I was on the Andrew Hall/Phibro beat for a while and must confess I dropped it in the finish-the-book crunch. I neglected to follow up on and important aspect of the story that is still germane.
Readers may recall the brouhaha: Hall, a high stakes oil trader, had received nearly $100 million in 2008 at Citigroup (Phibro, his unit, was a subsidiary) and had the potential to earn that much this year. His pay deal looked unseemly even by Wall Street standards. As we noted in our first post on this matter (where we took issue with the Wall Street Journal’s posture):
No where is the asymmetry of this arrangement mentioned: that Hall and his team get the upside (30%, more than a hedge fund success fee, more than even LTCM in its glory days, which got a 25% upside fee), but the taxpayer gets stuck with the losses. Hall and his bunch have the richest option deal going. Nor does it bother to point out that Hall would find it hard to get access to as much capital as Citi provides him on such rich terms from the outside. Citi not only provides him with more equity than he is likely to be able to raise (certainly for a 30% upside fee) and his cost of funding is sure to be considerably lower than if he were to operate on his own.
The indefensible aspect in our new bailout era was that taxpayers should be backstopping or funding activities only if they are essential parts of the financial infrastructure. Principal trading is not on the list.
What was intriguing was as things rolled forward was that is was increasingly obvious that Hall would not be able to replicate the conditions he had at Citi anywhere else. After some initial resistance to the pay czar pressure, Hall started negotiating with Citi. Huh? If he was such a hot item, he should have been able to decamp and raise money, or find a happy home in another bank. Contrary to conventional wisdom, not all banks in the world are walking wounded. The Japanese, who are keenly interested in oil thanks to their need to import a ton, would be candidates. Some Eurobanks are not on the government drip feed (Sandater, Deutschebank, although their regulators could have curbed a deal). And there was always the option of a joint deal, say a bank plus a deep pockets investor, private equity firm, or sovereign wealth fund (they took a hit, but should be showing some improvement as equity markets rebound).
But what did we see? Hall wound up at….Occidental Petroleum. Maybe the company has changed, but I had some very limited dealings with them in the 1980s (they were pedaling an utter garbage barge of an oil shale deal, and were so eager to foist it on the chump Japanese that I got to meet all the top brass. To put it politely, they were not nice people, and I see that some that I met are, ahem, still in positions of considerable influence. My dim views then were confirmed by commodity traders).
Now the Journal in particular put up a series of articles that finger wagged at government interference (see here, here, and here for a few examples, with a qualified exception here).
Whoa. Phibro earned an average of $351 million a year for the last 5 years. Oxy paid $250 million, the current value of Phibro’s trading positions. There was NO premium, zero, zip, nada, for the earning potential of the business. Zero. Oxy bought the business for its liquidation value.
Hall’s travails had been in the paper for months. The usual routine if you want to get offers for a division is to let the world know it is for sale (the usual code is “exploring strategic options” but more blatant forms like front page business section stories work fine too). Hall most certainly would have put out feelers; presumably Citi did as well. This was the best deal they could scrounge up.
So what does that say?
A LOT of Hall’s performance was due to cheap funding from Citi, and probably massive leverage too, conditions he could not replicate anywhere else. A risky, highly geared operation should pay an interest rate appropriate to the hazards it is taking, not the borrowing costs of its parent (this basic premise is widespread in financial firms, embodied in approaches like RAROC (Risk Adjusted Return on Capital), the Basel I and II rules, and Economic Value Added models.
Hall could not have been a balance sheet hero unless his pay deal did not adjust for the riskiness of his borrowings. Since Phibro acquired Salomon Brothers (which then came out on top in a palace coup) which was later acquired by Travelers and then merged into Citi, it is possible that Hall’s arrangement was grandfathered and the internal accounting made to correspond to it rather than the conventional metrics in use today.
It is impossible to know for certain, but the deal Citi cut with Oxy struck strongly suggests that Phibro’s preformance was in large measure the result of amped up leverage that no one outside Citi was able or willing to provide. Future financial reports from Oxy may shed more light.
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A LOT of Hall’s performance was due to cheap funding from Citi, and probably massive leverage too, conditions he could not replicate anywhere else.
Sounds like some allegedly profitable banks I heard about, getting cheap funding from the Fed and massive leverage backstopped by the government.
