Stay with me and you will learn. In a recent note I stated that “unfettered demand” would insure that “securitzed debt, which has become more popularly known as “toxic assets,” would soon return to being the principal source of credit. Well a New York Times small piece comments that banks and other financial institutions, including those who have received federal recovery funds, are offering huge bonuses in the competition to recruit the best traders of “derivatives” which are mainly, you guessed it, “securitized debt.” And these are not small bonuses, one trader got a $100 million guaranteed bonus. Eat your heart out Alex Rodriguez.
And why are banks offering such high bonuses for these traders in “toxic assets?” Well because these assets offer the best returns. The competition for the best comes from the fact this is a world that seperating the “good” from the “best” rests on knowing the tiny differences in interest rates that make for giant differences in returns. More relevant to my notes, this competition for derivative traders confirms my prediction that “securitized debt” would emerge from the “Great Recession” intact and ready to grow even more.
The article adds that the next toughest competition for recruiting top talent is in hiring the computer mavens who design and run the programs used by the derivative traders. Another recent blog of mine discusses a book that calls these programs the cause of the “Great Recession.” Well here they are, back in business, and yielding pay checks for their masters that would make Reynaldo of Real Mardrid envious.
In college I was the treasurer of the largest student organization on campus with almost 1000 members. I had to handle a sizeable amount of money, which I managed to do, since my first paying job at age 12 was as the bookkeeper for a sports group. I used to think of the treasurer job as being the realm of “ledger domain.” Not everyone got the pun referring to “legerdemain,” which means “slight of hand” or “magic.” But at the heart of every great pun is a truth and the truth here is that operating the books for any business or organization allows lots of room for “slight of hand” or “magic.” Doubt me, just talk to those who ran Enron.
My ability to understand financial numbers and how they work was confirmed when, in my final months at college, I took the Federal Reserve Bank’s exam for entry. Out of a group of 30 I was the only one offered a job as a bank examiner, and I was the only one in the group who did not hold an accounting degree. I just plain have a knack for numbers.
So back to the high bonuses being paid for derivative traders and their programmers. There are two ways to calculate results. First, you add all the inputs and get a a final product, one jigger of gin, three drops of vermouth and you have a martini. Second, where it is impossible to calculate all the ingredients, you use models based on correlations. You find the items that most closely predict a certain outcome and you use these to make a prediction. This is how the programmers create programs to calculate expected returns on investments. The traders take these predictions and make their trades.
The important thing to remember here is that all of these models have an inherent flaw, they do not include all the infomation required to give a definitive result. They are based on trends and past experience. So back to “ledger domain.” The ability to create and manipulate financial data in derivative trading is as ample and widespread as in keeping the books. And that is what led to the “Great Recession.”
Now in my flatly stated certainty that we will return to widescale use of “securitized debt” or “toxic assets” to generate even higher levels of credit, I also said the difference this time will be that the Feds will require greater transparency for these investment assets and impose greater regulations, as it does for other credit sources. Unfortunately the Obama Administration has not yet produced these new rules and controls. I hope it does and does so soon, since the wheels are already rolling along at a fast clip, with the traders using their “legerdemain” to create values.