There are times I think I am hopelessly naive.
For three years in the early 1990s, I had a cutting-edge Chicago-based derivatives firm, O’Connor & Associates, as a client. They had 750 employees and no customers, at least initially, which gives you an idea of the scale of their business.
O’Connor did statistical arbitrage, which meant they bought and sold derivatives when the market price was out of whack with the theoretical price. They also took some point of view positions based, for instance, on whether they thought volatility was cheap or dear. They often traded 5% of NYSE volume hedging their equity derivatives book They were big in FX as well, and had a risk arb book.
The firm was a cross between Wall Street and Silicon Valley. Half the firm’s budget went to technology. They ran the largest Unix network in the world and were constantly rolling out new trading algorithms. They were also very early adopters of the chinos and knit shirt dress code.
Why this long-winded intro? Because the view of the derivatives world I got from O’Connor and the one I got second-hand via Frank Partnoy’s Fiasco occupy parallel universes. Yet I would have no doubt that Partnoy’s realm was closer to industry norms than the world I saw (and I had untrammeled access to a firm so security conscious that it was compartmentalized physically, with each section having its own secure entry, and pass cards that opened all doors were the exception rather than the norm).
Due to the increasing efficiency of pricing in derivatives, the returns to its traditional arbitrage strategy were falling. O’Connor decided it needed to start serving customers to capture the additional margin. The firm quickly, along with Bankers’ Trust, became the leaders due to their ability to offer particularly complicated custom solutions (the trick was knowing how to hedge the trade, otherwise you couldn’t price it). O’Connor people often complained about BT because they were grossly overpricing their trades. You would think they would welcome that, since it give an umbrella under which O’Connor could operate. But the pricing was opaque; options typically had no explicit payment, but would involve the customer absorbing certain risks to get the protection they wanted. A simple version is a cap and floor. A customer worried, say, about interest rate increases might get that coverage in return for paying the dealer if rates dropped below a certain level.
The O’Connor crowd thought that BT’s practices would taint the entire product once customers figured out they were being had. Though BT was damaged when various lawsuits against them by aggrieved customer led to damning tapes of recordings of the sales force conversations were made public via discovery, the wider impact O’Connor feared idd not take place. BT was seen as a rogue operation.
Parnoy’s account of his time at First Boston and a longer stint at Morgan Stanley makes the BT revelations look tame. In realty, the seeming difference is probably largely a function of disclosure. But it certainly suggests the view that the public took, that BT was an outlier, was hopelessly naive.
Fiasco describes an environment where predatory behavior was prized and encouraged. Salesmen would describe with glee how they ripped a customer’s face off, or blew them up. Skeet shooting outings similarly and explicitly depicted the exploding clay birds as proxies for customers.
Partnoy also strongly suggests that there were pretty much no legitimate uses for derivatives. He divides customers into two camps: those that were knowingly using products with embedded derivatives to evade regulations, and hapless chumps (and those always got the first call when Morgan Stanley badly needed to place a trade). The skirting-the-rules uses included insurance companies that bought bonds that in fact were foreign exchange plays (bonds are permitted investments, FX speculation is a no-no), and Japanese companies who used derivatives to create phony profits to mask losses they had suffered elsewhere (in grossly simplified terms, the derivatives were sold to the customer, then in part sold back to Morgan Stanley. The sale back showed an enormous profit, which was reported immediately, the part retained has a corresponding very big loss, but that would not be reported till years down the road).
Partnoy is a skilled and often very funny writer, and he sets forth in detail that a layperson can understand how some of the products worked and what the economics to the firm were. But the centerpiece is the lurid, shameless, but prized for its productivity culture.
Aside from the frequent complaints about Bankers Trust (and this was not sour grapes; O’Connor’s market share was at least as high as BTs’ and its skills were probably a notch better, since O’Connor could sometimes place trades that BT could not).I did get some indirect evidence of the standards of the industry, or more accurately, the lack thereof. For instance, at one point, the O’Connor types were panicked that they were losing marker share, since their desk was hearing reports of big trades being done away from them, I was dispatched to investigate, and ascertained that the volume of trades was being exaggerated by a factor of three, perhaps as much as ten, as various firms were laying claim to trades they had not done. I had salesmen to my face assert they had done specific hedges on specific transactions that had been in fact done by O’Connor. There was, however, one market opportunity they had overlooked that was a natural for them, and once alerted, they pursued it to handsome profit.
