"We are out of money." Barack Obama May 23, 2009: Obama openly says what anyone with common sense has known for quite some time: the US is broke, and will not be able to honor its financial and fiduciary obligations.
“Quantitative Easing” it is called. As a refresher for readers with real lives and better things to do, QE is how central banks describe what is essentially an act of counterfeiting. They buy bonds with money created – electronically – specifically for that purpose. Abracadabra – “money” comes into being.
We thought the Bubble Epoch was the peak in claptrap and illusions. But we were only in the foothills. The feds now pretend to bail out the economy by giving money to companies that pretend to be concerned, run by people who pretend to know what they are doing. And when they run short of money, they create more of it, pretend it is real…and pretend they can tell it what to do.
~ Germany launches Gold-To-Go ATM's | Ladies & Gentlemen: the US Is Insolvent: “We are out of money.” Obama May 23, 09 | Avalanche of Claptrap Illusions ~
by Daniel Amerman, SafeHaven
While it may look superficially similar to the recent implosions of such investment giants as Fannie Mae, Freddie Mac and Lehman, the takeover and bailout of AIG is quite different, and means that the market is entering the next and even more dangerous phase. What is driving the fall of AIG - and potential government losses that may far, far exceed the $85 billion bailout announced late on September 16th - is not mortgages or real estate (directly), but fears that AIG's huge, global credit-default swap positions will unravel. The $62 trillion dollar credit derivatives market is 50 times the size of the subprime mortgage derivatives market, and is indeed larger than the entire global economy.
Unfortunately, few people understand credit derivatives, or the full risks to the United States and global markets and economies. In this article, I will take a Credit Derivatives Primer that I published in the spring of 2008 - which anticipated this exact type of event - and update it for the current situation. Through reading this article, you should be able to greatly increase your knowledge of what credit derivatives are, and why they are a far greater danger than subprime mortgages. We will end with introducing some concepts about how individuals can protect themselves and even profit from these unprecedented market conditions - something you won't find in recent financial history or conventional investments.
The Rapid & Dangerous Collapse of AIG
"The particular risks that brought the company (AIG) to the brink of bankruptcy seem to lie not with its core insurance businesses but with its derivatives-trading subsidiary AIG Financial Products. AIG FP, as it's called, merits a mere paragraph in the nine-page description of the company's businesses in its most recent annual report. But it's a huge player in the new and mysterious business of credit-default swaps: derivative securities that allow banks, hedge funds and other financial players to insure against loans gone bad."
- Time, September 17, 2008
On September 1st, few knew that AIG, the largest insurance company in the world with over $1 trillion in assets, was in deep trouble. By September 12th, the rumors about major trouble were everywhere. By September 15th AIG's corporate life expectancy was being measured in days, and the question was: bankruptcy, buyer or bailout? By the evening of September 16th, the federal government had massively intervened, making an $85 billion loan to AIG in exchange for a controlling 79.9% equity share of the company. [Not mentioned here is that AIG insures the Dept. of Justice, and a significant portion of the US Goverment]
Welcome to the brave new world of credit derivatives driven collapses. A world that is far more dangerous than the world of subprime mortgage derivatives. A complex world that because of its sheer size can potentially cause more damage in a matter of days than the subprime mortgage derivatives caused in their first year in the headlines. The chart below shows the relative size of the credit derivatives and subprime mortgage markets.
How great is the real danger? The bulk of the remainder of this article explains the extent of the danger. With a few market changes, this is the credit derivatives primer as published on May 2nd of 2008. There is also new material at the end of the article, talking about what could be anticipated, and introducing some solutions.
A Credit Derivatives Primer
In the article, The Subprime Crisis Is Just Starting, we explored the roots of the subprime crisis, demonstrated how mortgage securitizations work, and then used this knowledge to show why 2008 could be a much more dangerous year for the subprime mortgage markets - and the global financial system - than 2007. In this article, we show how the same fundamental - and quite human - motivations that created the subprime market crisis also imperil the $62 trillion global credit derivatives market.
Assumptions and Extraordinary Personal Profits
Let's consider the simple heart of what credit derivatives are all about. A major investor has the opportunity to make an attractive-looking investment that involves taking a risk. For instance, a bank or insurance company sees an opportunity in lending to a corporation, but they are concerned about the financial safety of the corporation. They would prefer to keep most of the positive returns from the investment, but not take the risk of the company defaulting.
So, as the employee of a company that creates financial derivatives (a credit swap in this case), what you do is promise - for a fee - to take the risk for them. Your company makes assumptions about how bad the risk will be, and based on those assumptions, you determine that this trade is profitable for your employer. You then personally take a nice chunk of those profits in your next bonus as a reward for having been smart enough to get your company into this lucrative transaction. And because this upfront booking of expected profits from these transactions is so lucrative, not only do you get an enhanced bonus -- but so do the other members of your group, your supervisor, their supervisor, and the president and other senior officers of the firm.
