In his new book, journalist Nicholas Dunbar provides a first-hand account on the dangerous mix of how bravado and academic analysis played a key role in the collapse of the global financial markets.
The following is excerpted from his upcoming book, The Devil’s Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street…and Are Ready To Do It Again.
I was granted my first look inside a modern investment bank around 1998, when I visited the trading floor of Lehman Brothers in London. What struck me was the confidence with which those traders and quants handled risk. On their computer screens were curves of risks and falling interest rates, plugged in to the pricing models used to value and hedge their trading portfolio. I could see that the future behaviour of these interest rate curves was uncertain, yet I listened as traders loudly opined that their risk models were the best on the street, bar none. They ridiculed their competitors for getting things wrong. There was not a shed of self-doubt in place.
On a later visit to the Lehman trading floor, I was introduced to the head interest rate trader, Any Morton, a blond Midwesterner with intense laser blue eyes. His acolytes were confident that their models had taken care of uncertainty, but Morton was a risk-chomping crocodile. He had come out of academia having helped invest the now infamous interest rate-pricing model, and no one on the trading floor had more reason to be assured than he was that Lehman had all its bases covered. By 2006 he was making over 10 million dollars a year.
That kind of confidence– based not on bluster or bravado, but on intellectual analysis and fervent belief in markets-had crept up on the world unnoticed. I got a ringside seat onto Morton’s world when I took a job at a trade magazine, editing and publishing technical papers by quants at Lehman and at the other big banks. There were debates aplenty over the risk models examined by my anonymous peer reviews, but no one doubted that finance was becoming more scientific and safer, while old-fashioned prudence and caution was belonged in a museum. The love-to-win mind-set was incubated and nourished within these investment banks. And the scientific gloss of the models assured you that the world outside, with its fear and inefficiencies, could be exploited to make you rich and virtuous at the same time.
The bankers and hedge fund managers celebrating their bonuses in the London nightclub had been created– and unleashed on the world– with an unnatural confidence about uncertainty that very quickly made our world a different place. And a more dangerous place.
All the disaster of the World…
How do financial institutions justify taking credit risk? Given that banks are by design hate-to-lose institutions, conditioned to avoid bad lending whenever possible, how do they come to terms with the uncertainty surrounding their borrowers? And if you don’t want this kind of uncertainty, whom do you pay to protect against it? And how much should you pay?
In the late 1990s, the way most bond investors and lending banks looked at credit was reminiscent of how insurance companies work. This safety-in-numbers acturial approach went back three hundred years, to a financial breakthrough that transformed the way people dealt with the misfortune: the birth of modern life insurance.
The early life insurance companies were based on the work of Edmund Halley, who published the first unsable morality tables, based on parish records for the Polish-German city of Breslau, in 1963, showing that about one in 30 inhabitants of the city died each year. Armed with these figures, a company could use the one-thirtieth fraction to set prices for life insurance policies and annuities.
If a life insurance company brought together a large enough pool of policyholders, individual uncertainty was ulmost magically eliminated…so long as the actuary did his maths correctly. The actuarial neutering of uncertainty takes us to the statistical extreme of probability theory-the premise that counting data reveals an objective reality. By analogy, bankruptcy and default are the financial equivalent of death, and are subject to statistical predictability over longer periods of time. A bank with a loan portfolio is equivalent to a life insurance company bringing together policyholders to pool morality risks. In other words, owning a portfolio of bonds might alleviate some of the anxiety of lending.
The Devil’s Derivatives goes on sale in the UK from July 12th.
Reprinted by permission of Harvard Business Review Press. Excerpted from The Devil’s Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street…and Are Ready To Do It Again. Copyright 2011 Nichoals Dunbar. All rights reserved.