The Hall situation reminds me why trading operations were not valued highly by acquirers in the ’90s. Their results were volatile, and the traders were a pain for management, since they always wanted more of the profits. Thus Salomon Brothers vaunted proprietary trading operation was quietly scuttled by Travellers (or Citi). The advantage enjoyed by proprietary trading groups like Salomon’s–if an advantage existed–seems, from various accounts, to have been in the information flow that existed on the trading floor, rather than in the remarkable abilities of the traders.
to suggest that one can earn $350m(after comp and all other expenses) just because of cheap financing is ridiculous given the facts you have at hand. as you are saying, his open positions at the sale closing are $250m, so this is about 140% annualized return after all fees on his working capital. hat off to mr. hall.
why is this, or any other, trader a thorn in the eye of everyone? the old man made money, he deserves his cut. there is an old adage: at banks there are old traders, and there are successful traders, but there aren’t old and successful traders at banks.
he’s an exception to this adage, maybe. he has not contributed to the company’s demise, to the contrary, he has made alot for citi.
traders do not bring companies down, it is complacent and incompetent management. had citi not given him so much money to play with, his bonus would have been much smaller. had citi kept more capable traders like him, they would have not been so deep in their own subprime/credit card $h1t.
Did you bother reading the post? If Hall is such a great trader, why didn’t he raise a fund? Why were there NO other bidders? Why didn’t Citi spin him out, and retain a stake? Oxy did due diligence and saw no reason to offer more than liquidation value. The fact that Citi or Hall did not say “stuff it” and go raise some money says the numbers did not look so hot when laid out in gory detail. Either tremendous volatility, and/or as other readers have suggested, way too little equity capital alloted to the organization (ie, no one else would be wiling or able to operate it as Citi had).
He most certainly did not “earn” $350 after his cut, all reports said his unit’s bonuses were based on “earnings”. His close to 30% came out of that total. And having had Citi as a client, “earnings” is profit center earnings, before overhead allocations.
and with regards to his leverage: good luck getting 10x leverage for commodities trading with those common 3-6% daily swings. even 5x seems remotely possible to me.
How much have oil prices risen this year, and how big might Hall’s book be? Anyone net long looks like a hero these days, and it is hard and costly in most markets to be net short for any length of time.
Your argument also presupposes that Citi shut down Hall’s positions every Dec. 31 (that is, you assume all of the net position value is pure 2009 profit). They didn’t, they simply calculated them at Dec. 31 for reporting and bonus purposes.
Unless Citi realized all the profit from last year at year end, his positions NOW include retained profit from prior years. And some portion (a lot?) also has to be attributed to the equity required to support the business, and hence is not a profit due to Hall’s action.
Re leverage, Citi could lever as much as they wanted to, in theory. If Hall was doing trades with exchange-traded instruments, it would be pretty hard to avoid daily marks and lots of volatility. But if he was entering into complex customized trades as a buyer or seller, he’d have a lot more latitude as to his valuations, and hence could buffer a lot of daily trading noise. It has been shown in a lot of other markets (structured finance being the poster child) that illiquid assets, which should be more risky from a trading business standpoint, are often treated much more favorably by the risk management police (and hedge fund consultants) because they can be valued to show less daily volatility, which is treated as less risky. Thus it is conceivable the business was geared more heavily.
if i recall corrctly when brian hunter blew up amaranth, his leverage was 6 times.
Amaranth was also a stand-alone operation, subject to the credit limits third parties and exchanges would impose on it. Not a relevant comparable. Moreover, Amaranth’s level of gearing was not the proximate cause of its demise. Like LTCM, Amaranth ignored liquidity risk, and held nearly 10% of the contracts in natural gas futures, a breathtaking gamble. Any postion that large, even in a very actively traded market, will prove very difficult to adjust quickly. You cannot run wagers that big with much of ANY leverage, unless you want to rely on luck. You have no tolerance for error.
philbro has been (and still is) part of citi. as such, it is subject to a company wide position cap that covers citi’s prop desk as well.
and do not forget that for the 1st half ot this year, there was a nasty contango in the oil market that would rip off any long only trader 5% every month at rollover. the only way to profitably play the long side of this year’s oil rally has been holding physical oil.
bb, I have had Citi as a client, including its biggest Treasury and trading operations, and I know more than a bit about risk management. These rules are implemented in practice FAR less rigidly than you suggest.
You are assuming a simple roll of the nearest contracts. A strategy like that puts you in the crosshairs of folks like Goldman who rips anyone, particularly commodity funds, that are committed to rolls of near futures at contract maturity. Longer dated contracts have also risen over the course of the year. You can be net long via a lot of other routes than a simple nearest futures contract roll.
i do not remember the 6 month forward WTI dipping below $60. now it is about 80, as much as the front month. 6 month forward contracts would have been subject to rollover risk as well during the past year. when goldman (who owns the pipe maintenance business that serves the Cushing, OK depot) and others pushed the front month down to $40, some smart guys began stockpiling and Cushing ran out of storage capacity very quickly. oil became a profitable game only for the insiders who can take physical delivery. all commodity ETFs and mutual funds got burned on the way up and then on the way down. there are still plenty of tankers stationed around the globe filled with oil owned by smart guys with real money like soros, rogers who can buy physical oil and hold it without worrying what the rigged market does in the meantime.
