposes and limited hedge-fund activity. And therein lies profound complexity.   

Regulators have spent the past three years trying to define all possible scenarios of client trading, hedging, and hedge funds with such fine-tooth clarity that banks won't be able to exploit loopholes in the way they can do adeptly and profitably to their advantage--and, in the eyes of regulators, at the expense of clients and individual customers.  Regulators, worried about how banks can exploit omissions in the rules, have tried to cover every base in hundreds of rules-making pages. 

Despite regulators' attempts at clarity, banks now prepare for the burdens and chores to remain in compliance.  Banks know well that trades that look like, feel like and were booked as client trades might evolve into prohibited proprietary trading.  New rules will allow "inventory" (securities and derivatives on banks' balance sheets) to exist on banks' balance sheets as items on a shelf to sell to clients.  But Volcker rules might define inventory exceeding a certain level or inventory maintained for more than a certain number of days as illegitimate "proprietary activity" (and determine it to be out of bounds). 

Banks that choose to remain prominent in sales and trading will need to invest in an army of compliance personnel and significant amounts of infrastructure to ensure they stay within client-trading or hedge-trading boundaries. A nightmare for some banks. An onerous cost of doing business at others. 

Volcker proponents say the new rules will reduce the likelihood of another round of "Whale Trading" losses at places like JPMorgan Chase, which lost over $4 billion from credit-derivatives trades in 2012. Critics and JPMorgan argued that "Whale-related" trades would have been permitted by Volcker rules. (JPMorgan launched the first phase of these trades for hedging purposes--to hedge credit risks in its large loan portfolio. But the trades piled on top of each other and the massive positions turned into something very "proprietary.")

Now big banks across the U.S. must decide (and have decided) whether (a) to stay in the game of securities and derivatives trading and eke out profits from client-driven flows or (b) to retreat, withdraw or just get out.

The bulge-brackets, such as Goldman Sachs, JPMorgan, and Morgan Stanley, are fully invested, have been adapting to a Volcker world. The big banks have resigned themselves to declines in trading revenues as much as 10% (25% at Goldman, one analyst contends). They hope to turn their once-magnanimous trading desks into humming, full-throttle plays on volume and flows.  Their desks have been reorganized and restructured.  They've shuffled talent, shut down some desks, invested in automated trading systems, and allowed many traders to seek employment at hedge funds.

Other banks have withdrawn and expect to engage in a token amount of trading at modest levels and minimal volumes--all client-related or tied to risk-management hedges.

In 2014 and beyond, critics, proponents, and regulators will watch banks closely.  Some say liquidity in certain sectors of capital markets will diminish, because large well-capitalized banks won't be able to buy, sell, and hold in large amounts of securities in the way they could before.  Some (municipalities, for example) say rates on bonds may increase because of diminished liquidity, because banks will nudge margins up to account for lack of liquidity, and because banks won't be to rationalize holding any inventory. 

(Imagine scenarios where banks can rationalize economically holding large amounts of securities/derivatives in inventory even for eventual client sales, but will choose not to build up inventory for clients to avoid the risk of penalties of not complying with Volcker restrictions.) 

Some say the best talent for managing trading volumes, risks, portfolios and positions will no longer reside at banks. Some say new rules will discourage financial innovation, because banks often trade and make markets in new products in large volumes to generate interest and liquidity. (Banks don't push new trading products if the profit dynamics don't make sense.)

Yet others contend we won't see those periodic billion-dollar trading losses because banks' "prop desks took a view" of the market or tried to guess interest-rate trends, commodity prices, or economic indices in their efforts to make gobs of money from proprietary positions.

At least for a while in 2014, banks will routinely convene troops of lawyers, traders and compliance officers to figure out this new world. It won't be easy. What happens if a bank amasses a position with intents to sell to a client, but the client decides not to pursue the trade? Will a regulator slap the bank's wrist right then and there? What happens if the bank purchases certain derivatives to hedge a portfolio, but volatile markets abruptly change the hedged position into an huge, unhedged derivatives position?   

Somebody within the banks' troops will be required to spend all-nighters trying to determine the  section in the hundreds of rules pages that cover these scenarios.

Tracy Williams

See also:

CFN:  The Volcker Rules, Here They Come, 2011
CFN:  Volckerized, 2010

At JPMorgan Chase, Is $13 Billion a Lot of Money?

The $13 billion: It can handle it.

A question has lingered for much of the past week, one that hasn't been asked often out loud or asked pointedly. Is $13 billion a lot of money for JPMorgan Chase? 