O’Connor sold itself to Swiss Bank in a two-step transaction because it needed access to a much bigger balance sheet. Unlike most big firm acquisitions of boutiques, SBC managed not to screw it up. SBC gave the O’Connor partners a number of board seats that was considered scandalous in Switzerland, and Marcel Ospel saw the transaction as a vehicle for transforming SBC and thus gave the former O’Connor top brass the variances they needed to be effective.
Unfortunately, as often happens when firms are acquired, the deal meant I was no longer seen as being a suitable advisor. Big firms tend to like to hire brand names, and the sort of projects I once did went to McKinsey. So even though I stayed friendly with my immediate clients, I have no idea how quickly the O’Connor culture moved to the low industry norms. There was an angry, almost offended reaction to the idea of buying Bankers Trust when the scandal-ridden firm was on its last legs (it was purchased by DeutscheBank). I have to believe, given how “talent” moves around in the industry, that SBC, later UBS (SBC was the dominant player in that deal, contrary to the retention of the UBS name) came to be pretty much like everyone else in derivatives-land.
Even though Partnoy’s book is now more than a decade old, I’d assume things have not changed very much. The internal banter may more civil, the predatory imagery less open, but I’d suspect that customers are still viewed as sheep to be sheared. Or worse.
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Predatory behavior evolves as a matter of course unless there are strong forces opposing it. I've seen it in a number of businesses I've either advised or joined. My experience (though necessarily narrow given I am but one person) includes numerous anecdotes of everyone from the CEO to the administrative staff ignoring the worst sorts of behavior (fraud, etc.). Sometimes this was willful, with the person fully acknowledging and often joking about the behavior, but more often it was just a deep denial on the part of the person who merely wanted more money (sometimes for need, sometimes not) that it just didn't make sense to question how the money was obtained. I'd be surprised that this experience doesn't expose something universal about humans. That this behavior runs amok in a business with high-comp workers and relatively opaque products fits in very well with this hypothesis.
Regardless, the "race to the bottom" idea is an old one. In businesses with opaque products, the more duplicitous operations succeed and drive out the more honest ones until the former are exposed as duplicitous. I don't know what could be controversial about this statement. Given opaque products, it could be years or decades before this exposure happens. This is why there has to be vigilance in any area like this, because socially destructive behavior will go on far longer than anyone could rightly imagine unless there are clear and enforceable penalties that alter the decision matrix facing the actors.
Yves
This is one of your best and most important posts. Kudos!
In the context of your post, I view the report today of record bonuses at Goldman Sachs with increased dismay.
I haven't read F.I.A.S.C.O. but I am currently reading another of Frank's book again, "Infectious Greed", and there again, he cites a lot of names that we have been hearing about recently. One more time, he clearly demonstrates what everyone is now suspecting, that after LTCM, Enron, Worldcom and related early 2000 debacle, nothing, and I mean absolutely no-thing was done to analyse, understand, let alone try to fix the issues of corruption, laissez-faire, and financial wizardry run amok that characterised these schemes.
If anything was changed, it is that now it's even bigger and more pervasive. We are in such dodo now it's not even fun anymore. Frank is a great read.
Yves,
Say more about your experience at OCA.
Back then the rumor in Chicago was that Steve Jobs, then CEO of NeXT Computer, was the biggest supplier of computer hardware/software to OCA. The story was: after getting kicked out of Apple, Jobs scoured the country for the "latest & greatest" desktop computer technology, ultimately settling upon Carnegie Mellon's object-oriented OS design. He hired a CMU Ph.D. named Avie Tevanian and launched NeXT Computer, whose biggest client would later become O'Connor & Associates in Chicago. supposedly because of the ease with which the NeXT Step OS lent itself to quick alteration.
