Friday, February 6, 2009

WSJ on Boaz Weinstein

The WSJ has a long piece on Boaz Weinstein's tenure at Deutsche Bank. Weinstein was DB's "star trader" for a few years—right up until he managed to lose $1.8 billion. So how did Weinstein lose $1.8 billion? The same way every "star trader" loses a boatload of money: they make a lot of money exploiting arbitrage opportunities in good times, and then lose it all when their market goes berserk in a crisis. Repeat as necessary. Specifically, Weinstein lost most of the money on basis trades when Lehman collapsed and the corporate bond market froze:

By early 2008, Mr. Weinstein was at the top of his game. He, along with a colleague in London, was overseeing global credit trading for all of Deutsche Bank. His own trading group, Saba, had grown greatly, to roughly $30 billion of positions and $10 billion in capital. And his control also extended to the bank's trading for customers. Wall Street traders were optimistic in early 2008 that the mortgage crisis was contained, though there were some strains in short-term lending markets, causing corporate-bond prices to decline. On several businesses, such as Ford Motor Co., Lyondell Chemical Co. and General Electric Capital Corp., Mr. Weinstein bought corporate bonds or loans as well as credit-default swaps. The swaps would pay off if the debt defaulted. And the cost of this protection was less than the income produced by the bonds. Mr. Weinstein believed the debt was cheap relative to the cost of protecting it with swaps. Corporate bond prices soon rallied, leading to a tidy profit for Mr. Weinstein's group, after the Fed's brokering of a deal for reeling Bear Stearns Cos. stabilized the credit markets. Emboldened, Mr. Weinstein added to his positions in succeeding months. His group entered September in the black for the year, expecting to tack on more gains. But the simmering financial crisis finally boiled over. The government said early in September that it would take over mortgage giants Freddie Mac and Fannie Mae. And Lehman Brothers Holdings Inc. was teetering. Traders worried about losses they might incur if Lehman failed. ... The next day it became clear Lehman would fail, and a struggling Merrill Lynch & Co. agreed to sell itself to Bank of America Corp. Within days, the government bailed out another big player in credit derivatives, American International Group Inc. Brooding in his office overlooking Wall Street, Mr. Weinstein remained outwardly calm as markets went haywire, traders say. The value of his group's holdings of corporate bonds and loans began to slide as other investors, needing to raise money, sold such securities. At the same time, trading in credit-default swaps was curtailed because market players were concerned about entering trades with banks that potentially could collapse. This left Mr. Weinstein's group increasingly unprotected against losses in corporate bonds and loans, because it used swaps to hedge those positions. Mr. Weinstein wasn't alone. Similar positions held by banks and hedge funds across Wall Street fell apart amid the seismic dislocations after the Lehman collapse. As prices of corporate bonds and loans slumped to new lows and stocks plunged too, Mr. Weinstein wanted to buy more swaps to protect his positions, traders say. He told traders that in such a trading environment, "the primary objective is to get as flat as possible to the market" -- not betting on either a rise or a fall -- according to a person familiar with the conversation. But in contentious conference calls, risk managers at Deutsche Bank told Mr. Weinstein to scale back positions or sell them entirely, traders say. Mr. Weinstein's stock-trading desk was instructed to sell nearly every holding, effectively shutting it down.
I don't think the dislocation in the CDS market after the Lehman collapse was as simple as the WSJ article suggests. It wasn't just that "players were concerned about entering trades with banks that potentially could collapse." That was definitely part of the problem, especially for Merrill. But as I noted earlier, a big problem was that protection buyers all wanted to lock in their profits when spreads exploded wider (or, alternatively, net protection sellers wanted to cap their losses). And since the dealer banks generally try to run matched books—note that Weinstein's biggest concern in the crisis was getting "as flat as possible to the market"—all the end-users demanding to unwind their CDS trades essentially forced dealers to unwind off-the-run contracts at off-market prices, which is expensive for the dealers and generally requires a sizable upfront payment. It probably didn't help that traders at the dealer banks, being traders, couldn't stop shooting at each other. As the WSJ article notes, however, the losses on Weinstein's basis trades came predominantly from the corporate bond leg, not the CDS leg. That's what happens when the entire corporate bond market suddenly shuts down, I guess.

10 comments:

Pat said...

good post, was wondering the same exact thing after I read the WSJ article. I'm disappointed with the WSJ on some of the details of this article, particularly the reasoning of why Boaz's holdings plummeted.

Anonymous said...

actually, the problem wasn't the CDS market, it was the bond market. The problem is that anything requiring capital was not bought and everyone needed capital so they sold assets. Players started buying protection to further hedge the drop in bond prices, spreads tightened still while bond prices fell, which is the opposite of what is supposed to happen, making the trade practically collapse. during that time, practically every relative value credit trade fell apart because the fundamentals of the trade are based on the relative value of CDS spreads between bonds and CDS but there is nothing hedging liquidity risk. the primary reason why bond/loan prices dropped and funding/LIBOR rates spiked is due to the lack of liquidity and there's no way to hedge except with capital. the only way to gain capital is to borrow money or sell assets. even in some cases CDS spreads tightened while bond prices dropped, which would imply that liquidity risk spiked while credit risk was relatively flat or experienced tightening driven by CDS market technicals (market participants selling more protection than they are buying). the entire market was driven solely on liquidity concerns and general fear and panic. neither fundamentals nor historical market technicals were driving prices or trading. marking to market became too painful and was so painful for most that it caused desks to collapse, investors to redeem, and everyone running for cover with the sole intention of protecting capital in order to hedge the massive liquidity crisis that ensued. hope that helps.

Anonymous said...

What this nameless commentator is saying, is NO ONE "had in flesh in their positions." And that is the essentail "redacted" meaning of CDSs when one focuses on its essential heuristic. yy

Anonymous said...

In fact, this sounds pretty much like a kind of "delta-hedge" gone wrong. While his portfolio might have been delta-neutral in the beginning, increased volatility in the shape of strongly decreasing prices for bonds lead to a situation where his portfolio was not fully hedged anymore. In fixed-income portfolio theory traders try to also gamma-hedge and stuff to make their portfolios less sensitive to volatility, but he probably held a speculative position and underestimated market volatilities. That would mean that his losses were not the consequence of excessive market disruptions, but "just" the result of sloppy hedging. This theory would be supported by the notion that "the return on bonds was higher than the cost for CDS(insurance)". This would, however lead to a further insight: his superior returns in the previous years were not the result of outperformance, he did not beat the market but just disguised the leverage he was running very well. Given that creating alpha is art, but creating beta just foolish, he was obviously one of those traders who got rich on playing the risk-management department. Oh good ol´ times, when I thought that playing the risk-management desk was only a theoretical experiment in textbooks!

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