#OWS: one insider's view on how banking lost its way (and what to do next)



I spent the first years of my career in derivatives.  I made it Executive Director at Goldman Sachs before I decided to pack it in.  The year I left the City for a bubble incubator called Speed Ventures, I divided my compensation by 10.  But I never looked back. I wanted to share briefly my story and how I think banking went really, really wrong.

Truth be told, I have a terrible background to be in venture capital.  I started life in banking.  Even worse, derivatives.  In 1995, whilst not having a real clue what to do with myself upon my return from Hong Kong to Brussels, I vaguely interviewed for some marketing jobs, toyed with some entrepreneurial ideas, hung out.  I came out of this process convinced I would rather shoot myself than be a product manager at P&G.  I interviewed (exceedingly badly) for strategy consulting jobs.   In the end, I got a summer job at JP Morgan, primarily because the guy who hired me had similar music tastes (truth).

 

What’s so seductive about banking ?

Here’s what a trading room is full of: fascinating, fun and smart people.  This one wanted to be a concert pianist, this one is a PhD in physics who consumes Mountain Dew, this one never leaves his trading jacket, recites entire passages from Wall Street and seems to have visual representation of risk in his head.  It’s fun, it’s fast, it’s creative.  One aspect that most people completely underestimate is that market divisions in investment banks are full of quirky interesting egos and creativity.  They also train people amazingly well.  I was quickly hooked.  It’s like coke, except it’s your work: fast, action oriented, a bit too smart for its own good.  Oh, and they train people REALLY well.  In our world where the value of training is sometimes completely forgotten, it’s easy to underestimate.  It was an amazing school for structured thinking and fast decision making.  The 6 months training program in New York complete with 30th floor apartment above the Reebok gym was not bad either.  It took me a while to wake up and smell the coffee.

 

Derivatives for Risk Management

I started with pricing and marketing cross currency swaps.  Help a borrower get money in Danish Kroner and hedge it back to Belgian Frank.   Help a large corporate manage its interest rate risk on long term debt.  Help folks manage acquisition finance.  Help a utility swap inflation risk out.  And so forth.  People forget, but derivatives started as a really elegant tool for MANAGING risk.

At the time JP Morgan was at the forefront of managing credit risk (counterparty risk) dynamically.  The bank would famously issue the so-called 4:15 (Value-at-Risk) report that helped it understand every day at the same time what risk it had across its book to everyone else in the market.  Awesome stuff.  We started to dynamically price credit exposure on our counterparties, trade-by-trade, before anyone else.  JP Morgan also created a subsidiary called LabMorgan which itself spawned RiskMetrics to industrialize this knowledge and take it out to market.

Next we were on to banks.  We took the knowledge we had built and started pitching comprehensive risk management solutions.  We looked at the entire balance sheet (what types of assets they held that we could hedge or securitize, how they were funded and how efficient their regulatory capital structure was) and we would show a set of options to drive better Return on Equity.  Securitizations, subordinated capital financings that qualified for regulatory purposes, high yielding assets.  The drift was starting: I remember being part of designing and implemented a new type of tax-deductible tier I financing for Deutsche Bank using an obscure Luxembourg-issued quasi equity instrument.  Regulatory arbitrage had started.  The race was on to arbitrage the regulator and the tax authority.

 

Rotten from the start

Whilst I understood (and liked) what we were doing as risk management, the endless innovative capabilities of financial engineers and greed had already started polluting the system.

At the heart of it all was AIG Financial Products.  You’ve seen from above that counterparty credit risk was always going to be central to derivatives.  Whoever provides you with a derivative hedge, you get exposure to.  Well, a savvy team of hungry ex Drexel Burnham Lambert (remember junk bonds) guys had understood this early and went out hunting for an indestructible AAA balance sheet that they could leverage to put themselves at the center of the credit puzzle.  That turned out to be the large and venerable AIG.  Junk bond guys meet the unsuspecting insurer, good things are bound to happen…

Well these AIG FP founders went to work with a black box they simply called “the System” and started making money.  ”We were all kind of artists,” one of the founders said recently. “The excitement of it wasn’t the money. The money was the scorecard. The drive behind it was creating something new.”  AIG became the “unsinkable balance sheet” that stood behind so many of the transactions that creative minds at Bankers Trust, Merril Lynch et al.  They priced the type of credit risk that no one else would.

