I remember getting my offer letter from Lehman Brothers in early 1997, a full 11 years before they went bankrupt, I hasten to add. For a whopping $34,000, I was theirs, green as a Granny Smith apple. My job was in a division called Global Corporate Equity Derivatives, and I was going to help the traders keep their trading books reconciled with the general ledger. It was my first, and last, accounting job, and it sucked from Day 1.
But I didn’t know that, so I leaped with glee into my family’s New Jersey living room, and yelped, “Ma, I got the job!”
My mother squealed, “I’m soooo proud of you!” And then she paused. “I always wondered how those banks made all that money.”
I had no idea because my undergraduate macroeconomic classes were a heaping mess of Keynesian nonsense. They failed to mention things like money printing, interbank lending, and bailouts. I was about to get the education of my life.
I remembered this episode fondly as I read that every major U.S. bank beat earnings estimates this quarter. JPM, MS, WFC, BAC, and GS shot the lights out. But the reasons why are no longer a mystery. After you read this piece, it won’t be a mystery to you, either.
Sure, the Rothbardian reason that banks are closest to the money printer is still valid, perhaps more now than ever. And yes, during good times, CEOs idiotically decide to acquire or merge with another company in transactions that make money for white-shoed investment bankers, but not their shareholders.
During bull markets, it’s almost impossible for banks’ sales and trading teams to lose money. That’s not even their doing. It’s their clients —the pension funds, sovereign wealth funds, insurance companies, endowment funds, and other asset managers—who want to hedge their bets. I’ll explain.
Here’s the Issue
Investment banks (the sell side) service asset managers, or the buy side. The buy-side is the people who take all of our assets and buy stuff, like stocks, bonds, commodities, and real estate.
Asset managers are buyers of mammoth amounts of stock. That means they are constantly long. Of course, if they’re long, they always want the market to go up. And, yes, that is, for the most part, true.
But we must keep two things in mind, only one of which is obvious.
The obvious one is they don’t want violent downward moves, like the March 2020 Covid crash.
The not-so-obvious point is that they also don’t tend to want the market to move too violently upwards, either.
It’s like “quality of earnings.” A nice, steady increase is good enough for most of them. Of course, TSLA quadrupling is just fine and dandy. But asset managers would’ve certainly been at least partially hedged.
So asset managers do two things to combat a precipitous fall or to prepare for a “sideways move” in the stock. Here they are:
The Protective Put
An asset manager will go to their investment banks and say to them, “Listen, I’m long this stock that has, say, appreciated 40% in the past year. I need to hold on to it because it’s part of my investment plan, but I’m worried about the downside. Can I please buy a put from you?”
When you take a long stock position and combine it with a long put position, you have what’s called portfolio protection. It synthetically creates a long call option on the stock.
This means you’re still exposed to the upside, which is great, but you no longer have any downside. The asset manager eliminated that downside by paying the option premium.
The Covered Call
The second scenario is this: a fund manager may be forced to own a stock that is not particularly good—a dog, in asset management parlance—a stock that hasn’t moved up in many years and doesn’t pay the best dividend in the world.
But they have to hold it because it’s a part of their index or basket. So what fund managers often do is sell call options against those stocks.
They are what we call covered call positions, and, synthetically, they are short puts.
The asset manager will do this for a few reasons:
- The asset manager immediately receives a premium from the sale of the put.
- That premium increases the manager’s return.
- The premium also acts as partial downside protection.
- Earning a premium is better than paying out for a put when the asset manager doesn’t expect a big fall in the stock price.
If you’ve got fund managers who are both long puts and short calls, who are long those calls and short those puts?
The investment banks are. They facilitate this trade, so they are synthetically long the stock market.
How is that?
The investment banks are the ones who buy the calls from the fund managers and sell the puts to the fund managers.
A long call plus a short put is equal to a long stock position. We call this an “ax.”
Who are the two most prominent investment banks in the United States?
Morgan Stanley and Goldman Sachs, occasionally known as Government Sachs. Other universal banks like Wells Fargo, JP Morgan, and Bank of America also participate.
Now you can see why there is an implied upward bias in the markets. And, of course, vested interests don’t want the markets to come down.
This gives credence to rumors of a plunge protection scheme and the “Fed put” that Alan Greenspan was famous for. BTFD takes on new meaning when you understand this state of affairs.
Wrap Up
But if you are someone who doesn’t have many assets yet, you’re waiting to get in on the action. And waiting, and waiting…
You haven’t been exposed to the natural price deflation seen in economic cycles because banks, asset managers, the government, and the media have done their level best to eliminate deflation altogether.
Guido Hülsmann, in his masterful essay Deflation and Liberty (page 26), gives us the exact reason why the vested interests will not yield to price depreciation:
There is only one fundamental change that deflation brings about. It radically modifies the structure of ownership. Firms financed per credits go bankrupt because at the lower level of prices they can no longer pay back the credits they had incurred without anticipating the deflation. Private households with mortgages and other considerable debts to pay back go bankrupt, because with the decline of money prices their monetary income declines too whereas their debts remain at the nominal level. The very attempt to liquidate assets to pay back debt entails a further reduction of the value of those assets, thus making it even more difficult for them to come even with their creditors.
The game may be rigged, but all you have to do to benefit like the banks is get long the market and stay long. Until the market finally, mercifully, turns.