Will it crush the bank's growth plans and business opportunities in the periods to come? Will it strangle a banking empire and cause it to retreat into a shadow of its post-crisis self?

Announced in business headlines everywhere, the $13 billion is the total amount in the bank's settlement with the U.S. Department of Justice, all related to the bank's mortgage-securitization business in the 2000's and the businesses it inherited from its acquisitions of Bear Stearns and Washington Mutual. 

The government claims JPMorgan and affiliates improperly and unfairly structured mortgage securities, leading to billions in losses to investors who had purchased the securities. The settlement puts an end to one chapter in the bank's efforts escape the mortgage nightmare of that decade. 

For a financial institution with market value and book value in the hundreds of billions and with billion-dollar earnings announced every quarter, is $13 billion a lot? Let's decide.

Of the $13 billion, about $7 billion is tax-deductible.  Hence, the bank will have a benefit on its tax books (reduction in tax liability, e.g.) of some kind for about $2-3 billion, effectively reducing the "pain" of the settlement by that amount. 

Of the $13 billion, about $4 billion is slated for mortgage relief for homeowners.  Banks and investors who hold those loans or hold securities backed by those loans have likely written them down, charged them off, or set aside significant reserves.  If JPMorgan continued to hold some of those loans and securities on its books, the settlement amount captures assets that the bank had previously written off or planned to write off. In effect, the settlement number acknowledges and accounts for write-offs the bank already took (related to mortgage securitization).

The rest comprises payments to state regulators and to investors who bought mortgage securities and suffered substantial losses.  In the $13 billion, the net cash payments due to organizations, regulators, and investors amount to something less than $8-9 billion (estimated). 

In 2012, the bank (consolidated) reported $21 billion in earnings. It operates at a pace of generating about $6-7 billion each quarter (or about $24-28 billion/year). Hence, a gross $13 billion settlement doesn't result in fiscal-year losses (comprising about half of expected annual income).  The bank will continue to be profitable, expecting to report profits above $15 billion in 2013 and above $25 billion in 2014. 

Even more, the bank indicated it has already set aside reserves (and adjusted financial statements) to account for the entire $13 billion--including about $9 billion in legal reserves (including write-offs and loss provisions) in the third quarter in anticipation of various legal settlements. 

JPMorgan's equity base exceeds $206 billion, an amount that has already netted out much, if not all, of the $13 billion. A $13 billion settlement comprises less than 7% of equity, if it had not already made equity adjustments for such charges. As massive as the number appears in headlines, $13 billion won't put the institution in financial peril. 

Has the bank's market value (share value) suffered because of the settlement?  In recent weeks, as the public heard rumors and eventually learned about a finalized settlement, the bank's share price didn't plummet and even flirted with record levels.  That's because the market, whether it's partly or fully efficient (depending on which finance theorist you believe), had already accounted for all possible losses related to the settlement.

Equity markets, too, like companies that flush out losses and start anew.  Markets like companies that erase vast amounts of uncertainty (especially related to lingering legal issues).  Markets appreciate and value companies when they clean the slate and eradicate such hangover. 

Then there are regulators, who have applied an increasing burden of capital and liquidity requirements to big banks. Does the $13 billion jeopardize regulatory compliance? Not really.  The bank had already begun to retain, boost and increase capital to comply not only with capital requirements of today, but the progressively increasing requirements over the next few years.  Its regulatory ratios were in good shape.

New regulation has certainly annoyed JPMorgan (and its peers) and has stifled business activity in certain segments (trading, the best example).  The bank continues to grapple with new rules regarding trading, leverage and liquidity.  But the settlement hardly influences the scenarios the bank confronts on these fronts.

Still, $13 billion is still a mind-boggling total, so it has to hurt somewhere, if capital ratios, earnings, balance sheet, and stock price have not felt pain.  Moody's, the ratings agency, in November downgraded the holding company a notch, but the downgrade had little to do with settlement figures, more to do with systemic issues and how Moody's suspects big banks can manage through crisis scenarios. 

Some "hurt” or injury should exist, contends the Justice Department, which wants the bank to comprehend the impact of its past actions.  The bank has weathered public embarrassment, glaring headlines and threats to gilded reputation, but all that could be short-lived, as regulators and the media move on to the next big issue plaguing financial institutions. 

For now, the "pain" of the settlement is not financial. Could there could be a cumulative, damaging effect from having to ward off the slings and arrows of many legal issues at once? They include (a) the time commitment and distractions involved in legal wrangling and legal negotiation, (b) the possibility, even if remote, of criminal charges arising from any of the past activities, and (c) other legal issues (including any related to last year's "Whale trading" derivatives losses that exceeded $6 billion. 