Early on, the potential of derivatives (and their beautiful complexity) was used to generate highly profitable transactions for the investment banks by fashioning investment products that offered ever higher yields (or ever lower borrowing costs).  Want to buy some Luxembourg bank exposure coupled with a barrier option on a given foreign exchange pair ?  We can do that for you !  And if you get in trouble, we’ll restructure the instrument and make it even more impenetrable.  Early incidents that I was a witness to included the Kingdom of Belgium, that tried to reduce its debt exposure with some funky FX structures and ended up with major leveraged position on Sterling right at the time when Soros decided to attack the currency.  The net result was that the hapless employee at the Kingdom of Belgium who had put on the trades killed himself, and had a funeral complete with City Bankers in long coats at the end of the procession (one of the great untold derivatives scandals of the 1990′s IMO).  I heard that when the barrier options came close to their limit, the Sterling dump that resulted contributed to Soros’ efforts in pushing Sterling out of the EMS (Black Wednesday).  Nicely done Merril Lynch (more here).

Merrill Lynch late last year paid the Kingdom of Belgium $100 million to end a long-running dispute over a series of derivatives losses that, at one point, totaled $1.2 billion [...]  The losses stemmed from a series of currency knockout and “power knockout” options written between 1989 and 1993. Power options are enormously risky structures, since their payouts are squared—meaning the notional amount of a contract may only represent the square root of the potential liability. In this case, Belgium took naked positions to reduce its exposures to currencies—one of which, it seems, was the dollar—in exchange for premium. The losses peaked at $1.2 billion when the dollar weakened earlier in the decade, but its subsequent strengthening reduced the losses.

 

Arbitrage the shit out of everything (the “Beautiful Game”)

By the time I decided to leave the City, here’s roughly what was going on:

  • Banks had securitized pretty much everything and their balance sheet was generally fully optimized though hard to comprehend.  The risk had been shifted to institutional investors and no one really knew where it sat anymore
  • Insurers then reinsurers got involved (aka greedy).  First we shifted risks away from the banks, then we shifted it from insurers to reinsurers.  Entities like Centre Re were lauded for taking on all sorts of creative risks. Everyone was looking to create “their” AIG FP, which by that time was a money making juggernaut.
  • And really everyone got greedy — investors would buy principal guaranteed exposure on basket of hedge funds instead of bonds, equities or straight hedge funds investments.  Borrowers would use increasingly fragile offshore funding structures to optimize tax and so on.  Asset managers no longer felt that buying straight assets and a few simple volatility instruments was enough.  Everyone was into structuring by that stage.
  • The banks had become impossible for the regulators to control.  The regulators were outgunned on modelling firepower and whenever they surfaced a strong exec, said person would be hired illico presto by one of the investment banks.
  • The core issue became “how do we hide our insane P&L when we mark-to-market the instruments“.  Not: are we putting our clients interest first ?  (Sorry, Goldman).

When your big concern is smoothing your P&L over time, there is a problem.  In the last year, I participated in “legal” tax minimization for corporations so they could avoid paying their dues in Argentina, in selling high risk Japanese banking assets repackaged into Austrian insurance bonds, and helped Greece massage its deficit, and so on.  Whatever happened to Risk Management ?   It was time to go.


Where does that leave us ?  #OWS ?

In the last 10+ years, I never looked back as I do my best to assist entrepreneurs in building companies.  I am not surprised by what happened, except maybe for the magnitude of the problem, and I understand the anger of #OccupyWallStreet and others.   But you can focus on the past (“who’s to blame ?”), or you can focus on the future (“what did we learn ?”).  The system needs to change, bottom up, for sure.  Between election lobbying, gerrymandering, filibustering and plain defrauding, it’s a pretty screwed up system all the way through starting with the interaction of business and politics.  I share Umair Haque’s anger (and enjoy his wit).  As for my views on #OccupyWallStreet, I am with Bryce.  For the record, I believe that an advanced society has a duty of care to its weaker members, believe in universal healthcare, separation of church and state, and building an inclusive society.  I am what you might call a sustainability-obsessed liberal.  But before you point the finger and say “it’s all their fault”, let’s rewind for a second.

When I joined JP Morgan in 1994, the #1 issue raised by our Chief Economist at the time went like this: “the #1 risk to the global economy is the over-indebtedness of the American consumer“.  That was 1994, people.  Not 2007.

Let’s say that the following needs to happen:  we get out of a get-rich-quick and spending mentality and back to a more rooted view of a sustainable path of wealth creation.  We need to deeply change attitudes towards credit, spending and leverage across the board.  We need to reintroduce broad notions of respect of constituencies (society, employees, management, shareholders) in the way we run and build companies.