Now, this is not to say that you and the other members of your group have entirely assumed the risk away. You make some allowance for the possibility that out of all these contracts that you're entering into, you may have to actually make some payments. To cover the possibility of losses, you set aside a reserve, or buy a credit derivative from another company to cover, or both. The key to your bonus this year is the particulars of the assumptions that your group makes about what those expected losses will be in the future. The lower the assumption for expected losses, then either the greater your profits in a given transaction, or the more competitive your bid, and the greater your chances of beating out competitors who are seeking the same "lucrative" business.
For example, if your firm is being paid $12 million to guarantee payment of a $500 million loan for ten years, and your group assumes there is a 4% chance of having to pay out $250 million on that guarantee, then your expected losses are $10 million - and your firm's expected profit is $2 million. This is shown in the top chart below, "Making Money With Credit Derivatives".
However, let's say that your group comes back and re-examines those assumptions. You find that if you make fairly minor and quite reasonable appearing changes to two of your assumptions, the potential loss on the derivative drops from an expected $250 million down to $225 million. Make two other minor changes in other assumptions that are also each individually reasonable, and the chances of that loss occurring drop from 4% down to 3.5%. As shown above in "Making A FORTUNE With Credit Derivatives", rerun the numbers with a 3.5% chance of losing $225 million - and your expected losses drop to $7.9 million, while your profits just doubled, going from $2 million to $4.1 million!
Now, it quickly becomes clear to any reasonable person that if you can double the profits your firm recognizes on a transaction by keying in four small assumptions changes on a computer model, each of which sounds individually reasonable, and the end result of those changes is to double the bonus you get paid this year - then the key to making some serious personal money is making the right assumptions! Something that is equally plain to your peers at competitive firms.
The Vital Role Of Competition
Ah, competition! Competition is where the process starts to get interesting over time. Competition for credit derivatives business, for these easy profits, means that you and others in your company have powerful personal incentives to make aggressive assumptions about how low credit losses will be, and to validate your co-workers assumptions as well. If your assumptions are not aggressive enough, you don't win any business, you don't earn bonuses, your bosses don't earn bonuses, and you are quickly out of a job.
The institutional culture then very quickly becomes that if you want to keep your job - you and the other members of your group make aggressive assumptions. If you want to make big bonuses - you make very aggressive assumptions about how low the losses will be on the credit derivatives, which then translates into increased business for you. And yes, other people will need to sign off on your group's assumptions - but they are in the same institutional culture as you are, with their own personal reward systems that are based on the company making money. Also keep in mind that even the internal (theoretical) watchdogs are put in place by senior management, who have their own incentive structure, which is based on the company making lots and lots of money this year.
In a free market, where all the employees and senior management of all the financial firms want their piece of this lucrative action, the first thing that happens is that the firms with aggressive assumptions keep the firms with conservative assumptions from getting any business. And then, because we have competition going on here, in the next stage of the cycle, the very aggressive assumptions firms take the business from the merely aggressive assumption firms. Then in the next cycle, the people making the very, VERY aggressive assumptions take the business away - and the bonuses away - from the merely very aggressive assumptions makers.
To understand this process - you have to understand just how much money there is to be made by playing the game by its own rules, which may have very little to do with maximizing long-term shareholder value. Personal bonuses can be millions per year (with far higher payouts for hedge fund managers). As an individual who is in the right place at the right time - you can make more money in one good year than a doctor or airline pilot will make in a career. Except there is none of this medical school, or being on call, or flying over the Pacific Ocean business involved, there's just sitting at a desk and manipulating some numbers while working the phone. As a corporation you can mint profits by the billions and tens of billions, without going through that messy business of actually building things, or selling toilet paper, or drilling for oil in two miles of ocean or such.
A Real World Case Study: Subprime Mortgage Derivatives
Where does this take us? What happens when firms compete to make ever more aggressive assumptions in the pursuit of some of the most extraordinary profit levels in the history of business, in nearly unregulated markets? As it so happens, we have a pretty good case study that is still unfolding for us right now, in a real world derivatives market that is tiny in comparison to the overall credit derivatives market. In the case of the subprime mortgage derivatives market, by the time the very, VERY aggressive assumption makers had bested the very aggressive assumption makers, hundreds of billions of dollars of mortgage loans were being routinely extended to people:
With poor credit histories of repaying their prior loans;
Who put no equity into their homes;
Whose self-reported and sometimes unverified incomes barely qualified at the initial teaser rate; and
Who had no known means to come up with the additional money when the mortgage reset upwards from the teaser rate to the real rate.
