das - traders, guns & money; knowns and unknowns in the dazzling world of derivatives (2006)

Better still, there is barely anequation in sight.’ Financial Times ‘Billed as part thriller, part exposé, it is that true rarity: a derivatives bookthat keeps your attention all the way

KNOWNS AND UNKNOWNS

IN THE DAZZLING WORLD

OF DERIVATIVES

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PRODUCT฀฀–฀AN฀UNKNOWN฀KNOWN.฀ YOU฀PROBABLY฀HAVEN’T฀GOT฀THE฀ FAINTEST฀IDEA฀OF฀WHAT฀A฀DOUBLE฀ KNOCKOUT฀CURRENCY฀OPTION฀

WITH฀REBATE฀IS฀OR฀DOES฀–฀฀

A฀KNOWN฀UNKNOWN.฀WHAT฀SHOULD฀ YOU฀PAY฀FOR฀THIS฀PARTICULAR฀

for how the whole derivatives game works Better still, there is barely anequation in sight.’

Financial Times

‘Billed as part thriller, part exposé, it is that true rarity: a derivatives bookthat keeps your attention all the way through … Beyond the entertainmentvalue for those who recognise their friends and colleagues – and perhapsthemselves – in the book, it also offers a good introduction to the world ofderivatives for people in other areas of finance or even the man on the streetwho wants to know more.’

Director

‘Its spicy gossip about the goings on in the dealing rooms of investment banks

makes for a riveting read – more riveting than yes, The Da Vinci Code.’

The Edge Daily, Malaysia

‘ … filled with examples of nạve investors sucked dry by sophisticatednumber crunchers who use smoke and mirrors to point to potential profitswhile stuffing the hard cash into their own pockets … contains more thaninvestor advice, with plenty of tales of gluttonous excesses and trading-floorantics gleaned from more than 20 years in the industry.’

South China Morning Post

‘a must read for all CEOs, CFOs, bankers and anyone who cares aboutwhat banks are doing with their money.’

Finance Asia

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The right of Satyajit Das to be identified as author of this work has been asserted

by him in accordance with the Copyright, Designs and Patents Act 1988.

ISBN: 978-0-273-70474-4

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List of figures and tables xii

Greek tragedies 198

CSI (Crime Scene Investigation) 1987 – ‘Oh LOR-dy!’ 202

structured products

Figure 1.1 Parallel loans 35

Figure 1.2 1981 World Bank – IBM currency swap 36

Figure 9.2 Collateralized loan obligation (CLO) 283

Figure 9.4 Fully funded CDO capital structure 286

Figure 9.5 Synthetic CDO capital structure 288

Table 6.1 Expected share price in one year 191

In March 1977, I began working in banking Early on I drifted into the arcaneworld of derivatives trading No qualifications were required; I just bluffed myway in The alchemy of futures, options and swaps was intoxicating Derivativessuited me Fortuitously, I seemed to suit derivatives.

Traders, Guns & Moneyis the record of my time in the derivatives try It is a collection of tales about the products, the people and the strangegoings-on in the business

indus-Ordinary men and women do not trouble themselves about this world.Just occasionally, an event such as Nick Leeson and Barings or LTCM spillsover into the news This infrequent appearance underestimates the impor-tance of the industry and its role in finance Every one of us is exposed toderivatives We occasionally trade in derivatives when we invest Our savingsare frequently lodged with banks or fund managers that trade derivatives.Derivatives have the capacity to enhance return on our investments or helpmanage the risk But every once in a while derivatives turn out to beWMDs (weapons of mass destruction), causing large losses that affect mar-kets, investors and banks

There is almost no literature that explains the industry in an accessibleway There is also little that sets out the practices, some of which are insane,

of this mysterious area of finance Traders, Guns & Money explains the

industry, how it operates and what it does The book does not attempt to

make a case for and against derivatives, it just shows what really goes on

every day in the dealing rooms in major financial centres, the real lifedramas and rational madness that shape modern markets

Traders, Guns & Moneyis intended for two audiences People in ing and finance, whether or not they are involved in derivatives directly, willfind it a wry and entertaining read They will recognize themselves orpeople they work with in these pages The book is also for those who want

bank-an accessible introduction to this weird bank-and wonderful world It will haps confirm their worst fears and prejudices about these strangeinstruments, what they are used for and the people who trade them

per-The book draws on my 25-odd years in the industry It is based on whatreally happens, however, the people and characters are not real Other thanwell-known individuals who are named and episodes that are identified asreal, all names, characters, places and events are imaginary The characters,places and events in the text are used for fictional purposes and do not con-stitute assertions of facts No resemblance to anyone or anything real isintended nor should it be inferred

I would like to thank the publisher Richard Stagg for believing in theidea of the book and for his support I would like to thank the editorialand production teams at Pearson Education, including Liz Gooster,Benjamin Roberts and Elie Ball for their help in preparing the manuscriptfor publication Special thanks to Jennifer Mair who edited the manu-script intelligently and efficiently and in the process made it better

I would like to thank my parents, Sukumar and Aparna Das, for theirencouragement and support which has enabled me to do what I do Iwould especially like to thank my partner, Jade Novakovic, for her patientsupport and encouragement over the years At least they will now have abetter idea of what I have been doing for all these years

Satyajit Das

Sydney, Australia

February 2006

we don’t know we don’t know.

Donald Rumsfeld, US Secretary of Defense, 12 February 2002 Department of Defense News Briefing.

I was shown into the conference room It was old-fashioned – dark woodpanelling, lined with slightly dusty old law reports Lawyers, especially inEngland, proudly resist modernity Modernity in the world of investmentbanks and dealers means trendy architecture by the latest wunderkind Itmanifests itself in acres of glass, steel, marble and uncomfortable chairs.Lucre & Lucre was untouched by these fads The thickly padded leatherchairs were comfortable It was, I feared, going to be a long meeting.The clients were already there There were two of them – Indonesians ofChinese extraction They were part of the infamous ‘bamboo’ network ofethnic Chinese business interests that criss-crossed South East Asia I wasintroduced We exchanged business cards I took care to accept the profferedcard with both my hands, my body slightly inclined at a respectful angle.

