Why I Won't Go Long Multinational Banks

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Includes: KRE
by: MA Capital Management

I have an interesting market view that I guarantee you have never heard before. It is not based on technicals or publicly available research. My market position on multinational banks is derived from 15 years of trading for Wall Street banks. For over 15 years, I had a front row seat for the transformation and deterioration of proper risk taking by the multinational banks. As each year passed, I watched this metamorphosis have drastic results on earnings. With each economic crisis, the risk exposures became greater and the losses larger and larger.

Common sense indicates that banks would learn how to avoid catastrophic earnings hits after experiencing large losses from LTCM or the Asian Crisis in the late 90s. However, as we turned the millennium, banks continued to experience huge losses from the I.T. Tech bubble, the mortgage crisis and now the European Debt Crisis. Bank employees are classified as professionals at handling money and market swings and yet they get hammered with each and every crisis. The losses and exposures have become so large that they have crippling effects on the economy. Now we are the ones paying for the banks' poor trading and risk taking decisions.

Bank losses will continue. They may abate from time to time, however they will always come again. Government authorities and the SEC feel that additional regulations and laws, on top of the heavy regulatory burdens that already exist in this industry, will resolve and stop the problem. This solution is naïve and falls short of the root cause of the problem.

When I started working on the trading floor in 1993, traders were aggressive, experienced and market savvy. Their primary focus was to make money for the bank and subsequently themselves. Traders were paid based on how much money they made for the bank. The more they made, the more money they were paid. As traders gained experience, they were moved into management roles. Management was a mixture of salespeople and traders. A mixture was deemed necessary. Traders had market experience and were better equipped to make smart decisions on deploying the banks' capital. On the other hand, salespeople were required for their knowledge of the client markets and finesse with the public. The balance in management was weighted heavier to the trading side since a bank's primary business goal is to make money. It was considered logical to have more management with experience in making money than having experience with clients and social refinement.

A trader-based management team understood the markets and completely comprehended all the risks associated with them. They had first-hand knowledge of trading positions and could lend an experienced hand to a trader during turbulent markets. Quite often, someone from management would restrict a trader's positions when he was nowhere near risk limits based on his or her experience. They knew the potential profits were not always worth the risk. When hard times hit the markets, management was on the trading floor expressing views and providing guidance to the traders. A market savvy management was a crucial component to making money and staving away losses.

Difficulties arose with bad traders or a salesperson with no relationships. A poor trader would try and take more than the offer to help cover his losses. A poor salesperson would always argue that a trader was taking more than the offer even when he wasn't. These battles were never ending and were intolerable to the good traders. Every second spent arguing with salespeople meant the trader was off the trading floor and resulted in a lost opportunity to make money. Salespeople were always ready to argue for more money and for the good trader this meant wasted time and a bother. However, it was a necessary evil. Until the 90s, a trader could only work at a large bank so he grit his teeth and bore the pain. In the mid to late 90s, this began to change with a bull run in the equity markets and the emergence of hedge fund companies. Suddenly, good traders had a place to go. They could go to a hedge fund, eliminate working with salespeople and get paid a percentage of what they made.

At first the amount of defecting traders was barely noticeable but the catalyst that brought us to our current problems had begun. As the years went by, the lure of the easier trading life pulled more and of the good traders out of Wall Street banks. At first we saw the most senior traders leave. As the hedge funds grew, the traders getting poached became younger and younger until there were few experienced traders at any one bank. Generally speaking, banks start to loose good traders once they have two years of trading experience. This leaves a very inexperienced bunch of traders running Wall Streets' money. The inexperience on the floor however is not the major issue. Banks were losing the ability to retain good traders, which meant that management was predominantly filled with sales people.

As salespeople began to dominate management, a shift happened on the trading floor. Internal policies were changed to allow more trades at questionable profit levels. This resulted in traders sitting on positions for much longer periods of time. Thus under the new regime, we have more business being done at unattractive levels being handled by less experienced traders. The problem does not end here.

With fewer senior traders in management, there were insufficient managers with the ability to properly access the risk the banks were taking. Risk limits were breached more rapidly without enough qualified people to implement and monitor smart stop-loss limits. Management focused on the huge profits and took down far too much risk based on the allure of potential profits. In addition, there are no mentors for the traders to go to for support and guidance during market turbulence. With the arrival of each economic crisis, all the good traders that lived through the last one had moved over to hedge funds and it appears that the bank is going through the upheaval for the first time. In bad times, management's market strategy basically does not exist. Young traders are left staring at their screens like a deer in headlights. They stare directly into the impending doom doing nothing to avert it since there is no one to guide and support them.

How can legislation fix this problem? Hedge Funds are growing in number but they also are growing in size. In the beginning, hedge funds could only deploy strategies that required limited infrastructure and capital. Now hedge funds are large with enough resources to handle not just market trading but all facets of trading from arbitrage trading to algorithmic trading. For the banks to survive, they need to change. Banks should give up their capital markets and become a facilitator between the risk taking hedge funds and the client markets. Trading is no longer the expertise of the bank. The real trading expertise now resides at hedge funds.

The losses experienced at banks will continue to happen. They might abate during good times but in bad times the negative numbers will continue to be reported requiring further bailouts. With this fundamental flaw in bank management, any long-term position in a multinational bank cannot be justified. For long banking exposure, one should look at strong regional banks (NYSEARCA:KRE). With regional banks, your investment risks are known and you are not putting your hard-earned dollars with some inexperienced trader who has little guidance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.