Why Banks Traders Make Record Profits...
As TPM has even point out, banks are now reporting sudden profits based on their trading activities. But don't believe for a minute that these profits come from the skills of the traders or that the traders are, in the end, worth the princely sums they demand in compensation.
One thing that's very hard to do, in money management and trading, is to separate skill from luck or, more appropriately, skill from market conditions in which it's almost impossible to do wrong. "Everyone is a genius in a bull market," the saying goes because in a bull market, most stocks are going up. You either have to be very bad or very unlucky to constantly pick the losers.
The current situation with the banks is far easier than trading stocks in a bull market. All these bank traders have to do is put the banks capital to work profitably. The banks are getting free capital from the government and near-free capital from the Federal Reserve. So the cost of capital is nothing. The trade you do to make money is very simple: buy anything. If you use free money to buy a Treasury bond, bam... you make 3%. Use it to buy a junk bond and, sure, you take some risk that you'll lose money it cost you nothing to obtain and will cost nothing to replace, but if the loan performs (as the vast majority do), you make 15-20%
Now, lets say your banks had to borrow its money at some actujal rate of interest, even 1-5% -- the trade becomes more difficult. Your junk bond stops paying, you lose your money and have to spend 1-5% to get it. Now you're in the hole and need a bigger win to make the money back. That's a hard trade.
What's happening at the banks now is a no-lose trade. There's no skill. Anyone can do it. Take free money, buy anything. Wait.
One thing that's very hard to do, in money management and trading, is to separate skill from luck or, more appropriately, skill from market conditions in which it's almost impossible to do wrong. "Everyone is a genius in a bull market," the saying goes because in a bull market, most stocks are going up. You either have to be very bad or very unlucky to constantly pick the losers.
The current situation with the banks is far easier than trading stocks in a bull market. All these bank traders have to do is put the banks capital to work profitably. The banks are getting free capital from the government and near-free capital from the Federal Reserve. So the cost of capital is nothing. The trade you do to make money is very simple: buy anything. If you use free money to buy a Treasury bond, bam... you make 3%. Use it to buy a junk bond and, sure, you take some risk that you'll lose money it cost you nothing to obtain and will cost nothing to replace, but if the loan performs (as the vast majority do), you make 15-20%
Now, lets say your banks had to borrow its money at some actujal rate of interest, even 1-5% -- the trade becomes more difficult. Your junk bond stops paying, you lose your money and have to spend 1-5% to get it. Now you're in the hole and need a bigger win to make the money back. That's a hard trade.
What's happening at the banks now is a no-lose trade. There's no skill. Anyone can do it. Take free money, buy anything. Wait.
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What a deal! Wish I could get me some.
May 8, 2009 6:01 PM | Reply | Permalink
There are costs to banking generally, and banks generally make their money from the spread. If there is no competition between banks, spreads go up. If you're suggesting that there is in effect a banking cartel operating now, maybe there is. I don't see it.
But you're right that when leverage is very high (30:1), $1 of equity can make a huge rate of return. A $30 investment using $1 of equity which returns a net profit (after paying off debt) of 1% amounts to a 30% profit for the equity. And if the deal fails, then the $1 equity is the maximum loss while the lenders take the losses over $1.
May 8, 2009 11:52 PM | Reply | Permalink
It's not about a cartel. It's about the largest banks getting free money as part of TARP and also Fed programs. So, no cartel. The taxpayers are giving them free capital which enables them to perform a very easy spread trade. When banks compete, rates aren't zero or near zero as they are now. The banks aren't refusing to compete, they just don't have to because we gave them free money.
May 9, 2009 12:12 AM | Reply | Permalink
TARP money is not free. Preferred stock has its price and common stock dilutes existing.
Fed low interest loans can go to just about any US bank, not limited to TARP banks.
Banks still compete for customers and generally LIBOR or very close to it is available to most banks. And deposit accounts at retail are paying over 1% with up to 4% for longer term deposits. Spreads are normal.
None of your comments makes factual sense. ??
May 9, 2009 4:49 AM | Reply | Permalink
The banks can go to the discount window for cash at less than .25%! It's free money, by design. Spreads are not normal.