Don't forget, too, the expected "pain" of explaining to senior managers, deal-doers, and business leaders how inappropriate it might be in 2013 to pay eye-popping bonuses in the wake of a $13 billion shakedown, an internal corporate message that always results in the risk of losing talent. 

And $13 billion is an amount of missed opportunities--new investments in business expansion, product growth and new technology that the bank could have made, but didn't.  The bank, nonetheless, would counter that it has ample resources, people and capital (from retained earnings) to make all the investments it needs in the post-crisis era. 

At JPMorgan, the "pain" will be bearable.  CEO Jamie Dimon will sleep at night. The $13 billion was, well, not too much money. 

Tracy Williams

Basel III: Becoming Real

For those who work in or work with financial institutions, it's nearly impossible to avoid discussions of financial regulation.  It's everywhere.  It can be the drudgery of banking, deal-making, trading, lending, and investing.  But in an environment that is hustling to rid itself of the stark memory of the financial crisis, it's inescapable. 

Financial regulation, Dodd-Frank and Basel III are hot summer topics this year, because it's time for the deliberation to stop and for the rules to become real.  Large banks, such as Bank of America, Goldman Sachs, and Citigroup, have sprinted tirelessly to get ahead of the 900-plus pages of Basel III regulation-- rules drafted by the Basel Committee on Bank Supervision, which includes 27 nations, and intended to have more meat than the rather languid rules of Basel II and Basel 2.5.

Basel III regulation consumes the minds of CEOs and global heads of legal, risk, and compliance.  Trying to gain a fierce grip around the Basel III monster requires resolve, patience, an obsession to detail and resources to hire people and invest in infrastructure to keep up with everything.

The essence of 900 pages of guidelines and rules is that capital is king, that enormous of amounts of bank capital act as a safe financial cushion in times of crisis, whether the crisis is caused by in-house failures or by system-wide troubles.  Basel III details explain the calculations banks must make to determine the precise amount of capital they must maintain for the level of business (measured by the level of assets--assets on and off the balance sheet) they are engaged in.  

To avert confusion of what is an asset and what comprises capital and to discourage banks from using financial tricks to circumvent the rules, Basel III painstakingly defines "assets" and "capital." It also permits other regulatory bodies (such as the Federal Reserve) to define assets and capital further and add their own pages to the existing rules. In other words, the Federal Reserve can choose to make the requirements tougher, as it did in early July.

Capital requirements differ for different kinds of banks, for banks of various sizes, and for large banks (like JPMorgan Chase, Wells Fargo, or Bank of America) that have what many say is extraordinary impact on the global financial system.

This month, the Federal Reserve took bold steps in the Basel III roll-out by tweaking the leverage rules, causing bank CEOs and compliance officers to squirm even more. The Federal Reserve proposed stricter leverage limits:  No matter how risk-averse a bank's balance sheet can be, the Federal Reserve proposes that the largest banks (those with assets exceeding $700 billion) must maintain $6 capital for $100 of assets, implying a maximum leverage (total assets-to-capital ratio) of 16-to-1.  (Basel III is more lenient at $3 capital/$100 assets, permitting leverage to rise about 30-to-1.)

What irks banks most nowadays are (a) the vast amounts of resources, time, and people they must deploy to comprehend and keep ahead of the rules and (b) the uncertainty of what's to come from further rules imposed by the Federal Reserve and other regulators. What has frustrated banks the past few years, until they begin to accept it as a matter of the way things are in the new world of banking, was the impact of increased capital requirements and reduced leverage on banks' returns on equity.  More capital and lower leverage, quite simply, imply lower ROEs.

Outside the offices of senior bank managers, what does Basel III mean to everybody else--bank shareholders, finance professionals, bank clients, and finance students pondering careers in banking?

1.  If there is another tumultuous financial crisis, most banks complying with Basel III will be better able to endure it.  Governments won't likely need to inject billions in new capital to give the banking system a spark.

2.  If one large major bank struggles and implodes, its collapse won't likely cause system-wide turmoil, won't threaten the global financial system, or won't cause hundreds of its counter-parties and clients to tumble with it.

3.  Regulators and market-watchers might forecast better which large banks are vulnerable and could be threats to cause damage to the financial system. They may be able to diagnose a sickness in the system before it causes a global plague.