I carefully studied the cards as required by custom Adewiko – PresidentDirector – was about 50 He was short and dressed in a somewhat ill-fitting designer label suit He appeared solemn The other man – Budi Titra– was younger, no more than 30 I guessed Budi was the Chief FinancialOfficer His card announced that he had an MBA The younger man’sebullience seemed inconsistent with the seriousness of the matter

Two people from a ‘Big Four’ accounting firm were also there (As Iwrite, the ‘Big Four’ are PricewaterhouseCoopers; KPMG; Ernst & Youngand Deloittes.) It could have been the ‘Big Three’ this week after a newround of mergers Andrews, the partner, was a reedy older man with small,intense eyes There was a junior, relatively innocent looking, who did notintroduce himself He said nothing during the meeting

The associate from the law firm was there ‘Albert, call me Albie, body does’ The partner eventually arrived Short and with a full figure,Morrison Lucre lumbered into the room There were more introductionsand civilities Then it was down to business, well almost Morrison produced

every-four pencils and carefully sharpened each one He then laid them carefullynext to the thick legal writing pad on the table It took about five or six min-utes to complete this activity At the hourly rates of the professionals present,

I calculated that the total cost of pencil sharpening was $2,000 – about $500per pencil It was truly a Zen moment

‘Shall we begin,’ Morrison intoned ‘I think it would helpful to go overthe chronology of the transaction,’ I began ‘Splendid,’ Morrison beamed.Everybody presumably was familiar with the transactions, but we were get-ting paid by the hour

‘OCM is a noodle maker?’ I asked ‘Yes’ it was Budi’s turn to beam Heunleashed a detailed history of the company The description was punctu-ated by the occasional detail supplied by Adewiko It was irrelevant It wasnot even interesting ‘Let’s focus on the transactions,’ I interrupted

‘Splendid Yes, let’s.’ It was Morrison

‘OCM operates in Indonesia and all its income is in rupiah [theIndonesian currency]?’ I asked Budi confirmed it ‘In 1995, you decided

to convert your borrowings into dollars?’ I continued quickly before Budicould launch another tangential verbal assault ‘Yes,’ Budi confirmed

‘Why?’ I asked ‘Cheaper, much cheaper,’ Budi said Adewiko nodded hishead in silent assent

‘What about the currency risk? You have borrowings in dollars but nodollar income If the dollar rose against the rupiah, then your dollar borrow-ings would show losses Did you consider the currency risk?’ I pressed ‘Norisk, no risk,’ Budi countered ‘Why?’ ‘Rupiah fixed against dollar, no risk,’Budi continued Adewiko nodded ‘So you assumed there was no risk?’ ‘Norisk, no risk.’ Budi’s exasperation at the expert witness – me – showed Hewas contemptuous of my seeming lack of financial acumen on this basic issue

‘Bank advise us They tell us no risk,’ Adewiko interjected ‘They advise

us that we have low cost, no currency risk.’ I looked sceptical Morrison,Albie and the junior accountant were making copious notes ‘Bank advised

them – no risk,’ Morrison wrote down with one of his pencils.

Miracles and mirages

In the 1990s, Americans and Europeans had ‘discovered’ the developingcountries of South and Far East Asia In earlier decades during a differentperiod of financial exploration, they made similar finds in Latin America

Massive foreign investment and loans

gen-erally followed the discoveries Asia was the

‘newest best new thing’ It generally was, at

least since the last newest best new thing

It ended invariably in massive losses

There were defaults on loans The

discov-ery turned out to be not quite what it had

promised There were a few recriminations,

usually from investors and shareholders Senior executives huffed and puffed– ‘We acted in the best interest of our stakeholders in pursuing this attractivegrowth option.’ The more literary frequently quoted Shakespeare’s Brutus atPhilippi: ‘There is a tide in the affairs of men, Which, taken at the flood,leads on to fortune; Omitted, all the voyage of their life Is bound in shallowsand in miseries.’ Unfortunately, in most of these cases the tide had not led tofortune Brutus had been defeated at Philippi

People moved on There was a period of house cleaning Then, the cyclejust repeated itself During my 28 years in the business, I had witnessedmore than half a dozen Latin American crises In the 1990s, Asia was ‘hot’:observers were smitten with the Asian ‘miracle’ Exactly why was puzzling.The Asian economies grew rapidly in the 1990s Much of this growthwas unsustainable Analysts were impressed by the high savings rates.Political instability and the lack of a social welfare system forced people tosquirrel away money (especially in Swiss bank accounts) Analysts focusedsagaciously on the growth prospects and high returns for investors Asianlabour costs were low and there were no employment laws Abundant natu-ral resources were free to be exploited without environmental safeguards.Unexploited domestic markets excited foreign businesses

There were, of course, ‘problems’ The sudden increase in the rate ofgrowth and demand set off rapid price rises The office space in Mumbai’sNarriman Point business district was among the most expensive in theworld, a matter of national pride Productivity was pitiful The phones andplumbing did not work The traffic was horrendous

Some experts even claimed to know the rules of the game I rememberone sermon The shaven headed, black leather-jacketed professional sceptic

of matters financial leaned against an ill-lit bar in Hong Kong’s Wan Chaidistrict There were ‘hostesses’ in fashionable déshabillé all round This wasthe Grand Master’s ‘office.’ I listened as he sallied forth

‘There are distinct phases in investment madness in emerging markets.Phase one is growth You get a lot of foreign investment It is mainly relo-

