Finance Roll

Investment Banking and global finance is a lot like a big craps game. Maybe with one fundamental change though. Just assume that every payoff in craps is increased by 1/36th. What this means is that the advantage goes to the player. The players are bankers and hedge funds with capital to deploy. The advantage, which I'm suggesting can be expressed as an increase in the payouts for the various bets. I chose the unit of measure: 6 x 6, since all of the bets in craps pay out in various multiples of six.

Call it growth-rate. 1/36 is a little over 2%, and is the basic unit of advantage in craps. There's a premium in our world for doing stuff, so it's not a zero-sum game - and certainly not usually in favor of the house. Who is the House? Well, in this example it would be waste and failed investments. Non producing assets if you will. Think of it like this: There is a huge amount of capital to be deployed at any moment. It can be kept on the sidelines but someone is quietly stealing your chips if you leave it on the rack. We have to lay out the bets. Most are conservative, or at least hedged in some way. A small amount may be place on hard-ways, the field, horn, craps, etc. A lot of ways to lose and make money. Most of us don't do this every day, but the finance guys do.

It's probably enough just to say that they know what they're doing when betting on the pass-line (long, equity investment), don't-pass (short), hi-low (IPO), place (bonds, CDO/MBS, preferred stock,) and crap-check (credit-default swap).

The idea is risk management. Large amounts are laid out on the table at one time and the rolls are cast. Notice how every night the evening news reports the economy is either on a rebound or plunging into the depths of hell? There is a certain volatility inherent in the economy, certainly exacerbated by the efficiencies of information flow to automated systems. Even if we didn't have the wonders of automated trading it still wouldn't change the fact that our entire system is built around our expectations of the future. Expectations that feed on new information. Volatility is like laying larger bets down at one time. I know that doesn't make a lot of sense, but it's supported by the math.

Bankers may have a little longer view than most people on some things. For example, we have 30 year bonds. We cash-flow on a pro-forma basis many years into the future. Our holy discounted cash flow model has all the answers, whose sum (turned into the Present Value of course,) equals our current expected value of, basically, anything. Bankers leave their place bets up and never take their hard ways down. Bankers will acknowledge the 5% disadvantage on the field, but time their bets as to when 4 non-field bets have come up in a row.

My comparison works even better if you realize that at various points in the past, the payouts have been even better. There have been several times in the last fifteen years that the payouts on various bets have been even better. The dot.com era was heavily favored on the horn and hard ways. Maybe up to 100:1 on things like Apple, Amazon, and Google at various times.

The current economy has not only removed the basic 1/36 advantage, in fact it has taken an additional 1/36, maybe more. Money can still be made in the game - and the Fed (the house marker) will loan the best collateralized as much as they need. It's just that their daily play (many times per day for many market participants,) is now seen with a slight disadvantage. There are still plays to be made, but credit risk managers are playing conservatively. Not a lot of horn or hard-ways right now. The point is ten, and we're loaded on the pass line with full odds. Just hunkering down and hoping we don't crap out.

One of the problems inherent to the industry is that these players can't leave the table. Their job is to entice capital with the promise of returns. When the advantage turns back to the players (as it does under lower capital gains and corporate tax rates,) we will see a return to more aggressive game play. Is it? was that at ten? Shooter!!