4.  Banks, not able to exploit leverage and constrained by rules from taking exorbitant risks, must settle for returns on capital in the 10-15% range, if they even manage themselves efficiently and maintain large market shares.  Days of regular 20%-plus returns will be almost impossible to achieve. With relative higher amounts of capital on the balance sheet, they won't be able to use debt to get boosts in ROEs.

5.  Economists and business leaders appreciate concerns about risks, weak balance sheets, and burdensome leverage and debt levels.  Some fear, however, good banks might become too strapped by rules and will become less willing to take prudent risks--risks that include lending to corporations, small businesses and start-ups that provide swift thrusts to a lagging economy. 

Others fear an irony.  Banks limited from growing balance sheets with debt will try to book as many high-risk, high-return loans and activities as possible to boost returns.

6. Banks will hire and might be willing to pay a premium for expertise in compliance, reporting, risk management, and systems.  Complex regulation will require experts to interpret rules, gather data, calculate requirements and report to regulators--in real time, all the time, for the rest of time.

Banks would have preferred to hire new people for revenue-generating businesses or deploy capital for new businesses and expansion. But they have accepted they must build stronger compliance and risk-management structures and show shareholders, regulators and politicians they are taking new regulation seriously. (In 2012, JPMorgan Chase reported it would take 3,000 employees and nearly $3 billion in costs to comply with new, ongoing regulation--over 14,000 different rules from all forms of regulation, not just Basel III rules.)

6.  Senior bank managers will spend more time acting as arbiters among business units scrambling for a precious piece of the bank's balance sheet.  There will be more defined rules for capital allocation:  Who will get to use increments of capital for business purposes? And who will be able to maximize the amounts allocated to them?

7.  Banks will obsess over their capital numbers.  They must develop strategies for how to comply with rules today and in 2018-19, when most rules take effect.  Should they  issue more equity in large amounts now to increase capital and proudly show excess amounts before rules are in effect? Should they maintain excess amounts to show markets, shareholders and regulators they are flush with capital, amply above requirements?  Or should they not raise capital, but choose to scale down businesses, assets and risks, based on current levels of capital? 

8.  Bank boards, sector leaders, subsidiary heads and senior managers will knock themselves out, figuring out how to squeeze more return from the balance sheet, how to nudge ROE upward one more percentage point. They face monstrous challenges to do so without increasing risk levels and credit exposures, without the privilege of growing assets any way they could in years gone by. Solutions to this problem won't come easily.

Basel III has rumbled into town. Many rules go into effect in 2014. It's a reality, no longer an academic concept or a discussion paper in volumes by professorial types in Europe. Banks knew these days were coming and have been preparing them, but they still know it will be a constant, everyday struggle to tame the impact of 900 pages of guidelines.

Tracy Williams

See also:

CFN:  Basel III and Capital Cushion, 2010

CFN: 2013 Outlook:  Reforms and Recovery

What Happened at JCPenney?

Waiting for the invitable b-school case

Eventually this will become an intriguing business-school case, particularly for those concentrating in marketing and general management.  Activist investors push hard to re-engineer, restructure and revitalize JCPenney, the old retailing outfit--languishing in modern times, struggling to expand, and suffering with losses and a tanking stock price in the post-recession recovery.

The old CEO resigns, and the company figures it has found the solution in a dynamic new CEO, who would swoop in and radically change JCP by casting upon it magical dust from Steve Jobs and Apple.  JCP, amidst fanfare, hires Ronald Johnson after he helped spawn and lead Apple's broadly successful and wildly popular store expansion.  Apple, Jobs and Johnson had transformed the branch-store and electronic-purchasing experience into in-store theater.

JCP succumbs to the nudges from shareholder activist and prominent investor William Ackman. They reason that Johnson would similarly transform the low-retail customer experience into something resembling an Apple store in over 1,000 JCP stores across the country.

Johnson was supposed to bring the secret code to the magic of Apple. He brought revolutionary transformation to JCP, eliminated traditional discounting pricing, and altered the buying experience by setting up stores within stores. He instituted change in Apple-like ways.  Just as Jobs would do, he avoided detailed, quantitative marketing research and analysis.  Just like Jobs, based on experience and hunch, he decided that he could determine what customers want and decide how stores should be designed and structured. Jobs used to say customers aren't sure what they want, so he should determine that. Johnson approached JCP's customer base similarly.  

Two years later, JCP seems to be in a financial quagmire, a retailing mess.  The stock price fell from about $37/share to less than $14/share in the past year.  Sales last quarter fell over 20%, and the company has announced losses and management change. The bleeding had to stop immediately. It even decided to invite back former CEO William Ullman, as if it will contemplate a reversion back to the old JCP.

