Rumours are all over the street about huge proprietary trading losses at most of the big houses in the fourth quarter and a quick glance at the results of Goldman and Morgan Stanley shows that VaR remains high by historical standards.
The first response to this is simply: Aarrrrrrrrrrrgh! What is senior management thinking? I'd guess two things - and both are flawed beyond comprehension.
The first is that prop is always a quick way to build the P&L (assuming, of course, that it pays off). Given the horrors of the past year, outsized returns towards year-end would be much appreciated. And given that bonuses are already likely to be negligible, the immediate downside from any losses will be minimal.
The second rationale, and one that's equally disturbing, is the view that this is too good an opportunity to miss. This argument goes that valuations and relative values are so incredibly skewed compared to historical norms that there are huge amounts of money to be made in the market right now.
For example, convertible bonds are trading well below their bond floors, equity correlations are at incredible highs, and a fundamental valuation of almost any asset will suggest it's exceptionally cheap. All of these speak, in normal times, to great trading opportunities.
These, however, are not normal times and traders need to appreciate that. Trades may be directionally correct, but market irrationality outlasts people's ability to bear mark to market losses.
Banks should know better. The market is so far removed from standard conditions that we can pretty much throw out every trading strategy for now. Risk remains unprecedentedly high, and worryingly no-one really understands it.
Therefore, the only strategy that works without luck in this environment is to be highly conservative and minimize risk. Having tried and lost, the banks have no choice now but to curtail their prop trading activities across all asset classes - and not just in those that we already knew were toxic markets. Prop traders should really be history.