Pointing the finger at the Man may help people feel better, but for me, it’s shared responsibility.

  • People at large got hooked on consumption and leverage.  Did anyone really think that borrowing 100% of the price of your house was sensible ?  Really ?
  • Retail banks pursued ridiculous lending policies.  Worst offenders: Swedish and German banks offering EURO denominated loans in Eastern Europes.  That’s called a carry trade, it’s criminally risky.
  • Investment banks do what investment banks do: they innovate and oil the wheels.  See above.
  • Regulators and the Government were drinking the cool aid of home ownership.  They helped make this happen.

For me, it’s all about looking forward.  I don’t think trying to take money away from banks or pointing the finger matters or will achieve much.  If excessive behavior happened, let’s pursue it.  But personal responsibility matters more.  When nearly everyone becomes a day trader or remortgages their house to buy plasma TV’s or spends their time watching reality TV, what kind of society are we building ?   Time for a reboot.  Greed and the politics largely got us into this mess, the silent majority will hopefully wake up and get us out of it, step-by-step.  And to take a leaf from Zen’s book of life, it’s not use pining for a different present.  The present is all there is.  It just is.

 

 

 

 

 

 

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  • Chris Barker

    it’s not how banking went wrong, it’s a symptom of the human condition – we are, have been and always will be motivated by greed and consumption. This has never changed throughout our history, everything we are driven to do is for greed of some description or other (life, fame, money, noteriety), very few individuals are entirely altruistic.

    For those who think our ability to self destruct is a new invention I would refer them to the south sea company from 1711 onwards, particularly 1720, which saw human greed in its raw form – fortunes were won and lost in days and weeks and the British econmy was severely jeopardised, parliament had to act – Sir isaac newton was famously quited as saying of the financial mess it created as ‘I can calculate the movement of the stars, but not the madness of men’

    So this isn’t new and hoping we can all ignore the greed principle and defer to our fellow man or learn to say ‘I’m full thankyou’ isn’t an answer, it’s a dream.

    Dealing with this financial crises is a bit like making love to a gorilla, there are only two ways of going about it: either very carefully or however the gorilla chooses – I’d incentivise the gorilla to be caring…. :-)

  • http://profile.typepad.com/me43 Me

    I don’t think trying to take money away from banks or pointing the finger matters or will achieve much.

    Yeah. I do. I worked for J P Morgan in the late 90s, and I was astonished at the blase attitude to risk management that was prevalent. The VaR was a PoS from the get-go. 20% movement of stock price and 20% movement of voaltility? Really? That’s the worst-case scenario you can think of? BS. It was just an attempt to placate shareholders and make the SEC believe that risk management mattered (which it never did – only profit mattered). I wrote the VaR report for the equity trading group (JPMSL) and one of the assumptions I questioned was volatility. “Where did the 20% volatility figure in our options pricing algorithm come from”, I asked. “It’s always been 20%”, came the reply. And at that moment, I knew we were f**ked. Prescient for a 22-year old, but was I wrong? No, sadly.

  • IsabellaBinney

    Because we know that humans famously screw up whatever they come in contact with, mostly through the errors of desire and delusion, what helps are guidelines, rules, regulations, laws. Without them, we destroy.

  • http://www.parkparadigm.com Sean

    I think it went off the rails when a toxic combination of Industrial Age (ie Baby Boom) HS Varsity Quarterbacks and early Information Age nerds came together to dominate the ranks of wholesale finance. The old jocks were clueless as to what their geek minions were really doing but it made lots (and lots and lots) of money and they had been groomed since youth to believe they were special so they just assumed the money was fairly earned as a result of their awesomeness. The quant nerds reveled in their new ability to get laid and their collective autism blinded them to the reality of the mess they were creating: all they saw was the beauty of the math. And the Ferrari. And the Spearmint Hippopotamus platinum girlfriend that finally recognized their true genius and charisma (unlike all those girls in high school.) Fucking train wreck.

    As you know like you, I too left mainstream finance for the startup world and although it’s a gross oversimplification / generalization but I would posit that the single biggest difference between the two worlds is hubris in the face of risk and a culture of entitlement. Ambition, energy levels, creativity, intelligence, egos, etc. all abound in both worlds, but hubris and a culture of entitlement are largely missing from the entrepreneurial genome.