Massive foreign investmentand loans generally followed the discoveries.Asia was the ‘newest best new thing’

cation of production facilities Cheap brown people to do dirty jobs fornothing You dig up, cut down everything you can The locals deregulateeverything because the World Bank tells them it will attract foreign invest-ment Government-owned businesses are sold cheaply to the favoured sonsand their foreign cronies Government controls are relaxed as the foreignerstell the locals that it will create jobs and wealth.’ The Grand Master paused

to take a drink

‘In phase two, living standards improve for the fortunate For the bulk

of people nothing changes, of course A middle class develops chasingMcDonald’s and Wal-Mart consumer heaven Property prices and shares gocrazy More and more money comes in Local banks lend recklessly Foreignbanks lend recklessly to local banks The foreign banks think the local bankswon’t fail because of government support Investors dive in They talkabout “growth” and “portfolio diversification” People are excited Pricesspiral up as the tidal wave of money pours in

‘Phase three Costs rise to levels that make the economies tive They are not cheap any more Alas, the capitalist caravan must move

uncompeti-on Everything is over priced Politicians talk bravely about the “need tomove up the value chain” They launch ambitious initiatives – the world’stallest building, the world’s longest building, a new port in a country whichhas no sea access, bridges over rivers between two cities that do not exist,entire new cities! Locals bristle at any criticism Everybody tries to shake offthe opprobrium of being an emerging market nation Talk of new para-digms becomes popular – “the Asian century”, “Asian values”

‘Prices don’t make any rational sense You only buy because you thinkyou can sell it tomorrow to someone else at a higher price You are caught

in an endless spiral of higher and higher prices Fear and greed rule financialmarkets You are afraid that you might miss out Your greed is endless.Foreigners develop a peculiar hubris They are bulletproof Fundamentals

of value are irrelevant in this world.’ The Grand Master paused and lookedaround to see if everybody was paying attention He leaned back and smiledwryly in a well-practised dramatic gesture ‘Then, of course, kaput It allcollapses’ This was in 1995 In 1997, Asia’s run as the hottest new ‘newthing’ ended abruptly

Other seers dispensed more worldly investment wisdom ‘If you arrive at

a country and discover limousines waiting to transfer foreign investors andtheir investment bankers to five star hotels, then generally speaking it istime to sell There is a second unfailing test If you can’t buy a good meal

and a young, attractive woman for the night for less than $100, then it istime to get out.’

The bankers and dealers had been enthusiastic cheerleaders for the Asianboom The bankers were all Keynesians Keynes held the view that in a

beauty contest it didn’t matter who you thought should win, the only thing that mattered was who the judges thought should win In finance this means

that you buy things that others will buy from you at a higher price than youpaid The banks and dealers were upbeat about the prospects for all thingsAsian They had fuelled the boom launching new issues of shares and bondswhich they sold to the investors who had decided Asia was ‘hot’ Theytraded securities on behalf of eager foreign investors and picked up handycommissions along the way

The Asian boom and bust saga had a new angle Financial products hadbeen added to the usually deadly cocktail of debt and greed Derivativeproducts had been available in developed

countries for years In the 1990s, dealers

had introduced these products into Asia

Asian companies and investors unfamiliar

with the abacus entered into complex

transactions that they rarely understood

The dazzling financial products had

seduced the Indonesians and many others Now, some years later, thelawyers and accountants (with me in tow) were picking up the pieces of theinevitable disasters The trick is always to make sure that you have a seatwhen the music in this game of musical chairs for high stakes stops

in the room glazed over I noticed that the eyes of the Indonesians alsoglazed over Surely, they must know what a swap is? They had done enough

of them

The dazzling financialproducts had seduced the Indonesians and many others

‘I suppose the easiest way to conceptualize it is as an exchange OCM hasrupiah debt They would normally make interest payments and repay theprincipal in rupiah to the Indonesian lenders In the swap, the dealerassumes the obligation to make the rupiah payments In exchange, OCMagrees to make a series of equivalent dollar interest and principal payments tothe dealer This means that OCM no longer has any rupiah payment obliga-tion In effect, it has borrowed dollars.’ I had a pleading look on my face.

‘Splendid That is very clear It is always valuable to have an expert’sview of things.’ Morrison did not look entirely clear on the swap ‘But whyswap?’ he asked It was Budi who replied ‘Cheaper, cheaper Cheaper than

if we borrow dollars.’ He was surrounded by financial incompetents ‘Bankadvise us,’ Adewiko joined in Morrison sighed audibly

‘That was first derivative OCM entered into,’ I went on ‘Yes,’ Budireplied ‘We know about derivatives We make study of market.’ ‘Bankadvise us,’ Adewiko corrected Budi

‘Then you restructured the currency swap This was the arrears resetswap.’ I continued reconstructing the chronology of disaster ‘First arrearsreset swap in Indonesia Ever Bank tell us.’ Budi was pleased with his pio-neering efforts Morrison cleared his throat I felt sure that he was about toask my expert opinion on the arrears reset swap

‘Under the original swap, OCM paid the dealer dollar LIBOR (LondonInter-Bank Offered Rate, the predominant money market floating rate paid

by banks to each other on deposits) This rate is set in advance – at the start

of each six month period, like any normal interest payment Under thearrears reset swap, OCM paid dollar LIBOR but it was set in arrears – it wasset at the end of each six month period In fact, it was set two days beforethe payment was to be made The arrangement was that OCM paid dollarLIBOR minus 40 basis points (that is, 0.40% pa),’ I explained ‘Yes, yes.Cheaper cost We get cheaper funding Save 40 basis points Cheap money.’Budi’s excitement was palpable ‘Bank advise us,’ Adewiko added quickly

‘Bank give us detail presentation They say dollar yield curve verysteep Get value from steep curve using arrears swap.’ Adewiko displayedsurprising animation ‘Bank know Greenspan Play tennis with him.’ Imust have looked surprised ‘Bank advise us,’ Adewiko said gloomily,remembering the script

I referred to my notes ‘Then, you terminated the arrears swap.’

‘Take profit, take profit,’ Budi interrupted ‘Dollar yield curve flatten

We take profit.’

I could imagine what had happened.