Of course, you don't need an MBA or PhD in finance to understand the problems with the loans above. That said, there are ways to make very good money through lending to subprime type borrowers - but you need a way to deal with the foreclosure losses other than just assuming that the losses won't occur, or that when the musical chairs ends and everyone sits down, it will be the other firms who are left standing.
Because, it just so happens that home buyers of limited means with bad credit and no savings often can't pay their mortgages when the payments skyrocket, and this leads to quite real losses that puncture all the levels of assumptions and risk passing. And these real losses do end having to be borne by investors after all, with implications that are still shaking the overall financial system. (This subject is covered in detail in the article "The Subprime Crisis Is Just Starting".)
Sure, there were red flags everywhere - obvious, glaring unmistakable warning signs. But no one really cared. Indeed the investment banks were ignoring their own due diligence reports, because it was a party where enormous personal wealth was being "earned" - and paid out in entirely real and spendable bonuses - so long as you played your role in the game aggressively, with no rewards for those who doubted.
(Eminently respectable senior executives from the most prestigious financial institutions in the world might very well strenuously object to the content of this article, and insist they have very tight internal controls that make this treatment ludicrous. The credit derivatives market is a complex place, with a huge array of different types of derivatives, and there is more to the internal setups than we can cover in this simple article. That said, when you hear some eminently respectable senior executive on TV speaking of standard deviations and assuring you that you have nothing to worry about - do keep in mind that such assurances are being delivered "buck naked" so to speak. The subprime crisis really is in process, the mistakes made were not "Black Swans" but of the simple human greed variety, and as in the story "The Emperor's New Clothes", the lack of clothing is difficult to deny.)
A Key Difference: The Number Of Assumptions
We need to keep in mind that there is an important difference between the smallish subprime mortgage derivatives market and the much larger credit derivatives markets. Mortgages are dirt-simple in comparison to the complexities that are involved with corporate credit analysis. With a mortgage, you have a house, you should have a pretty good idea of the value of the house (or so lenders thought), you have an individual borrower with an income stream and a source for that income, and you have a credit history. Put all those together and you have a reasonable idea about whether that individual can pay their loan, and put a thousand people like that in a pool, and you should have a very good idea about the likelihood of repayment. Yes, there are many complications in mortgage derivatives structures (as I cover in my books on the subject), and all sorts of "fun" investor challenges with prepayments and tranching and convexity and the like, but the underlying product is not all that difficult to understand.
Corporate derivatives are an entirely different ball game. With corporations you need to assess complex financial structures. You need to look at the industry as a whole, assess the relative competitive standing of the company, look at foreign competition, examine comparative growth rates, subjectively evaluate management capabilities, and dive into the footnotes for clues as to pension and health-care exposure, as well as including a wide array of other risks and factors. All of which require using assumptions. Now, as we saw earlier in this article, assumptions are where the money is made when it comes to derivative securities. When we compare the corporate credit derivatives market to the subprime mortgage derivatives market -- there is far more room to make money through making aggressive assumptions with corporate derivatives.
The Second Biggest Assumption: Recessions
There are a couple of credit derivatives assumptions that have the potential to dwarf the others. We will start with the lesser of the two mega-assumptions that have to be made, and that is: do you price for the possibility of a recession? You know your profits are going to be far, far higher if you don't include the possibility of recession. Indeed it might be difficult to get business at all if you build the possibility of a serious recession into your credit derivatives pricing.
And how much business can you get if you price for the chance of a recession but your competitor does not? Can you stay in the credit derivatives business at all?
It is when we assume the possibility of a recession, let's say in 2008, that the situation truly becomes worrisome. As we saw with subprime mortgages, there are problems with taking profits based on assumptions when real losses can occur. If you're looking at $20, $50 or $200 billion in real losses on mortgage derivatives, then that money really needs to come out of the capital bases of the companies that have purchased the derivatives for profit. The entire financial system cannot successfully pass the risks off through ever more "sophisticated" financial modeling, until the risks have been assumed away altogether. Rather, the real losses have to be really borne by someone in the system, with real pain if the losses exceed the reserves. That is the basic, common sense point that was being nearly universally ignored by the major financial firms in the subprime market. This basic principle is what is causing the decimation of the capital bases of such companies as Bear Stearns, Citibank and Merrill Lynch, and their needing to find additional investors.