Jobs eventually returned to Apple, named Tevanian his Chief Technological Officer, and had Apple buy all of NeXT's OS, which became the footprint for later versions of Apple's OS.
It seems to me, from the outside, that the early 90s was when Wall Street (led by OCA, CRT & others) was just beginning to exploit the capabilities of computer technology.
Is it fair to say that Wall Street's demand for technology also helped foment that decade's bubble in technology stocks?
Tell us more about OCA, in particular, tell us about their relationship with the Santa Fe-based "chaos theory" shop called The Prediction Company.
http://www.predict.com/html/company.htm
And what role did former OCA executives play in SBC's disastrous loan to LTCM (which is only alluded to in Roger Lowenstein's book "When Genius Failed")?
And what do you think the advent of arbitrage-related electronic trading systems means for the current state of the financial system?
Is the migration towards algorithmic trading generally "good" or "bad" in your view?
There are no new ideas in finance. Just new execution capabilities.
@chicago mike
Perhaps Yves will fill in some details about OCA, but on your general question about algorithmic trading you might look up Ed Thorp, who started doing computer-guided trading in the late 1960s. Also Elwyn Berlekamp, whose Axcom was purchased by Jim Simons and became RenTech. Both Thorp and Berlekamp were associated with Claude Shannon at MIT.
Yves,
I liked Sanjayat Das's book, Traders Guns and Money. Great book, not so great title. I've never read Partnoy's Fiasco, but they sound like the same book. Das's book spans about thirty years worth of developments in the derivatives trade, it's a juicy tell-all expose and derivatives 101 for the layperson. Das goes as far as offering a comprehendable explanation of the Black-Scholes pricing model but that is his only foray into mathmatics. Traders,G&M was released in 2006 so it is a bit more contemporary with a few chapters on credit derivatives. It's everything the layperson could want to know about CDS or CDO. Despite a few flaws I would still highly reccomend it to the derivative unititiated untill a better book comes along that tells the story of the 2008 meltdown.
I would love to hear more from your days at OCA as well.
YS, just to say I enjoyed this post and the one on securitization a few days ago. More & more looking forward to the book. You seem to be someone who can not only explain finance but give insight into both productive capital allocation and destructive predation. And as this post demonstrates, you've been around a while and seen some interesting stuff first-hand.
Not to contradict dd's pithy comment, but after looking on as a casual observer for 20 years, finance seems to me like a never-ending 24/7 Olympic Games in which any and all medical or mechanical advantages are encouraged, the rules are in a constant state of flux and never explicit, and the judges are addicted to intoxicants supplied by the competitors.
There may be nothing new under the sun, but the permutations offer quite a spectacle.
BT got bad press at the time on its Proctor & Gamble trades, but Merrill also had bad press on the Orange County bankruptcy, and Merrill survived.
At the time, BT were big proponents of financial technology. They used VaR to shut down low-margin businesses and invest in high-margin businesses. As a business model, VaR is insufficient, ripping off customers is a high-margin business, but not sustainable.
I don't think the brief against derivatives are as clear-cut as you are implying. You are really complaining about derivatives used as investment banking product, where the investment bank gets a high up-front fee and the client gets a poor return on investment. These trades are still available- but is the business of selling these trades really that different from the business of selling the current hot IPO?
On the portfolio management side, many structured derivative trades exploit some sort of loophole ("efficient" use of regulatory capital, taxes, and the like). The question is whether it is correct or not to exploit the loophole, and this depends on the loophole. It's not correct to use derivatives to facilitate accounting fraud (this was the thrust of some of Portnoy's argument). But it's generally correct to use derivatives to facilitate lower tax payments- if there's a problem, it's with the tax code, not derivatives.
Read Partnoy's "Infectious Greed" and Das's "Traders, Guns, and Money", written years before the crunch, and one can see the current financial situation was inevitable. Both are great writers and know their subject well. Das has a sardonic, snide, and sly sense of humor that continuously cracked me up.
