Tuesday, February 02, 2010

Greek For Moron Bankers

Professional option traders are, or should be, well-acquainted with their net *Greek* risks: delta, gamma, vega, and rho.

Today, we'll broach *rho* - the theoretical change in (total) option value given a change in interest rates.

For example, as substitutes or proxies for *owning stock*, call options have positive rho because they demand cheaper cash outlays. As interest rates rise, so do the prices of calls. Similarly, puts have negative rho. [short positions obviously have the opposite signed risk for each respective type of option].

But, for most traded options - those only 1-3 months from expiration - rho risk is fairly negligible. It's only when positions are taken in the out-months, 1-2 years out, that rho starts to even be a consideration.

And really, it's only a concern of large players or at the *firm-level*. I myself never much worried about interest rate ticks. After all, they usually only moved in quarter point increments, every several months.

But that's just in regards to stocks. Obviously, fixed-income products have a heck of a lot more *rho risk*.

Consider the TBTF (Too Big To Fail) banks:

Feb. 1 (Bloomberg) -- Wells Fargo & Co., unlike its three biggest competitors, is so convinced interest rates will rise that it sacrificed as much as $1 billion last year cutting back on fixed-income investments.

The nation’s fourth-largest bank, whose biggest shareholder is Warren Buffett’s Berkshire Hathaway Inc., reduced investments in mostly fixed-income securities by $34 billion in 2009’s second half, company filings show. JPMorgan Chase & Co., Bank of America Corp. and Citigroup Inc. boosted their holdings by an average of $35.5 billion.

By scaling back on the so-called carry trade, in which banks borrow in overnight lending markets at rates near zero and invest in higher-yielding securities, San Francisco-based Wells Fargo aims to protect against losses when rates rise. The three other lenders increased investments on the theory that profit will outpace any future losses.

So Wells Fargo is, supposedly, betting on higher rates. They are trying to increase the bank's *rho*. Nothing wrong with that, right? But how big is this bet?

Wells Isn’t ‘Speculating’

"I applaud Wells," said Chris Whalen, managing director of Institutional Risk Analytics in Torrance, California. "The other three are speculating, taking a position on risk, and Wells is not."

JPMorgan CEO Jamie Dimon told analysts on the fourth- quarter earnings call that the bank’s exposure to rising rates was "way down" after having been high.

"I wouldn’t worry about it that much," Dimon, 53, said on the call. JPMorgan spokesman Joseph Evangelisti declined to comment beyond Dimon’s remarks.

Wells Fargo had an investment portfolio of $172.7 billion at the end of 2009 after the reductions. Citigroup led increases at the three largest U.S. banks, adding $47.5 billion of investments in securities to bring it to $254.6 billion. Citigroup spokesman Jon Diat declined to comment.

Bank of America’s investment portfolio grew to $301.6 billion at the end of the year from $257.5 billion in June, according to company filings. In the company’s fourth-quarter earnings call, Chief Financial Officer Joe Price said the bank would benefit from rising rates because it would receive more income from loans and other interest-bearing assets. Spokesman Scott Silvestri declined to elaborate.

AND, how much overall interest rate risk does a behemoth bank have?

I'd wager that mostly the banks just park their scant cash in short term government instruments. And like near-month options, short term debt can't really bear that much rho risk. So what if rates pop and some of the banks are locked in at lower yields; probably in 6 months time, or less, they'll have their cash back and will redeploy at a higher rate.

So in that sense, JPM, BAC, and C are in fact correct - that positioning their tiny bond portfolios for higher rates in the future is not really that imperative - in the larger scheme of things.

And the larger scheme IS what's more important. In other words, what is the actual net rho of these banks?

The BAC CFO said:

...the bank would benefit from rising rates because it would receive more income from loans and other interest-bearing assets.

In other words, he's asserting that his bank has a POSITIVE RHO - that the net value of its assets would actually INCREASE should rates rise.

He's certainly correct in saying that the bank would *earn more* on its interest bearing assets.

BUT he failed to mention that its COLLATERAL, already distressed real estate, will get hammered even more (as mortgage rates jump). Okay, a little bit more interest on a couple hundrend billion dollar bond portfolio....versus....a massive depreciation in the value of multi-trillion dollars worth of outstanding loans. Hello, McFly???

I submit that banks, through their lending operations, inherently have MASSIVE NEGATIVE RHO. While Wells Fargo seems to acknowledge that in its actions, the guy from Bank of America sees the situation oppositely.

The idea that higher rates are good for banks is ludicrous on its face. If it was, you'd hear bankers clamoring for interest rate hikes - and the politicians beholden to them would actually be raising the cost of freshly printed fiat!

1 comment:

west coast tom. said...

great post - thanks.