Do you believe that such a financial system - one that refused to consider what would happen when a marginal home buyer inevitably had their rate reset within one year - would prudently pass up huge amounts of fee income in a far larger market, to make sure that their corporate credit derivatives business could withstand the possibility (but not certainty) of a recession over the next few years? Which firm do you think would get the derivatives business: the one that charged whopping fees because they made conservative assumptions that fully priced in the next recession, or the equally prestigious, world famous firms that charged much lower fees by ignoring the possibility of recession? What do you think the individual employees did if incorporating recession assumptions meant getting no business and losing their job, whereas ignoring the possibility of recession led to promotions and multimillion dollar bonuses?
The Biggest Assumption: Systematic Risk
Our second mega-risk assessment is the truly dangerous one: do you include in your wildest assumptions the possibility that every derivatives contract which you are underwriting is not independent but may all go into a recession simultaneously? And what happens to the capital base of your employer at that point?
Let's go back to our initial example of taking a $12 million fee for guaranteeing $500 million in corporate debt, where you think there is a 4% chance of losing $250 million. The idea, as with any insurance product (which is what credit derivatives essentially are), is that you sell that same guarantee on 500 companies, and you ultimately have to pay out on 20 of the 500 companies (4%). You pay out $5 billion - but you take in $6 billion from the 500 fees of $12 million each, plus you get the investment earnings on the $6 billion until the payouts occur, so the whole business is (theoretically) lucratively profitable.
Now the problem is that this model assumes that each company is an independent risk. Kind of like insuring 50 homes against the chance that an electrical fault will cause one house to burn. But what if the problem is not an electrical fire, but a wildfire burning out of control, and the homes you are insuring are on a bone-dry hillside in Southern California? The risks are no longer independent, and instead of losing on just one insurance contract - you lose on 20 out of the 50 contracts.
The credit derivatives equivalent of the wildfire scenario is "imagine what happens if a recession hits the entire economy, rather than just one company". Let's say that recession does hit, it's a bad one, and because you are guaranteeing the performance of 500 companies all of whom already have financial issues during a time of semi-prosperity (the corporate equivalent of subprime), 200 of those companies fold instead of 20 during a time of financial turmoil. Because it turns out that the risk of failure is not truly independent after all; there is a correlation of risks during a major economic downturn. Now at $350 million a shot (greater individual losses per incident, as we are in a recession), that is a $70 billion loss for your firm. Which just went bankrupt.
As did your firm's competitors. Since you and your competitors can't pay your claims, those companies who relied on your $70 billion in claims paying off - and your four largest competitor's $280 billion in claims - find out that they are not going to be paid. Which means they have to take the total $350 billion in losses. Which they can't withstand either. So down the tubes they go. Followed by the companies behind them, as the titans of the financial world turn into falling dominos (if you want to understand why the Fed consistently and aggressively intervenes at the first sign of derivatives troubles, this is why).
I've been trying to keep things very simple and basic in this primer, but the issues associated with correlation and systematic risk are at the heart of the most sophisticated financial concerns about whether credit derivatives decrease financial risk - or increase risks for the entire financial system. One key issue is - how can you properly reserve for a potential $70 billion loss when you are collecting only $6 billion in fees? The simple answer is - you can't. The only way you could do so would be to drastically increase your fees, and then transfer most of the risk to other parties. Which would price you out of the marketplace. So in practice, all that pricing for systematic risk does is remove you from the business, as you can't compete with firms that aren't pricing for correlated risk.
Even if you could get the pricing to work, however, there is a more fundamental limitation. Let's say you had no competition, and you could double your fees, and you used the extra $6 billion to buy credit derivatives for your derivatives portfolio from another firm, so that any losses above $5 billion were covered by them (assuming your firm could handle the first $5 billion in losses). Now we assume again there is a vicious recession, your losses reach $70 billion, you take the first $5 billion in hits, then go to your counterparty for the rest of the $65 billion - and from where exactly do they come up with $65 billion?
This goes to the core of the derivatives dilemma. Everyone can make all the assumptions they want, and merrily pass the risk along to the next counterparty, and book their profits and bonuses for so long as the music lasts - but what happens when the music stops? What happens when return once more gives way to risk as has happened time and again in the financial world? We have an example right in front of us now with the subprime mortgage debacle, and despite everyone having assumed that they had passed the risk along - when the music stopped, the risks were real, and the losses had to actually be borne.
Indeed, we unfortunately have two very good examples of what happens when systematic correlated risks meet credit derivatives, when it comes to MBIA and Ambac. Until recently, these two bond insurance companies were bullet-proof financial titans, with the unquestioned, gold-plated "AAA / Aaa" ratings to prove it. Armed with ample layers of capital, these two firms could by themselves essentially protect the creditworthiness of the entire nation against recession and even depression - on paper, according to assumptions used by the rating agencies and the rest of the financial system. Then, in the real world, they actually ran into correlated risks in one obscure corner of their overall portfolios of guarantees, when it turned out that if too many subprime borrowers started to default at the same time, it depressed housing values. Which turned out (quite predictably) to simultaneously increase foreclosure rates while increasing losses per foreclosure.
