The Global Economy Is Set to Find Out What Comes After Sadness

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It was by their recent standards a hugely successful campaign for the Cleveland Browns of the National Football League. Before this last season, the lovable losers had only managed a single victory out of their previous thirty-five games. Failing to win a single game in 2017, and only one in 2016, the beleaguered franchise wound up the 2018 season with seven triumphs (and one tie).

For the first time in what might’ve seemed a decade to Browns fans, there was excitement. A new rookie quarterback, Baker Mayfield, to energize the field playing alongside young talent on both sides of the ball. Cleveland’s football team throughout the season played the part, they were certainly up and coming proving as much with a couple surprising wins early on.

The first week in November, NFL’s Week 9, the Browns were matched up against the Kansas City Chiefs. These guys in red at that time were the NFL’s darling team, eight and one, playing behind the sensational second year guy, first year starter, Patrick Mahomes at quarterback.  

On paper, it should’ve been no contest. Yet, some big money in Vegas sensed an opportunity. The Factory of Sadness, the all-too-appropriate nickname given to Cleveland’s home stadium, could maybe be transformed for the scene of a monumental upset; the type that propels a previously downtrodden team into an era of winning and success. The Hollywood movie would write itself.

The betting line was set at around Chiefs minus 8.5 points (that is, for a gambler to win betting on Kansas City, that team would have to score at least 9 points more than Cleveland). Some observers were a little shocked at the line, thinking it would’ve been more appropriate at 10.5 if not, being less emotional, a couple touchdowns.

For the public, it was Christmas. The rest of the NFL could not care less about the wonderful, emerging underdog story of the Browns. At that point in the season it was no contest, Mahomes’ consistent magic should easily cover that small spread. Money poured in on KC, an incredibly lopsided 88% by the time it was all said and done.

Cleveland kept it close to halftime, but was overcome in the second half. Losers 37 to 21, KC easily covered. Vegas wept. Jay Rood, President of MGM, would admit to ESPN’s David Purdum:

“The sharps kept betting the Browns for a little bit, but the public just kept coming on the Chiefs. Everyone kept say [sic] that they thought the line would be 9.5 or 10. They thought it was Black Friday on the Chiefs.”

Sports books don’t bet on games. The house in most cases wants to be neutral, skimming about 7% of the overall take no matter who wins. The whole purpose of a point spread is to keep the money, therefore the risk, as evenly balanced as possible to both teams because you just never know. On a day when KC easily covers with seven-eighths of the money on them, that’s a disaster for bookmakers.

In this way, Vegas runs more of a matched book than money dealers. In Economics textbooks, market-makers are described in the way gambling houses operate. They don’t opine and take sides; money dealers make money on the skim.

If a hedge fund makes a serious bet on, say, a leveraged loan position it may wish to hedge its bet (that is the name of the kind of fund, after all) by purchasing an interest rate swap or some other similar protection from a dealer. The dealer is only too happy to oblige because it will pocket a small fee (spread).

But now the dealer has risk, and the textbooks all say that he will attempt to balance this risk by seeking out perhaps another hedge fund looking to hedge in the opposite direction. In this matched book way, the money dealer redistributes risk in the same general way as the point spread set in Las Vegas casinos.

This is the reason why according to academic convention dealers make money when markets are volatile. After all, if they aren’t who would need to buy up, and pay the fees for, lots of protection. If markets start to look squeamish, then dealers should be happy they have so many prospective customers – so long as they lay off risk and run their matched book.

That’s not how the world really works, though. Surprise, surprise, the textbooks have it all wrong, another key reason why 2008 was such a mess. And it is still a mess today.

Proprietary trading has become a dirty word for Wall Street and for some very good reasons. It was massively abused. That doesn’t mean, however, there is no legitimate basis for it. Some people may become emotional about these investment banks for what they’ve done, but the stone-cold truth of the matter is we need them to provide vital financial services in the areas which require proprietary trading.

The economy does well, or at least relatively better, when investment banks (what used to be legally distinguished as “commercial banks”) perform their warehousing services. It is very difficult for a company, any company, to finance its operations on its own. Debt products are vital to both the day-to-day liquidity management operations of any firm as well as meeting its long-range objectives most efficiently.