Marketing gurus and analysts will ponder this in the time to come and try to figure out what happened, why Johnson's strategy crashed, and why consumers who flock to whatever is new at Apple were turned off by Johnson's store changes and redesign. Business-school professors will decide this is a timely, significant case to study retail strategy, marketing management, and consumer behavior.

But there is a finance element to what happened.  The change was triggered by a large equity shareholder, activist Ackman.  He thought complete, rapid transformation was the best way to boost sluggish shareholder value. The company had--at that time--manageable debt loads, substantial amounts of liquidity and cash, and sufficient amounts of cash flow from the 1,000-plus stores to plow back into the business. Sales growth seemed to have stalled, mostly a result of consumers' reluctance to spend during and immediately after the recession.

The best way to get sudden boosts in stock price, he likely figured, was to make substantial changes in management and business strategy, while keeping the balance sheet stable.   The best and most popular choice would be someone who had that Apple magic.

Now with recurring losses and dwindling levels of cash, corporate-finance advisers may need to step in to determine clever ways to manage what could turn out to be a bothersome debt burden.

(Some will argue the company was distracted by current litigation related to Macy's and Martha Stewart. This might have been a thorn in management's efforts in the short term, but would not likely have proven to be the difference between soaring growth and sorrowful losses.)

JCP, Ackman, and Johnson all combined to take a significant business risk. Perhaps they should be and will be applauded for that. But somehow it didn't work. Or for the first two years, it didn't work.  Given time, it might have taken off later, or it might have eventually "clicked" with customers, or the company might have discovered a new, different customer segment to enjoy the different, more flamboyant in-store experience. 

Perhaps it pushed too hard, too fast. For now, marketing MBA students will have a chance to scrutinize what went wrong and why.  Finance MBAs may get a chance to study whether the strong voices from large activist shareholders can steer an old company that needs a swift kick, but does so in the wrong way.

Tracy Williams

See also:

CFN: Apple's Stash of Cash, 2012
CFN: Dell Going Private? 2013

Dark Days at Knight Capital

Despite all efforts to corral Wall Street to avert a crisis, avoid market collapse, and instill confidence in the system, guess what happens. Yet another major misstep in the marketplace by one of its big participants.  And not just the rare market mistake that occurs once every year or two.  Missteps, hiccups, and strange collapses seem to be occurring these days just about every other week.

This week, it's Knight Capital, the equities market-making firm that announced losses of over $400 million after it launched new software in its trading systems.  Software errors and technology glitches led the firm's black boxes to spew large orders of errant trades. By the time the firm's humans (not machines) could discover what was happening, it was too late. The losses had piled up on trades the firm had no idea it had booked and would have never wanted to make in the first place.  The losses wiped out about half of its book-value equity, and now it struggles to survive intact. Until this week, Knight existed quietly in a niche role in stock trading (institutional equity brokerage, trading and market-making) and had been successful and well regarded in equity markets.

The trading mistakes resulted after Knight implemented new code to capitalize on a new form of retail-related trading with the New York Stock Exchange. They follow a series of embarrassments and other blatant mistakes all around the financial system the past two years.  Knight's loss reminds us of the 2010 "flash crash," when computerized trading involving futures and equities led to a sudden, shocking, unexplained nose-dive in stock markets.  Regulators afterward implemented safe-guard measures to reduce the probability of another flash crash. Or they thought they did. This week, regulators observed the unusual activity at Knight. The overall market corrected itself, but it was too late to save Knight from itself.

Beyond flash crashes and trading losses from bad computer code or faulty systems, there have been steady occurrences of bad events--almost enough to scare retail investors away from markets for the rest of the decade.  In just the past several months, MF Global, the large futures brokerage, collapsed after taking on large trading positions in Europe markets and losing hundreds of millions in customer funds. The upstart trading system BATS, specializing in stock match-making and high-frequency trading, planned its own IPO, but canceled it because of technology problems in its own infrastructure.

JPMorgan Chase this spring announced over $5 billion in trading losses from trading credit-default swaps in what was supposed to have been a safe hedge on its balance sheet.  The Nasdaq Exchange and Morgan Stanley are being blamed for the problems Facebook had on opening day in its IPO. Facebook and others say Nasdaq's systems mishandled orders and trading  in the first moments of trading in Facebook stock.  Nasdaq has acknowledged some errors, but claims those errors have little to do with underwriters' pricing the IPO too highly and with the precipitous decline in Facebook share prices since Day 1 of the IPO.