Now, so long as the risks are independent, then MBIA and Ambac could have easily shrugged off increased losses in a few securities or even a few dozen securities. But, with correlated risks hitting tens and hundreds of billions of dollars of securities simultaneously - the "bullet-proof" capital base for a AAA rated insurance giant can turn into vapor in a matter of months. Something that the market has already incorporated into the pricing of these firm's stocks and debt, even while the rating agencies maintain the AAA façade to keep domino effects from imperiling the municipal bond and other markets.
Where Assumptions Meet Reality
Now here's the thing. The subprime mortgage market is tiny compared to the overall corporate market. A corporate market which has credit derivatives interwoven throughout. Let's say in this day of highly leveraged companies, that a real recession does hit and it takes down something like $2 or $5 trillion worth of book value along with it. Those would be real losses. Staggering losses that dwarf what we have seen with subprime mortgages.
Where is the money going to come from to pay for those losses? In theory, the way this works from an academic economics perspective is that you have all these hordes of incredibly intelligent people, each of whom is working for well-capitalized institutions, and they all backstop each other. They do so first by using that supposedly awesome collective intelligence to keep mistakes from being made in the first place. Next, the theory is that there will be multiple layers of protection available if there's a problem, to absorb any damage.
Unfortunately what we saw actually happen in the real world with mortgage derivatives was just the reverse of the theory. The multiple layers of the so-called "smartest person in the room" became multiple layers of people making steadily worse (and more obvious) mistakes in the pursuit of short-term profits until the situation not just predictably - but inevitably - collapsed upon them.
On top of that, far from the firms backstopping each other, in the real world we have a cascading series of credit losses that spread from one firm to another, as tens of billions of dollars in actual subprime losses multiplied out to become much larger hits to values of securities portfolios, nearly bringing down the industry together.
Which again brings up the question of what happens if a real recession hits the $62 trillion credit derivatives market?
by Frank Partnoy (Excerpt)
From 1993 to 1995, I sold derivatives on Wall Street [at First Boston and Morgan Stanley.]
My group [at Morgan Stanley] was the biggest moneymaker at the firm by far. Morgan Stanley is the oldest and most prestigious of the top investment banks, and the derivatives group was the engine that drove Morgan Stanley. The $1 billion we made was enough to pay the salaries of most of the firm's ten thousand worldwide employees, with plenty left for us. The managers in my group received millions and millions in bonuses; even our lowest level employees had six-figure incomes. And many of us, including me, were still in our twenties. Other banks—including First Boston, where I worked before I joined Morgan Stanley, could not match Morgan Stanley's aggressive new sales tactics.
The derivatives group received its marching orders from the firm's leader, John Mack. Following Mack's lead, my ingenious bosses became feral multimillionaires: half geek, half wolf. When they weren't performing complex computer calculations, they were screaming about how they were going to "rip someone's face off” or "blow someone up.” Outside of work they honed their killer instincts at private skeet-shooting clubs, on safaris and dove hunts in Africa and South America, and at the most important and appropriately named competitive event at Morgan Stanley: the Fixed Income Annual Sporting Clays Outing, F.I.A.S.C.O. for short. This annual skeet-shoot tournament set the mood for the firm's barbarous approach to its clients' increasing derivatives losses. After April 1994, when these losses began to increase, John Mack's instructions were clear: "there's blood in the water. Lets go kill someone.” We were prepared to kill someone, and we did. The battlefields of the derivatives world are littered with our victims.
At the time, I wasn't exactly a derivatives guru. I had attended law school, not business school, and the knowledge I had acquired, mostly from reading academic treatises, was useless on a fast-paced trading floor. Nor had my training courses at First Boston helped much. The year before I arrived, DPG [the derivatives products group] had arranged hundreds of derivatives transactions and had raised more than $25 billion of funding for clients. The group's new products included derivatives with names I'd never even heard of.
These were heady days at Morgan Stanley. No one seemed to care about how risky many of the hundreds of derivatives deals were. No one seemed to care about whether clients actually understood what they were buying, even when the trades had hidden risks. The group simply continued to pile trade on top of trade. Year by year, client by client, trade by trade, the venerable House of Morgan was building a precarious house of cards.
Early on I learned about one derivatives trade that I think exemplifies the group's business. This particular trade, and it's acronym, were among the group's most infamous early inventions, although it still is popular among certain investors. The trade is called PERLS. PERLS are a kind of bond called a structured note, which is simply a custom-designed bond. Structured notes are among the derivatives that have caused the most problems for buyers.