Wall Street is at its absolute best when it performs, and stays within, this role. Company A goes to Goldman Sachs or Morgan Stanley because it wants to finance XYZ. In a lot of cases, GS or MS will get together with other firms and syndicate credit tranches or put together a security floatation. They are brokers in the most fundamental sense, taking on a debt project (primary market) in order to later distribute the results to the rest of the investing public (secondary market).

This involves some risk on their part. If Goldman Sachs takes on new credit from Company A intending to push it out to private investors over time, that credit is at risk for the bank while it is in the bank’s hands. The debt is “warehoused” leaving GS with legitimate needs to hedge and create offsetting positions so as to manage that risk as it sees fit.

Because these hedges are for its own account while in GS’s sequential possession, this is proprietary trading. If it so happens that Goldman or any of them make money on their hedges, as can happen in the normal course of things, then the revenue is added to whatever fees the transaction may generate in other forms. It all goes into “bond trading” or what is generally known as FICC – Fixed Income, Currency, Commodities.

Where it can all start to go wrong is when banks stop hedging and start betting. Forgoing the matched book, they can become Vegas not just setting the point spread too low but then outright betting on the Browns on top. This happened quite a lot during the eurodollar, housing bubble era. One need only review Citigroup’s proprietary trading losses from 2008 to get a real sense of an extreme, thus why its always escalating bailout took on the same proportions.

There have been more recent examples, too. The infamous 2012 London Whale was one. In that case, as most others, they share a common trait. Here’s what I wrote several years ago, quite purposefully in December 2015, about JP Morgan’s unusually obvious affinity for IG9:

“While the basis of the London Whale problem propagated along a credit index called IG9, the last on-the-run CDX left after the panic, it was truly all over the place…It was, at its heart, a bet on the recovery - and the firm got crushed, spectacularly, in doing so. This has been the persistent theme of actual financial condition, over and over and over again. Economists have been more than promising this eventuality, they have made it their central case to all other exclusion. Banks have taken that backward application to actual trading and wholesale money propositions and have been burned repeatedly for their trouble.”

Whether it was QE2 or the LTRO’s set to be unleashed by Europe’s central bank, JP Morgan’s CIO office bought into the narrative of effective, if not over-effective monetary policies in late 2011. The firm’s official report on the fiasco admitted as much as to how a credit protection scheme (hedge) could otherwise end up with an enormously long risk position at one of the worst times in recent financial history.

“First, senior Firm management had directed that CIO - along with the lines of business - reduce its use of RWA. Second, both senior Firm management and CIO management were becoming more optimistic about the general direction of the global economy, and CIO management believed that macro credit protection was therefore less necessary.”

No matched book here. As the synthetic credit position(s) was shifted from protection to “more optimistic about the general direction of the global economy” the whole massive portfolio was bet on the Browns (Bernanke). Once it got long, JPM couldn’t get out, along the way advertising to all its competitors its mistake(s). Every shark in the area could see the whale floundering in all its optimism about the economy.

They all got to take a big bite out of him, thinking it was Black Friday in what was left of synthetic credit.

Even in the most basic of dealing procedures, the violation of matching principles is common. In the example I used above, the hedge fund buying protection on a leverage loan may lead the dealer to think the hedge fund is just wrong to do so. Instead of laying off the risk, it could just pocket the fees judging any adverse payout (on the dealer’s part) as a trivial, unserious probability.

But in so doing, the dealer is making a specific bet no matter if it is acknowledged or not. The bailout of Dexia provides perhaps the best example in this case. I wrote in 2016:

“Belgian bank Dexia was bailed out for a second time in October 2011 because it was funding a ‘carry trade’ via total return swaps that essentially shorted German bunds. Because they never thought that interest rates would decline and do so as much as they did, the bank was totally exposed when the (modeled) impossible did happen.”

It's not easy to distill all the complexities and evolving steps in these trades down to their most basic element. They are swung often by what may seem independently rational reasons. In the end, however, they all have this one thing in common, the basic view that central bankers are either right or they will in short order fix things and set them right.