The dealers had played these guys for the

suckers they were OCM had entered into

a transaction – the arrears reset swap

Dollar interest rates had moved, the dealer

had rung up to say that if the transaction

was closed out they would pay the

com-pany a profit, and the comcom-pany had jumped at it It was easy money What this had to do with producing noodles was a mystery I hadlooked at OCM’s accounts The company didn’t seem to make money butthey had once Ambitious expansion plans and the borrowings that theyhad taken on to finance them had eaten away the company’s profits If youtook away the effect of the cheaper money (rupiah interest rates were 12%and dollar rates were 6%), then OCM was losing money The odd profitfrom swap trading must have helped

The dealers were very happy to help Budi and the lads at OCM Theywere making healthy profits from trading with the company The party wasjust beginning

For a time, I had worked with Nero Nero was of Italian descent Hisname wasn’t really Nero, it was his nickname It was a tribute to his impe-rial airs and despotic management style Nero was in charge of sales and hadonce conveyed the essence of selling to me ‘Sonny,’ he had said, conde-scending to speak with a junior employee, ‘give the guy a win first up Anibble He’ll be hooked Then, you reel him, real slow That’s how youland the big ones.’

The essence of the advice was remarkably accurate The clients I haddealt with fell for the trick every time They put on a trade They mademoney Then, they kept coming back for more Even if they lost money,they kept coming back Nero was a reasonable judge of human nature.Budi and OCM certainly fell for it They came to see ‘complex financialtransactions’ (in Morrisonspeak) as a way to making easy money Easier, atleast, than the noodle business Or so it must have seemed at the time

I had reconstructed the sequence of transactions Next up, OCM hadentered into a swap to fix the cost of the dollar payments under the swap.The dealer had told OCM that he thought US rates would rise The com-pany had entered into the transaction to fix their rates They had traded inand out They made some more money Budi and Adewiko were undoubt-edly legends within OCM Then, the rot set in

I could imagine what hadhappened The dealers hadplayed these guys for thesuckers they were

OCM decided to enter into a complex swap – the ‘double up’ swap.OCM would pay fixed rates in dollars for five years The problem was theyield curve was steep – interest rates for five years were much higher thanfor six months This meant that OCM’s cost of borrowing would be higher.Cheaper than rupiah certainly, but more expensive than if they continued toborrow at the six month dollar interest rate To make the cost cheaper,OCM placed a big bet The deal was that if dollar rates went up, then thefixed rate would convert into floating rate If dollar rates went down thenthe deal would double in size In short, OCM’s transaction would nolonger be for $300 million (the size of the original swap) but $600 million

I had read and re-read the term sheet setting out the deal I couldn’tbelieve it The good old boys at the dealer – a big American investmentbank known for ‘innovative’ products – must have wet themselves in excite-ment The trader’s profits on the transaction would have been huge.OCM had dollar borrowings as a result of the original swap The newswap meant that they had fixed the interest rate on the dollar borrowinginitially But if rates went up they would go back to borrowing on a floatingrate basis In other words they would lose the protection of having fixedtheir cost of borrowing just when they needed it most On the other side, ifdollar interest rates fell then OCM would be left with double the dollarborrowing that it originally had The borrowings would be at rates thatwere high because rates would have fallen OCM weren’t protected againstdollar interest rates going up and they wouldn’t enjoy the benefit of lowerdollar rates if they fall It was very interesting

There was worse – a cunningly hidden currency option OCM wasalready exposed to currency risk It had switched its borrowings into dol-lars If the rupiah fell against the dollar they were, well, dead The new dealmeant if dollar rates fell then they would be exposed to currency risk on

$600 million not the original $300 million The exchange rate for thesecond $300 million was fixed at the original exchange rate This meantthat not only would OCM be borrowing more dollars, they would bedoing it at an artificially inflated exchange rate OCM would not only bedead, it would be hung, drawn and quartered

I took the assembled multitude through the structure For the firsttime, Budi seemed subdued He did not claim credit for what wasundoubtedly an ‘innovative’ transaction ‘Interesting,’ Morrison mused

‘But why?’ Why indeed? It seemed OCM aka Budi had entered into thetrade because it allowed OCM to obtain lower costs on its dollar fixed rate

borrowing The lower cost was the result of the massive amount of optionsthat the company had sold to the dealer OCM had sold options on dollarinterest rates and the rupiah/dollar exchange rate OCM had mortgagedtheir futures to factors over which they had no control They neededdivine intervention to save themselves from their own folly In the end, themiracle was not forthcoming.

Beginning of the end/end of the beginning

In July 1997, as the Grand Master had predicted, the Asian boom began tounravel The Thai baht fell sharply The Thai Central Bank had spentThailand’s entire foreign currency reserves trying to keep the baht withinits agreed trading range It finally conceded defeat and freed the baht tofloat The HMS baht was not seaworthy It did not float In fact, it seemed

to have no visible means of support It promptly plunged and in a matter ofdays it had halved in value Traders joked about submerging rather thanemerging markets

Investors belatedly reviewed the value

of investments Glamorous companies,

touted as ‘best-of-breed’ world beaters,

turned out to have no earnings, no cash

flows and no value Most seemed to be

vehicles for property speculation Investors

began to sell but there was a problem –

there were no buyers The music had

stopped and all the seats in this game of musical chairs were firmly occupied

In quick succession, the Korean won, the Malaysian ringgit and thePhilippine peso were savaged Even venerable bastions of Asian values such

as Hong Kong and Singapore were under siege The Indonesian rupiah? Ithad literally disappeared The Indonesian Central Bank managed the cur-rency within a fixed range It had been trading at around rupiah 2,000 perdollar It fell sharply and found its level – rupiah 8,000 per dollar It stabi-lized, then went into free fall to rupiah 12,000 before rallying to 10,000.OCM were finished The crisis had caused Alan Greenspan, Chairman ofthe Board of Governors of the Federal Reserve, to cut interest rates tosupport the financial system The fall in dollar interest rates and thecollapse of the rupiah signa-lled the beginning of the end at OCM