Morgan Stanley's derivatives salesmen made millions selling PERLS to investors throughout the world. These investors had little in common except that each of them would pay Morgan Stanley enormous fees, and many would lose a fortune on PERLS.
I discovered there are two basic categories of PERLS buyers; I call them "cheaters” and "widows and orphans.” If you are an eager derivatives salesman, either one will do just fine. Most PERLS buyers—the cheaters—were quite savvy. With PERLS, investors who were not permitted to bet on foreign currencies could place such bets anyway.
Morgan Stanley, in contrast, had nothing to lose. The firm would profit regardless of what happened to the various rates because it would hedge its foreign exchange risks in separate transactions with other banks. At the same time the firm would charge the investors millions of dollars in fees. In 1991 Morgan Stanley charged more than 4 percent for its multiple-investor PERLS. For $100 million of PERLS that would be $4 million of fees.
But there were other types of PERLS buyers who lacked the training and experience to understand them at all. They looked at a term sheet for PERLS, and all they saw was a bond. The complex formulas eluded them; their eyes glazed over. The fact that the bonds' principal payments were linked to changes in foreign currency rates was simply incomprehensible. These are the buyers I call widows and orphans. These are the buyers salesmen love. I don't mean to suggest that all derivatives salesmen sold PERLS to widows and orphans. But certainly some did. And many more salesmen tried to sell bonds similar to PERLS. The combination of simplistic appearance and complex fundamentals made PERLS a potentially lethal mix.
[One] salesman [who] had earned a giant commission on [a] PERLS trade asked me if I knew what it was called when a salesman did what he had done to one of his clients. I said I didn't know. He told me it was called "ripping his face off.”
"Ripping his face off?” I asked, wondering if I had heard him correctly.
"Yes,” he replied. He then explained, in graphic, warlike detail how you grabbed the client under the neck, pinched a fold of skin, and yanked hard, tearing as much flesh as you could. I never will forget how this salesman looked me in the eye and, with a serious sense of pride, almost a tear, summed up this particular PERLS trade.
"Frank,” he said "I ripped his face off.”
He then explained how you grabbed the client under the neck, pinched a fold of skin, and yanked hard, tearing as much flesh as you could.
I began to crave the sensation of ripping someone's face off. At First Boston I had never actually ripped a client's face off, and I certainly had not blown up anyone. Now, as I watched Morgan Stanley's derivatives salesmen in action, I began to like the idea.
Morgan Stanley carefully cultivated this urge to blast a client to smithereens. It was no surprise that I had caught the fever so soon. Everyone had caught it, especially the more experienced managing directors. My bosses were avid skeet shooters, constantly practicing at their private skeet shooting clubs, gathering for weekend hunting trips, and even traveling together on safaris and dove hunts throughout Africa and South America. When they screamed, "Pull!” they imagined a client flying through the air.
This kind of aggressive fervor was new to me. I had never belonged to a militia before. Even in its training program, First Boston had not been nearly as warlike. The salesmen at First Boston might have played practical jokes on their clients, but they certainly hadn't discussed firing shotguns at them or blowing them up or ripping their faces off. In contrast, Morgan Stanley was a savage cult. I marveled at how quickly the firm had seized on such a fierce creed.
The Pre4 Deal
In 1992, the Republic of Argentina issued the ugliest bond in history. The enormous $5.5 billion bond issue was popularly known as BOCONs.
The new bonds were issued in various series, one of which, called BOCON Pre4s, was by far the ugliest. It was almost impossible for the owners of BOCON Pre4s to determine what the bonds should be worth, and consequently investors hated them.
The Pre4s were not my first choice when my bosses instructed me to look for a derivatives trade in Argentina. They were too unwieldy. Nevertheless, with the end of the year approaching, we were looking for a home run to ensure that we could claim responsibility for plenty of profits at bonus time. We still were looking for the derivatives group's "trade of the year.”
We heard from a client that Goldman, Sachs had recently completed a large derivatives deal in Argentina. One of the DPG salesman quickly obtained a copy of the Goldman prospectus for the deal. It appeared that Goldman had taken some of the BOCONs, simplified them using derivatives, and sold the resulting mix to U.S. investors. They had made the purchase of BOCONs hassle free, and U.S. investors had purchased more than $100 million worth. By our calculations, Goldman had made several million dollars.
We began copying the Goldman deal shamelessly. The idea was simple enough, and Goldman's deal had some structural problems, which we began to correct. Investors loved the deal, and we had no trouble selling it.