Partnoy also wrote a paper in 1999 pointing out the uselessness of ratings agencies. What everyone now knows about the ratings agencies, they should have known ten years ago. (Free download: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=167412 )
Excerpts from The Siskel and Ebert of Financial Markets: Two Thumbs Down for the Credit Rating Agencies (Partnoy, 1999). (Emphasis added):
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The theory of why a CBO works is that the sum of the parts is greater than the whole.
In a competitive, efficient market, CBO transactions should not be possible.Put another way, the fact that CBO structurers make money is evidence of market failure of some type. CBO structurers appear to be able to make money from these transactions because either (1) high-yield bonds are systematically underpriced, because market segmentation limits the demand for these bonds, or (2) the methodology the credit rating agencies use to rate bonds issued by the CBO vehicle is misguided and allows the creation of a greater whole from the sum of the parts, despite the absence of any conceivable synergy. Again, there is little empirical or theoretical support for (1), and (2)contradicts the reputational capital view.
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[SIVs] invest mainly in sovereign bonds, bank debt, and asset-backed securities. Clarke has stated: "We are probably overweight in ABS, but where else can you invest in triple-A rated securities with a stable cash flow and a reasonable spread?" This statement and the very existence of these vehicles support the argument that credit ratings provide something other than accurate information.
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The notion is that a careful quarterly presentation to the agencies can present a rosier picture of that issuer than is really the case. The fact that the most sophisticated market participants are formally planning quarterly "window dressing" for the agencies indicates that such agencies can be duped, and probably are. The potpourri of new rating-driven transactions supports this conclusion.
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In sum, the above discussion has demonstrated that the three criteria that must be satisfied for rating certification to be credible are not satisfied for credit rating agencies. First, rating agencies have little reputational capital at stake in the certification activity; they can maintain whatever credibility they need by parroting market price moves. Second, the gain from inaccurate certification vastly exceeds the cost of any loss in reputational capital. (This is especially true if agencies are able to persuade investors that ratings are valuable information because they are correlated with actual default experience.) Third, the agencies' services are not costly; it is cheap and easy to follow market events and adjust ratings after the fact. In modern financial markets, the information asymmetries that generated the need for ratings in 1909 are long gone.
Yves, please allow me to notify the chump readers of this section abiut my change of status. Leo's readers have already been enlightened.
OFFICIAL NOTIFICATION
I would like to take this action and inform all our European chump readers that I hereby retract all the accurate and rightfully justified Euro bashing I have been carrying out here. I regret my past misguided efforts of exposing Euro hypocrisy and dragging it into the light from under the Euro rocks it often crawls under.
The reason for my sudden change of heart, my glorious enlightenment, my divine epiphany if you will, is that I have just been officially notified via an email from the Nigerian Ministry of Culture and Genealogy, that I have inherited 10 Trillion Euros (that’s “trillion”, with a “T”). This official email also notified me that extensive research funded by the Nigerian Government has revealed that I, Vinny Gold, am blood-related to Napoleon I, Queen Elizabeth II, as well as the “Artist Formerly Known as Prince”.
Given the well-researched information in the previous paragraph, I now consider myself to be a wealthy, Western European blue-blooded aristocrat, a superior Arian being, cultured, beautiful, and erudite as well. Did I mention blue-blooded aristocrat?
Therefore, I heretofore shall be referred to as “Vinny de Chicago” (accent on the last syllable, to sound more French, the language of the great Napoleon I, my ancestor and near-conqueror of mujics of peasanty Russia).
Nonetheless, given I am now a true Western European aristocrat, I have also instantly become a racist, chauvinist, anti-Semite, and all-round Euro SOB. Therefore, please note that as Vinny de Chicago, my land dominion does not extend over the entire city of Chicago, rather only over the north side. This for obvious reasons.
I now expect to be addressed as “Vinny de Chicago”. However, for historical reasons, “Yassa Euro Massa” is acceptable on the Deep South side…
Vinny de Chicago
PS – I was just told that Napoleon was actually Italian, but that’s obviously an lie perpetrated by the American CIA and the Jewish Mossad…