COMMENTARY
This is a fascinating portrait of the inside of modern banking and finance ... another portrait that adds to the growing collection of material that shows the moral and intelectual bankruptcy of the sector.

I used to be a CFO and in that role was also the 'risk manager' for the company. In this piece there is reference to derivatives being part of an elegant way of 'managing risk' but in this reference I see instantly a problem with a core perception of what 'risk' is, and how risk can be managed. Risk is not managed merely by splitting it up and spreading it around ... risk is managed by doing some real things that reduce the risk and keep risk under control, in other words, for example, you reduce risk using better engineering. You merely spread risk inside the banking and financial services sector.

Some of the rot described in this essay started in the financial engineering of the late 1960s ... for example to acquisition of the Hartford Insurance Company by ITT under Harold Geneen. Very prudent investment by an insurance company could easily be leveraged to improve the profit yield for ITT ... but in the process the quality of the insurance reserves was compromised. Nobody cares about this until the insurance reserves are needed which happens from time to time. An issue that was part of the financial dialog 40 odd years ago was balance sheet quality ... and subsequently replaced by dialog about profit and return to investors which in turn meant more and more profit on top of less and less equity.

This and later the junk bond fiasco of the 1980s meant that the balance sheets of US corporate business were gutted ... and the first generation of banksters became super wealthy.

There is reference to the complex instruments that were being used to finance government ... I did work for some Finance Ministries in developing countries over a number of years and saw these products from the other end. The bank behavior was essentially pure fraud and 'conmanship' ... and I was disgusted then and remain so today.

Peter Burgess - This is an interesting essay, and very distressing. There is really nothing particularly new in this ... books were being written about the disgusting behavior of traders and their bosses in the banking world back in the 1970s ... and of course the issues were given free rein after the deregulation of the Reagan era, fortunes were made and we had junk bonds and savings and loan scandals ... and then things got even worse or better as derivative maths became more complex, more profitable and more dangerous and even after Long Term Capital Management imploded nothing got done to make the industry more responsible. I completely reject the idea that we are stuck with the present and only the future matters. It is time that a generation of bankers are held accountable not only in a superficial manner, but in a very material way. The idea that a relatively few people can make their millions of dollar wealth while millions of people have their rather tough life made even worse. The idea that these people freely entered into their rotten mortgages is BS ... they were 'sold' these mortgages by hard sales teams who made big commissions on the sale, with no responsibility whatsoever for following normal rules. The law is complex and not very powerful ... and accounting and accountability disorganized. Nearly every mortgage in the past 30 years has made money for the originating team without them taking on any risk ... what a silly system ... but nicely profitable. The big banks and securitization was an essential part of the system ... but all sorts of others jumped on the bandwagon. ALL of the steps in the value chain are culpable and need to be held to account.

#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.

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

Posted by: Kamran Ghassempour | November 12, 2011 at 06:11 PM

Ahh yes, make your millions helping 'Greece massage its deficit' among other honorable activities, and now 'it's all about looking forward' people. There will be anger before there is acceptance - and I suspect there will be a lot of it, however this plays out.

Posted by: Dave | October 31, 2011 at 04:43 AM

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.

Posted by: Ned | October 30, 2011 at 07:12 PM

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.

Posted by: Sean | October 28, 2011 at 12:50 PM

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.

Posted by: IsabellaBinney | October 28, 2011 at 02:08 AM

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.

Posted by: Me | October 27, 2011 at 10:57 AM

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.... :-)

Posted by: Chris Barker | October 27, 2011 at 10:48 AM