The Pre4 Trust fit the pattern of RAVs [repackaged asset vehicles] we had been selling throughout the past year. First we found bonds that were subject to some type of costly investment barrier or restriction in a country outside the U.S. Then we found a way for the investors outside the country to buy the bonds and bypass the barrier. That formula had generated deals with sizable fees. Our trades also typically had one lead buyer, known as the lead order. The Pre4 Trust was no exception, and the lead order came from an insurance company in the heartland. Other Pre4 Trust buyers were more sophisticated.
However, even the most sophisticated investors obviously did not understand the mechanics of the trade. It was incredibly difficult to calculate the value of exchanging the ugly payments for simple payments. We had built an elaborate computer model to make these calculations, but I don't believe any of the buyers were able to create anything similar. If they had, they likely would not have agreed to pay Morgan Stanley several million dollars more than we thought the trust was worth. The excess payments were our fees.
A few investors had expressed concern about whether we would buy the trade back at a fair price. Many buyers didn't want to have to hold a trade for more than a few years and were worried that because the bonds were so unusual, they might not be able to find anyone other than Morgan Stanley to buy them. In such a predicament they feared Morgan Stanley would rip their faces off. They were right to be afraid. Morgan Stanley would commit to repurchase the bonds, but it wouldn't commit to do so at a fair price.
Despite these protests, the bonds proved easy to sell. A dozen or so investors were satisfied with the terms of the trade and agreed to buy. All told, we sold $123 million of Pre4 Trust units. The profits from the Pre4 Trust—approximately $4 million—exceeded those of any Morgan Stanley derivatives trade in 1994. The Pre4 Trust was our trade of the year, a clear home run, and my first "elephant.” The derivatives group was euphoric.
My bosses were avid skeet shooters, constantly practicing at their private skeet shooting clubs. When they screamed, "Pull!” they imagined a client flying through the air.
It looked as if I would have to close the Pre4 Trust alone. As I worked with the lawyers in Argentina and the U.S. to close the trade, several other DPG salesman tried to tell me that a $4 million fee was no big deal. One said he had made $8 million on one leveraged swap. Other salesmen said they had charged 5 or even 10 percent fees for derivatives trades. Even [the head of the derivatives group] burst my bubble, telling me a 4 percent fee was "OK, but it's not that great. We've taken more than that out, ten, twenty or more points.” I couldn't believe DPG had received a 20 percent fee on any trade, regardless of how stupid the buyer was.
There were two potential disasters on the Pre4 Trust deal. The first one involved the question of whether we should call the Pre4 Trust a "derivative.” Although the term was becoming more popular at the time, in reality, this was a minor point. Everyone knew the Pre4 Trust was a derivative. Nevertheless, I thought a clear statement that the trust units were derivatives would bolster the firm's case somewhat in any future litigation.
When [my immediate boss] returned from Mexico, I handed her a freshly printed prospectus and told her we were right on schedule. Boxes of prospectuses were on their way to the various investors, and I had a large box of them ready to distribute to the salesmen tomorrow. A few minutes later, I heard a blood curdling scream. When [she] saw the word "derivative” in the prospectus, she exploded. She began screaming at me, calling me every name she could think of.
"Godammit, this says derivatives! These aren't derivatives! Why does this say derivatives? Who told you these were derivatives?” She refused to let any of her deals be called a derivative, now that the term had such a negative connotation, and ordered me to halt distribution of any prospectuses with that filthy word in them. I conceived Federal Express to remove the prospectuses from their planes, just in time.
By Friday, September 30, [1994,] the details were done. The deal would close the following Monday, as planned. I stayed late Friday night, after everyone had left for the weekend, just to make sure I hadn't forgotten anything. I was alone on the deserted trading floor. Without the bedlam of angry traders and frantic salesmen, the place was spookily quiet. The phone rang. I was about to experience the second potential disaster on the Pre4 Trust deal.
It was the small insurance company from the Midwest, the lead buyer for the Pre4 Trust.
"We've decided not to go ahead with the Pre4 Trust deal.”
Pause. "Pardon me?”
"We've decided that the deal isn't right for us. I hope this doesn't cause any inconvenience for you?”
I tried not to panic. If they backed out now it would be a catastrophe. I looked everywhere on the trading floor. No one. It was now 7:30 p.m. I tried calling various managing directors at home, but no one answered. I tried calling the in-house Morgan Stanley lawyers, but they were gone, too. After leaving more than a dozen messages, I reached the partner from Cravath. Lawyers at Cravath were always at work.
I will not reveal the substance of our conversation other than to say that he used the phrases "What the fuck?” and "Shove it up their ass” more than a Cravath partner typically would. After I had briefed him, we called the insurance company.