Last month another futures brokerage Peregrine Financial, less well known in futures markets, collapsed, and customers and regulators are panicking to locate their own funds.  And now Knight Capital.

Knight Capital is being described as a high-frequency, algorithmic-trading firm, although its evolution is more conventional.  The firm was launched in the 1990s to act as a market-maker of Nasdaq-traded stocks.  Retail brokerage firms from every corner of the U.S. send their brokerage orders to Knight or similar firms that always stand ready to make markets (buy or sell), based on order flow from investors.

As equities markets advanced, became more deregulated, dispersed and decentralized and trading volumes grew and trading became more computerized, Knight advanced, too.  It retained its market-making roots, but transformed into a sophisticated institutional trading organization with a prowess for high-frequency trading and black boxes humming all over its offices.

It traded on behalf of clients, counter-parties, institutions and itself. Clients routed their trades to Knight because Knight promised them fast execution and best prices (when they bought or sold stock).  If mom or pop or a Vanguard mutual fund bought or sold stock, chances are the trade was routed toward Knight Capital for execution, or at least Knight had a chance to see it and make a rationale bid or offer. Or let's say, Knight's computers.

All major institutional players engage in some form of high-frequency trading today, if only to survive and have a chance to squeeze tiny profits from the system--whether they are Knight, Goldman Sachs, hedge funds like Citadel or one of the many "algorithmic traders" with names like Getco, Jump Trading, Sun Trading, Peak 6, Quantlab or Susquehanna.  Some firms like Getco trade for their own accounts, jump into and jump out of markets in nanoseconds to make minuscule profits based on market tendencies and discrepancies.  Market-making firms like Knight promise clients they offer technology advantages to get them into and out of markets with fast execution, best prices, and handsome profits.

JPMorgan is so large and so well-capitalized (and some argue, so important to the global system) that its billions in losses in the second quarter caused an unsightly black eye, but nothing more than a financial sprained ankle. Knight's losses wiped out half the firm's capital base, and it now struggles for survival.  It may not exist a week from now.

What will likely happen?

The firm's CEO Thomas Joyce says the firm has sufficient "excess capital" based on SEC requirements. That means the firm meets SEC minimums for capital and the SEC can't force the firm to shut down immediately. It doesn't mean the SEC can't swarm the firm with regulators and investigators to see what happened, decide whether there should be penalties, or urge the firm to wind down or sell itself immediately.

At Knight, losses over $400 million imply the firm needs new funding immediately--new capital, new long- and short-term funding. Funding is necessary for ongoing, everyday operations--to support trading and market-making positions, to fund deposits at exchanges and clearing organizations, to pay down worried short-term lenders, or to pledge more collateral for other lenders. The longer it takes to replace the $400 million, the less likely Knight will survive in any form.


Already brokerage firms, trading counter-parties, institutional traders and hedge funds have stopped funneling trades its way, reducing revenue flow. They stand on the side lines to see how this story will unfurl. Perhaps they will resume trading once they see an outcome comfortable to them. Few outcomes, however, will be comfortable for Knight shareholders and employees.

The likely outcome?  With lenders, creditors, clients and counter-parties retreating and not willing to engage with Knight until after figuring out what happened--and with regulators and the public crying "mismanagement" or lashing out at technology-based trading, Knight Capital will likely have to sell itself in entirety or in bulk pieces.

Once it is confirmed that the firm's loss was due to technology or programming errors and not fraud or an attempt to do something illegitimate, larger financial institutions funds will see value in its parts or whole.  There is value in its order flow from hundreds of broker/dealers and hedge funds with long-term relationships with the firm (if they all choose to return when the madness dims). There is value in its existing memberships, tie-ins, and plug-ins to equity and futures exchanges. And there may be value in the existing black boxes that have worked well in normal markets (if we assume that the problem this week was all due solely to the firm's lack of patience in testing new trading code).

Bankruptcy is always a route to get to the best possible result for shareholders, who will no doubt suffer. CEO Joyce's acclaimed career in equity markets may end and his successful efforts to turn Knight into an important market participant could be forgotten.

Have we come to expect mammoth market mistakes to be the new normal, despite the good intentions of new regulation and oversight? What else could possibly occur this month, when we usually think Wall Street slows down for vacation?

And just think, all the turmoil and chaos this week because of a 15-minute, computer mistake in Jersey City.

