#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.