Glamorous companies,touted as ‘best-of-breed’world beaters, turned out

to have no earnings, nocash flows and no value

The dealer had triggered the option to double the value of the swap.OCM now owed the dealer $600 million on which it was committed to pay

a fixed rate for the remaining life of the transaction – three years OCM hadoriginally borrowed rupiah 1,200,000 million (rupiah 2,000 multiplied by

$600 million) At the new exchange rate (rupiah 10,000), OCM wouldhave to repay rupiah 6,000,000 million (rupiah 10,000 multiplied by $600million) Just on currencies, OCM had lost rupiah 4,800,000 million(rupiah 6,000,000 less rupiah 1,200,000) In real money, this was theequivalent of $480 million (rupiah 4,800,000 converted at rupiah 10,000per dollar) In fact the real loss was larger It was closer to $550 million There were so many zeros that I had trouble doing the figures on mycalculator It was Monopoly money, a lot of noodles OCM didn’t have themoney The loss was larger then the total capital of the company, a smalltechnicality The dealer must have become concerned It was not overOCM’s fate, it was over the risk that the company may not be able to paythe amounts owed

The internal email traffic within the dealer contained frenziedexchanges ‘The credit risk on this transaction is totally unacceptable andmust be dealt with immediately.’ The credit department wanted the trans-action terminated on the grounds of a material change in circumstances.This would trigger an immediate claim on OCM for the entire amount.The credit department was settling old scores with the traders

The traders had different concerns They had already taken the profits

on the transaction upfront (under a quaint practice called mark-to-marketaccounting) Sadly, the investment bank’s unenlightened management didnot let traders take their share of profits in the first year Some of the profitswere suspended and would only be recognized over three years If thetransaction was terminated and OCM failed to pay, then these profits would

be written back The traders would lose out It was imperative that OCM

be placed on life support at least for the time it took the traders to receivetheir share of the large profits The traders had negotiated a fixed profit

share (30% was the rumoured profit split) when they had moved en masse

from their previous employer

The traders negotiated a new trade with OCM, reaching a new plane of

creativity Under the transaction, the offending transaction was cancelled at no

cost to OCM In its place was a new swap The new transaction was for $600million Under the swap, for the next three years, OCM would pay a fixed

dollar amount The amount was $4 million a month In return the dealer

would pay OCM an amount calculated according to a complicated formula:

Maximum of [0; NP × {7 × [(LIBOR2× 1/ LIBOR) – (LIBOR4×LIBOR–3)]} × days in the month/360]

Where

NP = $600 million

LIBOR = 6 month dollar LIBOR rates

The financial engineering was dazzling but there was just one problem Thecomplex equation, if you did the algebra, always equalled zero The dealerwould never pay OCM anything but OCM would be paying the dealer $4million each month for three years This was the intended effect

That was the deal, almost There was an ‘extension’ option The dealercould, at its sole choice, extend the transaction at maturity by an additionalthree years This option was repeated every three years, with the maximummaturity 30 years ‘Is this customary for a transaction of this ilk?’ Morrisoninquired I had responded in the negative I had never seen one before ‘Itssole purpose appears to be to disguise the fact that the dealer will keepextending the transaction until it finally terminates at the end of 30 years.OCM will pay back its loss on the terminated swap together with interest inmonthly payments over 30 years.’ ‘Interesting,’ Morrison observed

‘Isn’t it just a disguised loan?’ Andrews, the accounting partner, rousedhimself from the silent vigil that he had maintained throughout the morn-ing I agreed ‘Interesting, most interesting,’ Morrison observed, makingnotes with his pencils which would be fairly blunt by now Adewiko andBudi had lapsed into a sullen silence I doubted that they found the transac-tion ‘interesting’

OCM prepaid the first three payments It was a condition of the deal.The company supposedly used its last available cash resources to make thepayments Then, it had stopped paying The dealer had terminated thetransaction and sued OCM for the amount owing – just under $540 mil-lion That is how we were where we were

OCM had approached many lawyers The big firms had all declined toact on its behalf, claiming a conflict of interest Some appeared to haveacted for the dealer, but there seemed to be conflicts of interest even when

this was not the case The firms were concerned about a potential conflict

of interest arising The message was clear – they would not act against amajor investment bank as it might prejudice future opportunities for lucra-tive work

Only Lucre & Lucre had been willing to offer representation Morrisonwas descended from the one of the original founders of the firm and its

expertise seemed to be in the area of shipping, especially in the arcane area

of ‘bottomery’ This was the biggest case in the firm’s history The firm’sstrong suit was litigation, Morrison had assured me, and it would need to

be The establishment firm of Killem & Billem, acting on instructions from

the American dealer, was moving in to administer the coup de gr ace ^ – theywere seeking summary judgment

Knowns and unknowns

I walked back to my hotel contemplating the position What did we know?What did I need to know? What didn’t I know? What was I doing?

During the Iraqi conflict, Donald Rumsfeld, the US Secretary ofDefense, had inadvertently stated a framework for understanding themodern world There were ‘known knowns’ – these were things that youknew you knew There were ‘known unknowns’ – these were things thatyou knew you did not know Then, there were ‘unknown knowns’ – thingsthat you did not know you knew Finally, there were ‘unknown unknowns’– things that you did not know you did not know It also fitted the deriva-tives business Derivatives professionals dealt daily with combinations ofknowns and unknowns The unknowns, both known and unknown, createdfear and suspicion The knowns were synonymous with greed This waseven before the Defense Secretary articulated the principles They had notknown that they had known all along – an unknown known

Derivatives were a known known – known to be WMDs (weapons of mass

destruction) After all, the august figure ofWarren Buffet said so, there was no doubtthat they existed The results of the use ofWMDs littered financial history – Barings,Proctor & Gamble, Gibson Greeting Cards,Orange County, Long Term CapitalManagement (LTCM) A known unknownwas why people dabbled with WMDs Whatcould they hope to gain? It was definitely a known unknown