Tracy Williams

For more, see also:

CFN:  JPMorgan and Trading Losses, 2012
CFN:  MF Global and Its Demise, 2011
CFN:  Facebook and Its Rough IPO, 2012

For the Fortunate Few: Comp Packages

Bonus season at financial institutions has come and gone. Yet for the month or two afterwards, there is the inevitable aftermath, the ruminating over what happened and the pondering over whether lucrative payouts in years past will ever reappear.

In the post-crisis financial industry, where many just feel fortunate to be employed, there will still be some degree of anger, frustration, or disappointment in payouts. Many yearn for the times of the 1990s or the early 2000s.  Most know the industry is still enduring a shake-out or a re-engineering of sorts, and compensation is a candidate for shake-out, too. 

Handsome compensation packages still exist in certain segments, perhaps most prominently at venture-capital firms, private-equity companies and hedge funds.  Even in 2012, you can read about insane, mind-boggling bonuses, likely because someone made an insane, mind-boggling hedge-fund trade.  Payouts at banks, investment managers and other financial institutions (or in general finance roles) still appear to be attractive to some, even if they have slipped to pre-2000 levels.

Financial institutions, however, are trying to be more creative. More than ever, they are tweaking the structure of compensation packages--more stock, less cash, some options, and even some distressed debt or arrangements with "claw back" features (where employees are required to return promised payouts if individual or institutional performance reverses itself).

In this post-bonus season in 2012, reports are widespread about the reduction in payouts or the clever structures of packages.  Morgan Stanley, for example, capped cash payments at $125,000. Credit Suisse and others transferred certain structured bonds or mortgage securities from their spruced-up balance sheets into the pockets of some senior managers.


The structure of comp packages depend on market and peer practice and institutional performance, but they also depend on experience levels and individual performance.  Accounting rules, impact on overall ROE and long-term corporate issues are also factors.

Senior bankers and traders are more likely to be awarded packages that include restricted stock, deferred compensation and/or options.  More junior personnel (analysts and MBA associates, e.g.), still with little leverage, will have less say-so and may be awarded all cash or some stock--whatever is rationalized by senior management at the time.

If you are a finance professional and if you are lucky enough to receive a comp package, what would you prefer? From the list below, what is the optimal structure for the firm and for you, no matter whether times are good, bad or so-so?

1.  Cash
2.  Cash and options
3.  Cash, options, and restricted stock
4.  Cash and deferred compensation
5.  Cash and debt securities

 Over the past two decades, there have been variations.  Recall the dot-com era, the explosion of Internet businesses and stocks.  In the late 1990s and early 2000s, some financial institutions awarded bankers and traders stakes in venture funds, start-up companies or leveraged investments.  More firms today are exploring debt compensation.

Two Wharton researchers argue comp packages should include debt securities issued by employees' companies. (See Wharton Research:  Alex Edmans, Qi Liu)  They argue that senior managers should behave like owners to maximize returns, but also behave like debt-holders who, because they aren't promised high returns, are more careful about managing and controlling risk.

As debt-holders, managers at financial institutions will be more apt to manage businesses within more comfortable risk bands. A payout, for example, of 80-percent stock and 20-percent debt makes sense.

Younger professionals usually prefer cash, partly because they need it.  Experienced bankers, traders and managers sometimes prefer cash, because they contend they can manage the cash better and more suitably for themselves than the employer.

In the dot-com era, younger professionals (including analysts and MBA associates at prominent firms) actually demanded it, or they threatened to leave finance for opportunities in technology.  And the bulge-bracket firms at the time obliged.  This same segment has less leverage today, but will likely still be paid minimally in stock holdings.

All the world knows, if the company is expanding and growing and has a bright horizon, then packages adorned with options and stock are welcome.  If the company has stumbled or is struggling, employees will shirk equity that will likely decline, although a cash-strapped company will tend to award just that because cash is necessary to stay viable.

Deferred compensation and options are unattractive when the company's prospects are failing. Options over time can expire worthless. And institutions sometimes go bankrupt (Lehman, e.g.), at which time deferred comp becomes just another debt claim.

For the newer MBA associate or first-year vice president at stable institutions in stable industry segments, non-cash compensation is not as bad as it sounds when managers hand over the envelope with "the number."  Non-cash comp comes with restrictions and requires patience, but there are advantages (although sometimes hard to see when you are just starting out):

(a) The upside tends to be greater in the long term.
(b) And yes, it can be a disciplined savings plan for those who haven't yet begun to appreciate the values of long-term investing.

