“Risk-free” kings or investment banks’ games

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понятия «доходность» и «риск» всегда идут рука об руку

It is well known from the finance theory that “ profit” and “ risk” terms always go hand in hand, as in case of change of any parameter the other one changes as well. There are a lot of theoretical and applied researches based on the classic “Portfolio Theory” of Harry Markowitz describing a combination of risky and risk-free assets (practical financiers also widely use the William Sharpe ratio).
In the real world there are no risk-free assets, but in practice in order to analyze attractiveness of investments U.S. Treasuries are used. It is obvious that profitability of Treasuries is not attractive to investors, but their risk-free side thereof is very alluring.

 Inventors of risk-free or, if to speak more exactly, low-risk strategies and even markets are abundantly present among the investment banks. There are no doubts that using this or that strategy it is necessary to stick to certain principles.

 Principle 1: “Too big to fail” – always works. This principle is also called “moral risk”: it means that the government will not allow a significant financial institute to collapse or, in simple terms, it will always help. Thus, Ben Bernanke, the head of the US Federal Reserve System, started to talk about the need to bail out investment banks in the summer of 2008. As a result as soon as in June of 2008 the unprofitable marginal Bear Stearns bank was acquired by JP Morgan Chase banking corporation almost for free. Problem assets in the amount of 30 billion US dollars were financed by the Federal Reserve Bank of New York, which is a division of the US Federal Reserve System, at the rates as for March of 2008. After four consequent unprofitable quarters Merrill Lynch&Co has been formally acquired by the Bank of America Corporation and the deal amounted at 50 billion US dollars. De facto the sponsors were the Federal Reserve System and the US Treasury by infusion of the stock through the TARP program in the amount of 20 billion US dollars and provision of guarantees for compensation of asset losses in the amount of approximately 118 billion dollars.

 Principle 2: “Hoarding effect”. As a rule, the market is heated up by several players which gradually begin to relish, attracting new players. The collapsed mortgage bond market is the best example of application of such an approach. During the market meltdown all the participants suffered significant losses and Lehman Brothers went bust. A little bit earlier, in the 2000s, there was a “dot-com bubble”. There is a suspicion that now oil and gold markets are in the same condition.

 Principle 3: “The use of speculative arbitrage”. Sounds good at first glance, but really it often turns out that there was not even a trace of the supposed arbitration. It is normal when financiers, being carried away by the imaginary “risk-free” structure of the deal, fail to control the financial leverage, which skyrockets but becomes the catalyst to the downfall upon shrinkage of liquidity. Up to 2008 at the heated real estate market there was an active “risk-free” game with sub-prime mortgages and sale of insurance policies for them in the form of credit default swaps (CDS). AIG Insurance Company tried to take part in this big game as well. The result of such a reckless step was that in 2008 the U.S. Federal Reserve System was forced to allocate 85 billion US dollars, which made the company almost completely nationalized. Goldman Sachs which has about $ 10 billion of secured debt, at that time, depended on the creditworthiness of AIG, must be grateful to the Government of the United States which supported insurers in the hard times. However, the question of the cost of security of monetary claims at that moment remains open up to now, regardless of the fact that Goldman Sachs continues to state that all the positions in accordance with the deal were reassessed at their market value. The most important is to choose the right partner.

There is no doubt that it is not quite correct to treat all the investment banks the same way - some of them suffered more serious losses and some of them suffered less serious losses at the expense of others. The expected risk diversification did not happen, but a common redistribution occurred. The law of conservation of energy worked in general, but not in particular. 
There is a lot of information publicly available on the following technologies of gaining profit:

  1. Playing at the market of secured mortgage loans. It means that a pool of mortgages with different credit quality combined into a single portfolio and is assigned with a high investment grade rating category in anticipation of diversification and maturity and is advertised to potential investors accordingly. Formally “independent” rating agencies contribute to the process of heating up the market as they actually become interested and can’t resist the temptation of missing earnings at such a market. In particular, blind faith in validity of ratings and hope for diversification resulted in bankruptcy of Lehmann Brothers. Reorganization of the other organizations was performed by governmental institutions all over the world. 
  2. Taking opposite positions towards the advertised products. Due to this reason the two biggest investment banks Goldman Sachs and JP Morgan have already paid penalties in the amount of 650 million dollars. These banks simply charged a commission from investors having allocated their assets with the simultaneous concealment of information on the counter position taken by the other party of the deal.
  3. Excessive prices at mineral and precious metals markets. Now we can only guess the real cost of oil and gold. By different assessments the part of speculative component in their prices ranges from 30 to 50 per cent. Of course it has something to do with the investment bankers. 
  4. Manipulation with national debts. Goldman Sachs signed currency swap deal with the Greek Treasury not at market prices, but at artificially lowered price, as a result of which Greece’s debt to the bank arose. The debt was immediately insured by Goldman Sachs (which cost was considerably less than the rate of Greece’s debt) in the form of a synthetic CDS from the German insurance company Depfa. The manipulation was in the fact that this debt was not mentioned in the national debt of Greece and the investment bank easily made its risk-free profit.

 We can talk as much as we want about the Federal Reserve System activities’, about excessive liquidity and several quantitative easings (Quantitative easing 1 and Quantitative easing 2, QE1&QE2) as well as about their role and disadvantages. As for the situation of 2008, in conditions of almost complete freezing of the interbank crediting market (at that moment it was about several hundred billion dollars), the question about where to get the required liquidity from arose. It was necessary to obtain and allocate funds in the market; otherwise we wouldn’t be able to talk about someone's rightness now. It is also necessary to understand that the Federal Reserve System is just a tool and the main question is in whose interests it is used and who controls this system.

 Broadly speaking, the fact of getting a big profit at markets is not a crime, but participants thereof, fortunately or unfortunately, have a short memory regarding serious miscalculations and losses. 
In the final analysis the following questions naturally arise in respect of the activities of investment banks:

  • Is there a need for creation of such pretended “risk-free” markets as mortgage bonds?
  • Will there always be a possibility in case of serious shocks to use, directly or indirectly, the governmental help in accordance with the principle “too big to fail”?
  • How safe is it for the financial system to ensure profitability only at the expense of the tenfold capital leverage and asset management fees at the rate of 1.5-2 per cent not connected with the results of activities?

 And finally the most important question. What are the risks for the Wall-Street investment institutions when speculative growth of artificial markets is over, billions in profit disappear and all progressive risk management systems fail? How long will the “risk-free” asymmetry continue to exist?