The unknown known was also self-evident Derivatives were a simplecase of greed and fear Clients used these instruments to make money(greed) or protect themselves from the risk of loss (fear) Frequently, theyconfused the two Clients were fearful that they would miss out on the

Derivatives were a known

known – known to be

WMDs (weapons of

mass destruction)

promised bonanza – fear of losing out on greed Dealers also used theseinstruments to make money, primarily for themselves (greed) They fre-quently dealt in WMDs because they feared that if they did not then theircompetitors would (fear) They too, it seemed, feared losing out on theproceeds of greed The dealers also feared that in trading derivatives theirgreed would lead to losses (more fear) No one in the derivatives industryreally wanted to admit this Most of all they did not want to admit this toregulators and politicians, who just might do something about it (the sum

of all other fears)

The unknown unknowns were more difficult There were probablymany of these, but no one knew them, of course, at least not yet

Unreliable recollectionsMorrison had arranged a ‘without prejudice’ meeting with the dealer Iassumed it was to surrender and throw ourselves on their mercy As a pre-caution, I had looked up Portia’s ‘quality of mercy’ speech in Shakespeare’s

Merchant of Venice It was not exactly within my brief as an expert witness,but who knows, it might prove useful

We had assembled in the lobby of a modern office building in CanaryWharf, once the dilapidated docklands of London The area was still ratinfested and the language was still filled with profanities The East Indiaships and sailors had just been replaced by traders There was a high degree

of security and we were escorted to a conference room where, the receptionparty was waiting There was internal counsel, three lawyers from theLondon operation (headed by Louise), internal counsel from head office inNew York (who said he was there to ‘observe’), and external counsel – twopartners from Killem & Billem and two associates

There were people from the trading side led by Mark Neverfail, aManaging Director The next line on the card proclaimed ‘Head of Global

Markets’ Neverfail was definitely in charge He really was important – ‘da

man’ Neverfail had brought along several colleagues: the head of Asianmarkets, the traders involved in the dealing with OCM, and the head oftrading in Singapore And there was Richie, the salesperson who hadarranged all the transactions with OCM He was Indonesian, coveredIndonesia for the bank and had been at university with Budi We werehopelessly outnumbered Investment banks hunted in packs We would beeasy pickings

I had Googled Neverfail on the Internet He was the scion of an oldmoney family from the north east of the US and had an MBA from a presti-gious university Neverfail did have impeccable derivative credentials: he was

an alumni of two of the best firms in the derivatives trade To cut it there,you had to be very good

The atmosphere was distinctly frosty ‘I think everybody who is coming

is here,’ Louise began There was no pleasant bonhomie The art modern chairs were uncomfortable I didn’t think the meeting wouldtake long

state-of-the-‘Right, let’s get on with it Let’s hear what you have to say I don’t havetime for this stuff I am very busy.’ Neverfail was taking charge As the resi-dent alpha male he was moving to mark territory

Morrison cleared his throat He had clearly sharpened his pencils beforethe meeting ‘Thank you very much for agreeing to meet with us,’ hebegan slowly ‘The transactions that are the subject of these proceedingswere entered into by my clients under questionable circumstances Myclients are not financially sophisticated They relied on the advice of theirbankers It appears that the transactions were entirely unsuitable for myclients and did not fulfil the objectives they sought…’ Morrison made it nofurther Neverfail exploded

‘This is bullshit This is f****** nonsense Your clients entered into thetrades of their own free choice.’ Neverfail wagged an accusatory finger inthe general direction of the defence team ‘Your clients were provided withinformation about the trades They were fully aware of the nature of thetransactions They signed disclaimers that state clearly that they were notrelying on us They state clearly that they knew what the risks of the tradeswere They signed the term sheets They signed the f****** confirmations.Every bloody document What do you mean they did not know what theywere doing? We have dealt with these people for years They knew whatthey were doing They were aware of the risks This is f****** bullshit.’The dealer contingent was nodding their silent support

I wondered if the ‘c’ word would appear I didn’t have to wait long

‘Your clients are lying c****! As far as the firm is concerned, your clientwill honour the trades or we will take every possible action to enforce thetransaction against them Is my position clear?’ Neverfail focused a sternglare on Morrison and then the Indonesians

Adewiko and Budi had turned pale Our ‘Big Four’ accountant lookedshocked at the strong language and seemed in need of a good strong cup of

tea Richie was the only one of the hanging posse who looked able; there would be a price on his head if he dared enter Indonesia again.The ‘quality of mercy’ speech seemed to have gone entirely out of my head.Morrison appeared entirely unconcerned and met Neverfail’s glare withsurprising equanimity He cleared his throat ‘Thank you Thank you forarticulating your firm’s position with robust clarity.’ He paused, taking inthe effect of his words ‘The matter is hardly as simple as you make it out tobe.’ Neverfail’s mouth opened The second tirade was on its way butMorrison was having none of it With a gesture as if waving away an errantvalet, he snapped, ‘Thank you sir We have all heard what you have to say It

uncomfort-is my turn to state our position You, sir, shall luncomfort-isten.’ Neverfail turned son He had clearly not been spoken to like this since he was a child Hiscolleagues seemed to be secretly pleased at this unexpected turn of events

crim-‘As I was saying, it is true that my clients signed certain documents It isentirely true that they appear to indicate that my clients were possessed of afull and complete knowledge of the transactions This is, in fact, entirelyerroneous They relied on your firm Specifically, they relied on certain rep-resentations by your staff.’ He looked pointedly at Richie and the head ofAsian markets Both looked uncomfortable and could not meet his eyes

‘Did I say representation? These statements were, we will be alleging,

misrepresentations – misrepresentations of the most profound kind In fact,they were of a nature that I venture to say could be viewed as fraudulent

