Friday, May 11, 2012

Barry Ritholtz - Imperfect, OverReaching, Bonus-Driven Bankers

It took less than 3 years after the financial crisis peaked for traders to engage in the same sorts of highly leveraged reckless speculative bets that helped crash the economy last time. Imagine the sorts of risks these mis-incentivized desks will be doing when the memories of the crisis fade 10 years after.
Read it at The Big Picture
Imperfect, OverReaching, Bonus-Driven Bankers
By Barry Ritholtz

During my first year out of college I worked as a stock options market maker for a proprietary trading firm. Spreads had been tightening over the past couple years making it difficult to earn easy profits from trading both sides of the market. Obviously not ready to give up the potential for enormous profits, many traders began to shift portfolios to try and take advantage of apparent inconsistencies in the volatility curve. The firm was also growing at the time and in trying to build a reputation was pushing to take bigger positions.

VaR (Value-at-Risk) was our preferred risk measure during those days with limits set at various overnight percentage moves both up and down. It didn’t take long to figure out some obvious troubles with using this measure. For one, the amounts “at risk” assumed no change in volatility despite the out-sized moves that would be occurring. Second, risk limits at the tails could be manipulated relatively cheaply by trading far out of the money options. These are just a sampling of the problems and don’t highlight the numerous other ways in which the measures become effectively useless precisely at the time they’re most important.

As a trader, we were constantly pushing to relax the risk limits or explaining why the measures always over-represented our actual risk. This is a natural part of the speculative trading business where individual bonuses are based solely on the income earned, not on the amount of risk taken. Trying to alter the trader’s incentives is and will remain nearly impossible.

An important distinction is that I was working for a firm with no clients, where all losses ultimately fell on the company. JP Morgan remains one of several TBTF organizations whose activities are subsidized by their protected status (and in many other ways). This loss, to date, is only $2 billion but may well be closer to $4-5 billion when all is said and done. The reality, though, is that the losses could have been significantly larger. In the few years since the banks were bailed out, almost nothing has changed regarding the ability of TBTF firms to take enormous, leveraged risks in OTC markets. AIG was practically brought down by a small group of traders taking massive risks that eventually blew up. LTCM was brought down almost 15 years ago by a similar situation. Since bailing out the banks remains a politically preferable option, hopefully this new incident will re-spark support to completely ban prop trading at these firms.

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