are you suggesting that there were huge arbitrage opportunities in oil and gas markets? i doubt it, arbitrage funds would have closed the gap very quickly.
truth is, one can get ample leverage only in interest rate instruments as they are most liquid, commodities are always subject to the highest margin requirements possible, no matter if it is internal business or not.
bb, from your comments it appears your experience extends only to exchange traded instruments, from the vantage of a retail trader. Financial firms like Citi do not assign “margin” charges to internal operations, their methodologies are completely different. I suggest you limit your comments to areas where you have expertise or at least first hand knowledge.
if you trade energy on an exchange, the exchange makes your margin calls. if you do it on the OTC market, your counterparties (like goldman) make the margin calls on you. suggesting that he had played with 4x leverage ($1bn in total) means that he would have had a few $100m daily swings this year.
i am confident that citi’s management is both incompetent and clueless, but to flip on a daily basis so much money for the margin calls of one client is unimaginable. you can easily trick the internal risk management unit, but can you trick with the daily marks your counterparties?
can you give me an example of how one can take a long position of oil/gas without having a counterparty or without having contractual margin requirement?
the only thing in my head is taking physical delivery of oil and stocking. please be polite and educate me.
bb, as I said, this is clearly an area where you do not have professional expertise and your comments continue to demonstrate that, whether you have the ability to recognize that or not. You referred to Citi charging margin to Phibro, as I indicated, that is not the approach large financial firms use in managing their operations, they use different risk management methodologies. You then attempt to deflect the topic to the margin Phibro has to post with third parties, which was not the matter I took up with you. You use that line of argument to imply that I made some error, when I had not mentioned the matter of margins posted externally.
I am always willing to hear from experts, whether they amplify or correct what I have said. I also welcome the view of people who have some knowledge of an area, but recognize the limits of their expertise, since many times we can combine our information and ideas and come to a better understanding. I am not interested in the comments of someone who not only asserts expertise in an area where he has limited knowledge, and further tries to twist my remarks in order to score points.
“A risky, highly geared operation should pay an interest rate appropriate to the hazards it is taking, not the borrowing costs of its parent (this basic premise is widespread in financial firms, embodied in approaches like RAROC (Risk Adjusted Return on Capital), the Basel I and II rules, and Economic Value Added models.”
You’re half right about the interest rate. But that’s not the real problem. The problem is the assessment of required internal capital, which is supposed to be covering the risk. If the capital attribution methodology is wrong, that’s where most of the effective subsidy is.
I suspect Oxi’s compensation policies also played a part in why they acquired Philbro. Oxi has always avoided relying on prop trading – so rather curious they wanted Philbro.
Maybe not so curious, however, when you consider Oxi ALWAYS ranks near the top of any executive comp survey. It becomes much easier to pay the CEO a huge bonus/salary, when you have a subordinate who earns more.
Yves, I’ve pointed out Andrew Hall’s 100 million dollar losses at a previous employer…
Worst Day in Phibro’s History: As U.S. began bombing Iraq, Jan. 16, 1991, Phibro is said to have posted a $100 million loss in a 24 hour period, as the unit’s bets on high priced oil and oil futures were crushed. Star trader Andrew Hall called it a “freak occurrence.”
Do you have a source? This also supports the idea that his deal, and some of his related accounting, were grandfathered (perhaps when Smith Barney bough Salomon, Phibro was a Salomon operation).
Also, ironically, I had a derivatives trading firm (O’Connor) as a client then. They made a fortune that day. Some people played the first Gulf war correctly.
If I was coming into huge money and needed some great traders to invest my capital, there are at least a dozen names I would prefer to Hall.
To name a few: John Henry, Liz Cheval, Bill Dunn, Salem Abraham, Jerry Parker, Ed Seykota, Amhet Okumus, Jeremy Grantham.
Yves, why do you assume there were no other bidders for Phibro? Oxy strikes me as an excellent company from which to run a commodity prop trading operation. Huge balance sheet, good credit, and a natural information advantage over the market as a whole. Also, Oxy isn’t a bank or a fund, which has huge regulatory advantages if legislation restricting the positions of financial participants in commodities markets comes into being (which seems more and more likely, to the detriment of us all).
Finally, you never answered BB’s question – how could Phibro be playing the balance sheet/leverage game if the market value of their assets was only 250mm?
Yves, there are two logical homes for Phibro. One is an investment bank. GS and MS have Phibro-like units. The other is an energy firm, like OXY.
The investment bank has the trading culture. The energy firm has a wider array of contacts and information from production activities, and consumption activities (OXY makes petrochemicals). That can leverage insights for Phibro, potentially, plus, there is no Chinese wall inside the energy firm. The two may be more powerful together.
This all assumes that they don’t lose other industry contacts in the process, who may view OXY as a competitors. On second thought, that is a very realistic possibility, which may truly account for the low price. OXY better hope that Phibro brings some real synergies.