As for the disclaimers, we are not talking about a dealing between equalshere Our clients were dealing with a leading, prestigious financial institu-tion Your firm had knowledge and skills far beyond that of my clients It is

my sad opinion that individuals – perhaps rogue individuals – within yourfirm exploited this skill in an altogether most cynical way to take advantage

of my client’s lack of financial sophistication Unfortunately My clients are,after all, in the business of noodles They were alas not financial practition-ers versed in the intricacies of sophisticated financial instruments Theyrelied entirely on the guidance and advice provided by your staff

‘I do not need to remind you that your firm operates under the aegis ofHer Majesty’s FSA [Financial Services Authority] It is, I seem to recall, apart of the requirements that banks and entities licensed by it operate con-sistent with specified standards One of these standards, I don’t need toremind you, is the principle of ‘suitability’ In short, your firm was underthe obligation to ascertain that the transactions that you were recommend-

ing to my clients were suitable to their requirements The evidence is clearthat these transactions were not suitable for my clients Quite simply, we

would not be here if they were Quite simply, sir, my clients nạveté and

trust was sadly and cruelly exploited by your staff for the making ofboodle’ I later learned that ‘boodle’ meant money, filthy lucre For themoment, the room looked confused

Morrison was now in full flow ‘I am, sir, a mere lawyer unfamiliar withhigh finance However, there are certain matters relating to this matter thatremind me of other relevant cases I seem to recall that many of the individ-uals in your firm were employed previously at an investment bank that was

a party to some of those cases Proctor & Gamble, Gibson Greeting Cards,Lemon County.’ It was actually Orange County, but who cared? Morrisonwas now in full control of the events Neverfail looked surprised The legalbattery, including the partners from Killem & Billem, were looking forflaws in the gleaming glass top of the conference table Richie? Well, hewould have preferred that the contract on his life had been executed

It is my understanding that several regulators prosecuted that firm andlevied substantial fines in relation to certain selling practices and behaviours

that were evident in those cases In simple terms, sir, they have form.’

Morrison was clearly enjoying the obvious discomfort of those arrayed onthe other side of the vast conference table

‘We intend, should this matter reach court, to highlight the selling tices and behaviours of your firm and its staff.’ He paused and added slyly,almost in a stage whisper, ‘I am sure that many regulators, both here and inyour native land, will be interested in these issues I dare say that the

prac-Financial Times may find some aspects of the matter interesting and worthy.’ Neverfail had gone very pale The head of Asian markets lookedlike he was having difficulty swallowing I wondered whether they knewPortia’s speech

news-Morrison was reaching the peroration of his speech ‘Rarely, in my sional experience, have I seen such egregious conduct or mendacity on the

profes-part of reputable professionals It is a savageindictment of the dark times we live in.’ Iwould have to look up ‘egregious’ and

‘mendacity’ in a dictionary later Adewikoand Budi were beaming They didn’t have aclue what ‘egregious’ or ‘mendacity’ meant.They didn’t care

Rarely have I seen such

egregious conduct or

mendacity on the part of

reputable professionals

‘We came in a spirit of conciliation, to attempt to straighten out an ous misunderstanding I regret deeply to say that it seems such a hope onour part was entirely misplaced.’ He paused to look at Neverfail and hislegal counterparts from Killem & Billem ‘I think that’s all.’ He rose We allsnapped to our feet ‘Thank you for your time, gentlemen and lady,’Morrison smiled warmly at Louise She smiled back wanly The defenceteam led by Morrison walked out of the room.

obvi-It had been a truly extraordinary performance obvi-It almost made mebelieve that OCM were the innocents that Morrison had depicted I wasbeginning to understand why this tiny country had once ruled much of theglobe and I understood why few have managed to conquer it – it wasbecause of Morrison and his kind I had entirely underestimated the man.The world was full of so many unknown unknowns

Outside the building, the defence team regrouped ‘Went well, don’tyou think?’ Morrison was cheerful I wasn’t sure My confidence, inspiredbriefly by his Churchillian speech, had begun to wane The dealer wouldstill be seeking summary judgment There were still all the documents thatOCM had signed, seemingly without coercion ‘One thing at a time, myboy.’ Morrison seemed sanguine about the prospects

I remembered an undoubtedly apocryphal lawyer’s story The accused

in a criminal matter is most impressed by his lawyer’s blistering examination of the police witness ‘We are doing great,’ the accused says

cross-to his lawyer ‘I am doing great,’ the lawyer snaps back ‘You are goingdown for 20 years.’

Summary judgment

It was the day of the hearing The dealer was seeking summary judgment

In short, they were asking the court to enforce the signed written tracts It was up to OCM to show the court that it had a reasonabledefence to the claim

con-I had sweated out a thick expert report that was part of the defence caseagainst summary judgment I had learned over the years that size reallydoes matter in expert reports In a curious anachronism, experts have aresponsibility to the court, not to their client The expert must not takesides They must have a dispassionate expert’s view of the matters within

their purview This was patently impossible given that experts are in realitytrained assassins employed by each party Each was paid to deliver the killerblow to the opponent’s case An alternative interpretation of the expert wasthat of a prostitute – they were employed to seduce the judge.

Given that OCM had signed all the documents, I couldn’t believe thatthe court would not award summary judgment to the dealer

Just before 10a.m., the hearing being the first matter of the day for thecourt, Morrison ambled into view With him was a bewigged and cloakedsenior counsel – Stuart SC I walked up to them anxiously ‘They have with-drawn their application for summary judgment I told you there wasnothing to worry about.’ Morrison was in a good mood

Why had they withdrawn? It did not make any sense at all ‘No idea,dear boy,’ Morrison shrugged his expressive shoulders ‘Most helpful yourreport, by the way,’ he said as he wandered off with Stuart When I hadrecovered from the initial shock, I was racked by morose doubts It wasmerely a stay of execution We would surely get done at the trial

The next day I was at the airport waiting to catch a plane back toAustralia The Indonesian pair from OCM were there and it turned out thatthey were on the same flight They would change planes at Singapore forthe short flight to Jakarta

Adewiko and Budi were in a good mood They appeared to have spentthe day shopping, judging by their hand luggage ‘We win,’ Budi pro-nounced, showing his deep appreciation of the legal position I smiledthrough gritted teeth; I had no sympathy for either the dealer or the noodlemaker’s conduct

On the plane, my mood soured further I was in business class and theIndonesians were in first For two disgraced executives of a near-bankrupt

company, they were doing very well How did I get here?

