October 2009 – 6 am pacific

Wall Street Bonuses are Not the Real Issue

This month the biggest Wall Street companies reported their quarterly earnings. JP Morgan Chase and Goldman Sachs reported bumper earnings, Citgroup and Bank of America, not so good. But if you leave out write downs on debt, everyone had a great quarter in their capital markets businesses. Billions have been budgeted for year end bonuses.

As could be expected, the issue of Wall Street compensation raised its head again. And this time there is the weight of the federal government behind it. Banks that have taken TARP money will see their executive compensation capped. And the Federal Reserve has suggested that all large banks that fall under its jurisdiction will be reviewed on on going basis to ensure that executive bonuses do not produce risk taking behavior that could put the banking system at risk.

There are several memes that get mixed up in any discussion about Wall Street compensation in the media. Add a lot of emotion from a distraught public and it becomes for a tangled mess where the media feeds the furore but there’s no real understanding of the underlying issues. Let’s see if we can parse the issues out.

Insider Trading

Raj Rajaratnam the boss of Galleon, a hedge fund in New York was arrested on Friday for being the mastermind of an insider trading network. That network included people in other hedge funds, private equity funds, consultants and corporate executives – all involved in trading insider information on public companies for profit.

In my four years at Gridstone, I met many hedge funds on sales calls. We offered a research platform with deep data on public companies which should have been of interest to any analyst who invested in public companies based on their fundamentals. But slowly I realized that there were very few in the hedge fund world that actually researched companies to any depth. Most just “traded the news” or were what is called “momentum traders”.

There were reasons for this. Understanding companies requires time and application. At about twenty companies in one or two industries, you start hitting the ceiling of what is possible for one analyst to cover. Hedge funds often don’t have the assets to be able to afford that many analysts.

But I think the real reason is that it is too damned difficult to beat the index just analyzing companies based upon publicly available information. Everyone is seeking an informational edge over the market. Some of this edge is through channel checks and such legal but proprietary sources. Much of it is through rumors – legal but quasi-public. And some of it is through insider information.

Informational edge is a slippery slope at the bottom of which lies insider information – the most alpha-producing informational edge. If you are a high achiever like most hedge fund managers are, and you have profited from proprietary information in the past, it is almost irresistible to cross the line. It doesn’t help that the difference between the difference between a rumor and insider information is only in how the information was procured. A rumor very well could have started its life as insider information. On large caps, placing a bet that is significant for the fund but small enough to escape being noticed is not too difficult. My belief is that insider trading is far more common than what one major bust every few years will make it seem like.

For Raj Rajaratnam and Danielle Chiesi this was about their hedge funds’ performance. But why did Anil Kumar and Rajiv Goel get involved in this? Perhaps the price of admission to invest in Galleon – which was ironically a fund whose performance was based on insider trading – on their tips.

The other irony here is that two of the major players in the insider trading ring are of Indian origin. So is the prosecuting attorney – Preet Bharara – US attorney for the Southern District of New York.

KenKen Puzzles

KENKEN Puzzles - NYTimes.com-2

In the last two months I have gotten hooked on to a puzzle called KenKen. It is similar to Sudoku, but different. I never played Sudoku much so I am not the best person to do a compare and contrast. But like Sudoku it comes to us from Japan. It was invented by Tetsuya Miyamoto, a Mathematics professor.

Will Shortz of the New York Time explains how to play it.

The New York Times has other coverage, besides hosting new puzzles every day.

Try it. It’ll give you hours of enjoyment. Also, if you have school going children, especially elementary school kids, this is a good way to make practicing arithmetic or logic, fun.

Leaving the Kindle On During Takeoff

airplane The last time I took a flight somewhere with my newly acquired Kindle, I was posed with this dilemma – should I turn my Kindle off during takeoff and landing? Or should I pretend that I was just reading a book that looked a little different?

Now the airline rules are very clear and are rigorously implemented by the airline crew:

1. All Portable Electronic Devices (PED) must be switched off during takeoff and landing.
2. No wireless devices can be operated during the flight.

The second rule is pretty unambiguous in how it should apply. All cellphones, laptops and devices with WiFi – anything with an RF signal – must not be turned on during the flight. The Kindle does have a cellular signal which can be easily turned off. Not a problem – the wireless anyway drains the battery real fast and its probably a good thing that you have to turn it off in case you had it on at the time.