Tracy Williams

MF Global: Too Small to Save

Not the same impact as Lehman

Late last month the world of finance, brokerage and trading experienced a hiccup--beyond the daily eruptions from Europe.  It wasn't yet another day of market swoons or showdowns in Europe.  It wasn't yet another day of a nose-dive in the Dow or headline disagreements on how the economy should recover.

MF Global, the futures brokerage firm, filed for bankruptcy.  It was deemed too small to save. MF Global was not a household name (but so wasn't Bernard Madoff before the world found out about that fraud). Few outside the industry knew much about MF Global. Some knew that former New Jersey Governor Jon Corzine was its CEO. And they knew Corzine had been the head at Goldman Sachs in the 1990s.

MF Global was known as a major player in futures and commodities brokerage. It had institutional client accounts with hedge funds, pension funds, corporations, banks, other brokerages, and other trading firms. It facilitated futures and commodities trading on all the important derivatives exchanges around the world and special trading over the counter.

For the most part, it acted in intermediary roles, a broker for clients who wished to engage in futures and commodities trading for hedging purposes or for taking a bet or view on interest rates, crude oil, foreign currencies, or stock indices.  Clients deposited funds at the firm, and the firm facilitated trading at futures and commodities exchanges or "over the counter." It earned commissions (or "mark-ups"). Client funds not yet deployed for transaction purposes were supposed to be deemed "safe" and "segregated."

MF Global was supposed to be somewhat insulated from virulent swings in markets, as long as there was some activity or some transaction for which it could charge a commission. While clients try to hedge against market swings, MF Global is supposed to thrive in market volatility, not suffer inexplicable trading losses that lead to bankruptcy.

Entered Corzine, recovering from a devastating loss for reelection for a gubernatorial term in New Jersey and perhaps hoping to write a thrilling second chapter to his career on Wall Street.  He felt he could be the catalyst to wake up a sleeping MF Global, which had stumbled through a few performance and risk-management issues before he arrived.

To provide earnings spark and improve performance, Corzine felt he needed to reinvent MF Global. It wouldn't move away from its core brokerage expertise, but it needed to be more daring. It would take risks in the same way Goldman evolved to become a trading powerhouse under his helm in the 1990s.

MF's demise has caused ripples in markets, not a Lehman-like thunderous roar. Its disappearance won't be a threat to the global financial system. But many market participants wonder whether other medium-sized brokerage houses are similarly vulnerable or could be next. Who could be next? Unfortunately, too, at MF Global, regulators are scrambling to locate hundreds of millions of dollars of missing customer funds. Many experienced brokerage personnel at the firm must look elsewhere for work. (Over 900 were let go this week.)

What happened at MF? What hastened its demise?

1.  Corzine likely tried to hard too fast to replicate parts of Goldman and had a stubborn belief in his old, successful ways. About a year after Corzine had settled in, MF Global started to suffer substantial losses from leveraged bets on Europe sovereign debt this year (exploiting its access to "repo" markets and credit-default swaps, but stumbling soon thereafter).

2.  Risk management lacked a voice or authority to restrain the trading and the firm's piling up of risks. It certainly lacked authority to second-guess Corzine. He presided over a risk-management structure that didn't allow risk managers to say "no" or "slow down."

3.  MF was non-responsive to regulators' persistent requests to increase its capital base.  Capital might have been adequate for a pure-brokerage role, but it wasn't when it began to engage in proprietary trading on a large scale. Instead of boosting capital to comply with requests, Corzine and team would lead arguments for why it felt new capital wasn't necessary.

Are there lessons to be learned from the MF Global mini-crisis?

1.  Leveraged trading is still risky, even if it involves trading government securities.

2.  Risk management within financial institutions must have an authoritative voice to be effective.

3.  Old, successful ways of making money in trading may not be magical and profitable at a different firm in a different era in apparently different market scenarios.

4.  Plain-vanilla brokerage and banking businesses may not always lead to stellar returns, but can help ensure long-term survival.

What happens over the next year or two?

1. The bankruptcy will run its course. It will continue to be a business headline, because customer funds and deposits are missing and can't be accounted for. Regulators, market watchers, and business media will persist in asking how that could happen. They will blame woefully inadequate operations, and some will suspect fraud.

2.  Exchanges and regulators will ponder rules changes to discourage futures brokerages from taking big proprietary-trading risks. As with other financial reform, new rules will be thoroughly discussed, but won't be implemented soon.

3.  MF Global will become a broker/dealer-industry footnote like Rothshild, Hutton, Refco, and Drexel. That it will become a footnote in the history of finance is probably good. It meant it was too small to save, just a market ripple.


Tracy Williams