    Of course accomplices were needed to allow the bankers to take everything beyond the limits and then still not satisfied hit the nitroboost, and – while we’re in sweeping-generalisation-mode – lucky for them they had the baby boom generation who in the western democracies were perhaps the most selfish and self-satisfied generation in modern history, riding the demographic wave like Kelly Slater on the North Shore growing more and more convinced of their innate genius while spending the savings of their parents, their own (impressively produced) wealth and then their children’s and grandchildren’s (which is where the financial engineering really came in handy.) In the process, the notion of personal responsibility was crushed like a bug to be replaced with a highly refined strain of personal entitlement.

    I’ve been very fortunate in my life – yes just plain lucky – starting with winning the ovarian lottery. But that doesn’t mean I haven’t worked incredibly hard to make the most of the good hand life dealt me. And so I believe that I have earned my good fortune fairly. But I sure as hell know that I wasn’t entitled to it and that serendipity and luck have played a part (in both directions good and bad.) That’s fucking life.

    And so to conclude, the single worst legacy of the last 40 years isn’t the trashed global balance sheet in my opinion, but this insidious, cancerous belief that we are wizards and can eliminate chance, eliminate fortune and if we fail it is not because it is impossible to eliminate failure or risk but rather because we aren’t trying hard enough and just need to try harder. This culture of zero tolerance for risk or failure, this culture that dismisses serendipity as irrelevant, this culture of Newtonian certainty is killing us. It gives us the abominations that are our legal, regulatory and tax codes that just get more and more and more complex (2600 pages just for Dodd-Frank, and that’s going to make things better? really? really??? ) and allows our societies to absolve themselves of self-sufficiency and personal responsibility because after all in this world you are entitled to have it all and if you don’t well it’s somebody’s fucking fault and can and should be fixed.

    The entrepreneurial world is impossible to remove from the greater human polity and so isn’t without original sin, but it is one of the last corners of our society where there is least a preponderance of self-sufficiency, personal responsibility and a tacit acknowledgement that things can go spectacularly right (or wrong) JUST BECAUSE and the best you can do is work hard to put yourself in the best position to take advantage when the stars align in your favor through no fault of your own.

  • http://profile.typepad.com/d95581305915807499 Ned

    Nice details, but the story doesn’t add up. As crazy as the derivatives might have been, they cannot result in losses across the financial system – they are basically a zero sum game. How could all these firms incur losses betting with each other, to a such degree that the smartest and the most successful among them barely broke even? They couldn’t…

    What happened was a huge housing market bubble, that was initially fostered by the government, and than took a life of its own, as people piled into the real estate because “it only goes up”. When the bubble finally burst, the home owners took some of the losses, the government covered some due to bad loans it had guaranteed, and the rest ended in the financial system. Japanese banks were not very active in the US MBS market, so they were ok, but UBS, Deutsche and Credit Suisse were not so lucky. US banks, of course, fared the worst. There is no need to invoke “greed” (how are bankers in 2000s different to those that came before them?), although I’m not surprised that the author, being a “sustainability-obsessed liberal” does.

  • Kamran Ghassempour

    Fred,

    Nice post and for someone being at the same time than you in JP Morgan and switching from IT to trading, I recognize the fascinating atmosphere of the trading room. IMHO, things started to get wrong once we were allowed to bet with other people’s money and rewarded only for risk taking and not for risk management. I remember resigning from my trading job and going to a product management jon in an incumbent telco (Belgacom), the MD (Hervé) looked at me like I was insane and told me “don’t you want to make money ?”

    It was a great training job and it allowed me to manage my own money wisely but I would never go back (even if I miss the cheese cake in NY ;-)

    Take care
    Kamran

  • http://profile.typepad.com/tvinx Tvinx

    Very good article – nothing new on this Planet. Ups and downs, period of gread is followed by period of depression (recession perhaps sounds better). There are always new generations coming, that want to be in the first row, voluntarily making same obvious and silly mistakes, because ‘this time it will be different’. Ofcourse it is never different, we canot defy laws of Nature.

    I remember first Dot-Com bubble, we really believed that nothing will be same – economic laws will change, profit is not important anymore. Ofcourse, laws didn’t change and I needed a couple of years offline to rest and fall in love with Internet again :)

    I think people need landmarks, lighthouses, moral authorities – whatever, something to rely on during all times. We live hectic and confusing lives, we really need help. Let’s find best among us and let them guide us into better society.

    I am optimist