May 9, 2009 10:12 AM | Reply | Permalink
That's not TARP money, and yes, we both already mentioned the Fed. ??
Your sayso about spreads is not an argument. In fact, banks usually mark up their retail rates well above their cost of money. That markup is a spread and is quite normal. It goes to costs and profit margin.
May 9, 2009 8:32 PM | Reply | Permalink
If Congress won't fund the projects,
the markets will, an Iran Contra for today.
When funding "The National Interest"
we can give up the trades early,
before the public knows!
....and we do not have to pack
or ship anything......
May 9, 2009 12:05 AM | Reply | Permalink
I don't know whether these profits come under "trading profits" but they tickle my fancy.
You see FASB Statement 159 expanded mark-to-market accounting rules to provide that banks' own liabilities be valued, currently. Here's how that produces profits -- "phantom" profits.
Say the bank owes an obligation that it's carrying at face value ($100). Last quarter that obligation was trading in the market at $95; this quarter because the bank's credit worthiness has deteriorated that same obligation is now trading at $75.
Statement 159 allows the bank to revalue its liability at $75. The idea is that it could go out and buy it at that price and extinguish the entire debt -- which leads to a balance sheet "profit" of $20. And the worse the bank's financial condition the more profits it "earns."
As they head toward insolvency banks write down their liabilities and their profits go UP.
Neat, eh?
May 9, 2009 9:53 AM | Reply | Permalink
As an aside it should be noted that sophisticated investors in bank equity don't rely on the P&L statement -- or a bank's announcement of its quarterly or annual profits.
It's all and always the condition of the bank's Balance Sheet which determines its worth.
May 9, 2009 10:05 AM | Reply | Permalink
Very true. Though the banks rely on the P&L to justify compensation. Funny that no one gets a bonus for creating a solid balance sheet.
May 9, 2009 11:35 AM | Reply | Permalink
But that concept applies to everybody, not just banks, right? Doesn't GM and Kraft get to do the same thing?
May 10, 2009 12:54 AM | Reply | Permalink
And I grew up thinking that bankers were conservative bastards.
Now I find out they are lying thieving bastards.
You know Destor, you have more ENERGY in your avatars than anyone I know. HA!!!
May 9, 2009 11:28 AM | Reply | Permalink
Destor - You're confusing banks' tradings desks with money managers who might buy a bond and hold on to it for price appreciation expectations.
Traders at the large banks usually don't carry large positions on their books for a long period of time. So yes the market has gone up over the last two or so months, but that's not why the banks are making more money. They aren't going out and buying HCA bonds and holding them on their books and enjoying the big run up. They are usually trying to stay flat by the end of the day or by the end of the week.
Traders are making more money because the bid/ask spreads have widened dramatically since the Fall. Fewer dealers means less competition which means spreads are wider.
Last year you might have had 8 or so dealers making active markets in a particular issue like HCA. Today it's probably half that on average. It's a combination of some dealers no longer in existence (Bear and Lehman) plus other dealers are much less active because they can't allocate their desks as much capital (ie Citi and BOA).
Last year the average high yield bond used to be quoted in 1/8 to 1/4 point spreads. Today it's usually 1/4-1/2 point and in some cases you see bonds quoted in full point(s) spreads.
May 9, 2009 1:21 PM | Reply | Permalink
If you can trade against free money, the duration of the trade doesn't really matter, MCB. It's still very hard to lose money and if you do manage to execute a losing trade, since your cost of capital is near zero, it's not hard to make up the difference.
May 9, 2009 5:22 PM | Reply | Permalink
And in your original post - when banks buy Treasuries or HY bonds, they're NOT making the 3% or the 15-20%. Because they're not holding the bonds. They are trading to a neutral book and just pocketing the spread.
May 9, 2009 7:26 PM | Reply | Permalink
But they're not really using that new "free money" to do more trading with it. Like I said, most banks are committing less capital to trading. Most aren't doing much proprietary trading, so they're just earning the spreads, which are much bigger than they used to be.
If the TARP money was encouraging people to do more trading, then spreads would be narrowing, and they're definitely not.
Duration definitely matters. If they're instantly selling after they buy something, then they're not capturing much "price appreciation", but instead just pocketing the spread.
May 9, 2009 6:49 PM | Reply | Permalink