For almost an hour [the client's attorney] raised numerous objections, each of which we batted down, until finally there was only one issue remaining. They wanted an amendment to the trust deed for the deal. They said if Morgan Stanley could agree to this amendment that night, they would stay in the deal. If not, they were out.
Just minutes before I was about to commit Morgan Stanley to these new obligations on my own, [my boss] called me from home. I quickly explained the situation, and she agreed to the amendment. The deal was saved. I was a nervous wreck, sweating and delirious. There was no one there to congratulate me. My bosses better give me some credit for this, I thought.
The next day, when Peter Karches, the head of the trading floor, walked over to DPG and asked, "Who did this Pre4 trade?” [The head of the derivatives group] took credit. I was angry and wished I had been able to claim full credit for my efforts. However, I understood the firm's hierarchy. At least if anything went wrong with the deal, everyone would blame him, not me.
[He] seemed happier now. He and I previously had argued, in a congenial way, about whether financial markets were efficient, with me taking the more commonly espoused view that they were. Now he told me "If I ever hear you talk about efficient markets again, I will make you go stand in the corner.” I laughed. He had a point. How could you make $4 million virtually risk free in so little time in an efficient market?
Everyone I knew who had been an investment banker for a few years, including me, was an asshole. The fact that we were the richest assholes in the world didn't change the fact that we were assholes.
DPG suffered some anxiety in early December , when one buyer of the Argentina Pre4 Trust said it wanted to buy some more. Two months earlier we had told the same buyer that the price was around $95. Since then the price of the bonds had declined. While we were trying to calculate the new value of the bonds, one derivatives trader stopped by for an update. The trader was nervous about whether we were offering to buy the bonds at a fair price. He was still concerned that if we lowered the price too much, the investors might realize how much money Morgan Stanley had made on the trade.
The Argentine Pre4 Trust was among the victims [of the December 1994 peso crash]. It lost $50 million in a few weeks. Investors were furious, and called constantly for explanations and up-to-the-minute prices. Traders no longer had to worry about whether a fair price was $90 or $95. Suddenly, $60 seemed pretty good. One trader said we should prepare to be sued.
The Pre4 Trust wasn't even close to the worst-performing derivative. One of the buyers of the Pre4 Trust, a fund manager from Morgan Stanley's own asset management group, said the Pre4 Trust was only his second worst performing investment. Another bank had sold him a Mexican peso structured note that had dropped from $100 to $27 in one day. I heard about several other derivatives that had dropped from $100 to zero. By comparison, the Pre4 Trust didn't look so bad.
As the Latin American markets continued to crash, the Pre4 Trust was among the worst-hit victims. The DPG trader who was giving out Pre4 Trust prices was about to snap. When one client called for a price, he said, "Use fifty, sixty, I don't give a shit, We're all fucked any way.” By mid-January, DPG was offering to buy the Pre4 Trust at $42, and offering to sell at $50. An eight point bid-offer spread was unheard of. Could it get any worse? One of the salesmen said he was a big buyer of the Pre4 Trust at zero.
By April 1995 I had become, in my judgment, the most cynical person on Earth. I now believed everything was a fraud, and I had a well-founded basis for my beliefs. Derivatives were a fraud, investment banking was a fraud, the Mexican and Japanese financial systems were frauds. It was depressing.
Everyone I knew who had been an investment banker for a few years, including me, was an asshole. The fact that we were the richest assholes in the world didn't change the fact that we were assholes. I had known this deep down since I first began working on Wall Street. Now, for some reason, it bothered me.
I don't mean to get on a moral high horse here. There is nothing impressive, from an ethical perspective, about my quitting a high-paying investment banking job. If anything it was idiotic. What I mean to convey is the reason why I decided to quit so quickly. For most people in the financial services industry, their job is morally ambiguous. That's the only way to survive. I had believed mine was, too. Moral ambiguity is just fine, especially while your salary is increasing. However, when I began to think, unambiguously, that what I was doing with my life was fundamentally wrong, I simply couldn't do it anymore. I had no choice but to stop.
What lessons did I draw from my experience selling derivatives? I believe derivatives are the most recent example of a basic theme in the history of finance: Wall Street bilks Main Street. Since the introduction of money thousands of years ago, financial intermediaries with more information have been taking advantage of lenders and borrowers with less.
If you still want to buy derivatives, you may as well buy them from Morgan Stanley. You can give them a call or just stop by the firm's new building at 1585 Broadway, just off Times Square. Don't tell them I sent you.
Source: Derivative Strategy; PDF: Data of Top 25 Investment Banks with Largest Derivatives Exposures, from GeorgeWashingtonBlog