When Bond Gods Ruled

I found an article on yesterday’s Bloomberg website very interesting. The title is, “Debt Rules as Diamond Ascent Sees Kengeter Converge With Jain”.

The article went on to discuss that Carsten Kengeter who had been head of fixed income trading at UBS was appointed to head all investment banking. It cited two other debt trading execs, Anshu Jain of Deutsche Bank (DB) and Robert Diamond of Barclays (BCS), who have been promoted even though we have just lived through a debt induced crisis. A head hunter opined that it was quite surprising that these men all came from areas where all the money had been lost the last several years and the area that caused the financial crisis. He then relented, conveying that of course now those areas are making money and that’s what counts.

What struck me is the relationship of this story to one of my favorite Yankees, whose picture is on the wall of my office, Yogi Berra. After watching Mickey Mantle and Roger Maris repeatedly hit back to back home runs in the early 1960s, he crafted one of my favorite Yogiisms, “It’s Déjà vu all over again”.

My personal “déjà vu all over again” relates to the early 1990s. In the late 1980s and early 90s, the U.S. got into a real estate and debt related crisis because of poor credit practices at the S&Ls. A lot of the S&Ls’ troubles stemmed from their interaction with Wall Street firms. The firms created products and services that many S&L managers and customers didn’t understand. Sound familiar? The Resolution Trust Company was set up by the government to undo the problems at a huge cost to taxpayers.

In the aftermath the environment was such that bond desks made a lot of money. Many bond managers were promoted to run Wall Street Firms. This happened just before the greatest decade for U.S. equities took place.

One of my close friends at Harvard clearly summarizes the difficulty in understanding equity values with the following observation, “Equity is the residual security value”. Everything that happens that creates value for debt holders is then followed by a complicated set of processes that either does or does not end up in the residual equity being worth a lot or not.

Another way of saying this is that learning all you have to know about valuing bonds only takes you half-way to being able to value equities. Some fixed income products are not that complicated. Commercial paper has to be analyzed against a backdrop of whether the company will exist to pay off its debt in days or weeks. As maturities increase things get more difficult to analyze. By the time you get to the infinite maturity of a stock, you need to make a lot of macro and micro assumptions to do valuation. Some bond trading executives understand everything about all types of securities, some do not.

Having bond trading executives running banks and investment banks isn’t inherently bad. It is interesting to note, however, that after the enormous 1990s decade of equities ended in 2000, the last crew of bond leaders took their firms to unprecedented levels of debt creation. Duh, what would you expect bond guys to do after equities stopped producing bonus pool? Einstein said the definition of insanity is “doing the same thing over and over again and expecting different results.”

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