A Little Perspective, Please - Wall Street and Trading Risk

As some of you likely know, there has been a bit of a rhubarb over Credit Suisse’s reported $120 million derivatives trading loss in South Korea (supposedly on reverse convertible notes - ooooh, how scary!). This has been discussed in both MSM (mainstream media, for those who don’t know my use of the acronym) and the blogosphere. For an overview, let’s take a look at Monday’s story in the Financial Times:

Brady Dougan has been talking about the need for “disciplined risk-taking”
since he took charge of Credit Suisse’s investment banking unit in 2004. But
perhaps only the second half of the message is getting through.

The bank’s equities desk is reported to have lost about $120m in the third
quarter from issuing reverse convertible notes (RCNs) on Korean stocks. It
remains to be seen how this fits into the overall trading result, but it is a
big number all the same.

RCNs are popular among Asian investors because they pay a generous coupon
like a high-yield bond. The quid pro quo is that the issuer can force conversion
into a stock if that stock falls by more than a certain amount over a designated
period. This gives the issuer an effective put option on the shares in question.
Credit Suisse’s losses were apparently made in so-called “worst-of” RCNs, a
particularly risky breed. These convert into the equity of the worst performing
out of several stocks. Hedging these is hard but, for a sophisticated
derivatives desk, not impossible.

The most likely possibility is that falling volatility reduced the
mark-to-market value of those embedded puts. The best that might be said for
Credit Suisse is that it chose not to hedge its exposure fully in this case -
aiming to maximise its profit on the trades assuming the underlying stocks
performed to expectations. The snag is that this goes against Mr Dougan’s
strategy of disciplined risk-taking. Some rivals say Credit Suisse should have
responded to early warning signs of slackening volatility.

These are problems that are capable of being solved by stronger management.
As it happens, Mr Dougan has just overhauled Credit Suisse’s top equities brass
after repeated wobbles in the equity trading unit. Having restored Credit
Suisse’s appetite for risk, it may be time for more discipline.

I was asked to comment on this story for National Public Radio on their daily show Marketplace. The text of the story is below. As you can see from the questions and the comments of the Morningstar analyst who spoke before me, it’s plain to see what the interviewers are pulling for:

KAI RYSSDAL: Let’s take a second to do a little financial
etymology here. Derivatives is the word of the day. Financial instruments whose
value is derived from something else. In the most basic sense they’re bets. That
oil, for example, will go up because we’re going to have a cold winter. Or down
‘cause it’ll be warm. Either way, derivatives are risky. An easy way to lose
money. There’s word today Switzerland’s second largest bank — Credit Suisse —
lost a lot of it on a bad bet in South Korea. Marketplace’s Amy Scott has
more.

AMY SCOTT: The situation in North Korea has captured the
attention of options traders, who have taken advantage of volatility in the
South Korean stock market. According to Bloomberg News, Credit Suisse adopted an
aggressive strategy to cash in on that volatility. When the market calmed down,
the report says, the bank ultimately lost $120 million. Morningstar analyst
Ganesh Rathnam says Credit Suisse was late to the game its rivals were playing.

GANESH RATHNAM: The big lesson is don’t chase
something just because everybody else is making money on it. If you chase a hot
investment, more likely than not the later players are gonna get
burned.

Credit Suisse may have been under pressure to boost profits
in its equity trading division, which haven’t kept pace with competitors.
Analysts say that may have driven Credit Suisse traders to take bigger
risks.

But Roger Ehrenberg with research firm Monitor 110 says this is
what investment banks do. Sometimes risky bets pay off. Sometimes they don’t.
ROGER EHRENBERG: The person sitting on the trading desk that
incurred that loss is certainly not feeling so great about life. But by the same
token, is that within the range of expected outcomes? Sure. A Credit Suisse
spokesperson wouldn’t confirm the losses, and said the company won’t comment
until it reports third-quarter earnings in a few weeks.

Analysts we
talked to don’t expect banks to disclose specific losses like those in South
Korea. But if the word does get out, one said he’d rather hear it from Credit
Suisse than Bloomberg.

In New York, I’m Amy Scott for Marketplace.

Sure, makes for some nice headlines, but what does this mean? After reading a bunch of commentary on this loss, I am thoroughly convinced that virtually nobody writing about this story has any idea what the hell they are talking about. In fact, it infuriates me when people take up column inches writing stuff that has no basis in reality (but looks great in black and white). Do you know how many bulge bracket Wall Street trading businesses have suffered a $120 million loss on a particular desk in a quarter (and we don’t even know this to be the case - the loss in question is on a particular strategy)? I tell you how many - EVERY SINGLE ONE. Why? Ok, here is the answer. I want to make sure you are listening. Ok? Here it goes.

Trading desks try to make money. How? By taking risk. What does this mean? I will sometimes win, I will sometimes lose. Ok, but how much? Well, let’s say I am running an array of positions across a $25 billion balance sheet (but in fact the bulge bracket broker/dealers are much, much larger). I have a risk budget. Maybe it’s derived by Value at Risk, maybe by Monte Carlo simulation. Whatever. Bottom line - I have an expected loss factor for a day, a week, a month. These loss factors take into account rising correlations across asset classes, exogenous shocks that cause 20%, 25% or even greater losses over short periods of time. When I am allocating capital across my trading desks I am conscious of the cross-correlations on my trading platform, and using my skill to tilt bets based upon my expertise and those of my traders. Given all this, trading businesses over the past three years have done extremely well. However, within that time frame, say, the second quarter of 2004, trading desks got absolutely murdered. After a record P&L in Q1, most desks got carried out in Q2. I know people who literally dropped $200 large - that is $200 million - in that quarter. But you know what - they still ended up a $1 billion+ on the year. And these outcomes are well within the expected probabilities based upon stress tests. Were people unhappy during Q2 2004? Sure. But those with cooler heads went on a tear and had a great 2004.

So why am I saying this? Because while I don’t know Brady Dougan personally (though know plenty of people at CS), I think he and CS are getting a bad rap. A $120 million loss on a trading desk, unless the loss was the result of poor controls or a rogue trader, is neither a show stopper nor something that warrants intense eyebrow-raising and upset stomachs. THIS HAPPENS TO EVERY FIRM. Even the almighty Goldman Sachs drops a few hundred million (give or take a few hundred million) now and again. So people, please, if you are going to write about trading please get a clue. You’re wasting all of our time. And get off Brady’s back. He’s doing ok.