This belief is what moved both Dexia and JPM’s London Whale. They made spectacular bets on subjective positions they did not think were really subjective; bets they didn’t appreciate as bets. If Ben Bernanke, or Jay Powell, says his statistical models show improvement and effectiveness, why not bet with them?

This is why when markets become volatile (read: in the downward direction) money dealers tend to fare very poorly. Again, the textbook says volatile markets are a godsend for the matched book. Nobody runs them; everyone bets, and a lot of times on the Fed, ECB, and other central banks if not directly on their policies than in line with their forecasts.

The predominate one over the last two years has been this “globally synchronized growth” nonsense. If our hypothetical hedge fund has been worried about its leveraged loan position because despite Janet Yellen and Jay Powell’s insistence the unemployment rate is the right measure for the economy the flat yield curve makes a far more compelling argument against them, our hypothetical dealer (especially at the management level, as in JPM’s London Whale and Dexia’s short bunds) may seek out as many hedge funds like the first to replicate the same trade – without laying off a part or even all of the risks it takes on.

Hedging is costly, even when hedging against hedges you’ve written. If you are the dealer and you think there is no way Powell could be wrong this time, why bother reducing your profit? Book the trade with the hedge funds and keep what you expect will be robust profits – so long as overall markets trade with Powell’s view, therefore your bet.

The big banks this week have reported their quarterly results for Q4 2018. Last quarter was uncomfortably volatile in all markets, and with short-term rates (not long-term) on the rise money dealers should’ve been cleaning up. Instead, they were cleaned out.

FICC was awful all around the Street. You can google the reports or look them up on the 10-K’s filed with the SEC’s Edgar for all the gory details. They are no matched books.

Funny, though, whenever that is the case and things start to go against dealer bets they try to revive the textbook. They may not have hedged when they laughed at the hedge fund who was (at their own expense), but once it becomes clear (yet again) Powell is incompetent (the Chairmen change but the models never do) don’t they all rush to lay off what becomes immediate risks even at huge costs.

I’ve written several times of the surge in open interest in US Treasury futures the last week in November. It was absolutely incredible. We see open interest spike in the weeks or days leading up to some of the worst financial events in modern history: in December 2015 before CNY and the Swiss National Bank; just prior to Bear Stearns; and not long before LTCM and the Russia ruble wreck.

In short, there was massive interest in liquidity and deflation hedging just before all Hell broke loose last month. Who was it that pushed the yield curve into inversion, the eurodollar futures curve even farther out of character?

The FICC numbers declare exactly who it was. All the banks were running their books in Powell’s “more optimistic about the general direction of the global economy” scenario. Confronted with too many contrary signals, especially China’s eurodollar warnings, they ran for cover almost all at once. Cleveland never really had much of a chance to upset Kansas City.

FICC used to rule on Wall Street. The BSD’s (you can google this, too, but fair warning) of lore were all bond traders in this space. They aren’t any longer because dealers have been consistently burned by “more optimistic about the general direction of the global economy.” I really have a hard time fathoming why they keep falling for it time and again.

In the bigger picture, I guess, they haven’t. What I mean is dealer books have been so shrunken and pared back that while occasionally they bet them with a Bernanke, a Draghi, or a Powell the bets have become smaller and smaller over time (especially in non-linear terms).  In 2008, the potential for losses was massive, everyone thought subprime was contained. In 2018, the revenue comparisons in FICC are very ugly but no bank is going to fail for them.

It is the lost decade’s paradox. We need dealers to be dealers but they’ve been burned so many times they put no real stake in being a dealer. Why would they?

The only other option is to replace money that requires money dealers (credit-based currency) with some stable monetary alternative. That ain’t gonna happen. So, we’re stuck with banks cutting back FICC because they lose money in money betting on a recovery that can’t happen until they stop cutting back.

Meanwhile, Jay Powell’s attention remains fixed on IOER (the lost decade’s biggest joke) and its poor relation with federal funds, the money market that doesn’t matter in any of this. And now not even the unemployment rate can smooth over worries. Cleveland has its Factory of Sadness, we have a global economy on target to find out what comes after sadness.

At least the Browns are heading into next season with everything in their favor. I wouldn’t bet on it, though.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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