Many of today’s traders hadn’t been born when I stumbled accidentallyinto derivatives trading I had spent over 25 years in this world of traders, gunsand money The traders and money were clear enough And you couldn’t havefinancial weapons more powerful than derivatives – they were the big guns ofthe trade And lawyers? I seemed to be spending a lot of time with lawyers get-ting to the bottom of some very odd derivatives transactions

How did I get there? I had followed the money I had ridden the tidesand currents of financial markets I had not known very much about deriva-tives when I started How did I get here? It was a long story This is thatstory It is also coincidentally the story of the rise and rules of derivativetrading – its ‘knowns’ and its ‘unknowns’

Financial WMDs – derivatives

demagoguery

In 2003 there was a debate about financial WMDs (weapons of mass

destruction) – derivatives I have been around derivatives all my working lifeand was unaware that I had been handling WMDs The Indonesians proba-bly agreed with this description of derivatives: they should have worn theirhazardous materials suits when handling their trades The debate wasbetween two giants of American capitalism – Warren Buffet and AlanGreenspan Warren Buffet is ostensibly the chairman of Berkshire Hathaway,basically an investment company, and his fame relates primarily to his leg-endary stock picking skills But it is a tendency for folksy wisdom that hasturned Buffet into an iconic figure – an American ‘original’

Buffet’s well-known statements include: ‘We eat what we cook’, ‘Onlywhen the tide goes out will we know who is swimming naked’, and ‘The viewthrough the rear window is much clearer than the one through the wind-shield.’ Buffet groupies treat these statements reverentially His annual ‘Letter

to Shareholders’ is regarded as a sacred text Berkshire Hathaway’s annualmeeting, an immense religious jamboree attended by adoring converts, isknown as ‘Woodstock for Capitalists’ Buffet is the ‘Oracle of Omaha’

In 2003 Buffet took aim at derivatives, calling them ‘financial weapons

of mass destruction’.1He was joined in this crusade by a few notable ures A significant fellow-traveller was Bill Gross, who managed PIMCO’s(one of the world’s largest investment management companies) vast fixedincome fund Their complaint seemed to be that derivative contracts had

fig-hidden losses that would eventually emerge This would affect the banksand insurance companies who traded in these instruments They were con-cerned that derivatives allowed companies and investors to gamble withother people’s money I had nạvely assumed that gambling with otherpeople’s money was part and parcel of capitalism

The catchy line and the fact that it was from Buffet ensured immediateairplay Buffet’s assault rattled the derivative dealers who feared that others,especially regulators, would take notice What if new regulations were to beimposed on derivatives trading? The derivative lobby went into overdrivebut they needn’t have bothered

The major defender of derivatives was Alan Greenspan, Chairman of theFederal Reserve Bank of New York, effectively America’s central bank Itsresponsibilities include ensuring the integrity of the financial system and thestability of banks The head of the central bank’s role as cheerleader for thederivatives lobby was curious

Greenspan had succeeded Paul Volcker in the late 1980s Volcker hadembarked on an unpopular strategy of high interest rates that had ulti-mately proved successful in beating inflation, although there had beencollateral damage The entire US Savings and Loan Industry had ended up

as road-kill But the high interest rates opened up la belle époque – an era of

low inflation, low interest rates and rising stock prices ChairmanGreenspan found himself in command of the ship just as it sailed intocalmer waters Woody Allen observed that 80% of success in life is justshowing up at the right time The Maestro, Greenspan’s nickname, hadimmaculate timing

The tennis-playing, jazz saxophone-loving Greenspan has presidedover an unparalleled period of prosperity, the bond market collapse of

1994 and several asset price bubbles and collapses Greenspan is famousfor two other things – lengthy sentence construction and an unfetteredbelief in new technology

Greenspan’s regular congressional testimony attracted financial lysts, journalists and linguists in equal numbers An industry ininterpreting Greenspan’s prognostications has developed Without a hint

ana-of self-parody, Greenspan himself provided guidance to interpreting hispronouncements ‘I know you believe you understand what you think Isaid, but I am not sure you realize that what you heard is not what Imeant,’ the Maestro once offered as explanation He further clarified his

position with unusual directness: ‘If I have made myself clear then youhave misunderstood me.’2

Now, Greenspan turned his considerable elocutionary powers to thedefence of derivatives During the height of the Internet boom, he heldforth lyrically and at length on the impact of technology on productivity.Greenspan’s infatuation with derivatives appeared no less intense

‘By far the most significant event of finance during the past decade has been the extraordinary development and expansion of financial derivatives

… As we approach the twenty-first century, both banks and non-banks will continually reassess whether their own risk management practices have kept pace with their own evolving activities and with changes in financial market dynamics and readjust accordingly Should they succeed I am quite confident that market participants will continue to increase their reliance

on derivatives to unbundle risks and

thereby enhance the process of wealth

creation.’ Thus spake Greenspan.3

Were WMDs truly a dangerous menace?

Was Buffet right? Was the correct position

that taken by Greenspan? So what are

‘derivatives’? What do you need to know

about them? What had I been doing with

them all these years?

School days

My experience with derivatives began in my student days ‘Financial

deriva-tives’ did not exist but I had come across options Today the graduate student can take ‘Derivatives 101’ In the 1970s, options was a quaint

sideshow in Business Finance

The lecturer was a young man who had studied at the University ofChicago Graduate Business School, an emerging hotbed of financial think-ing Nuclear physicists of a different era had asked: ‘What is Copenhagen’sview of this?’ In the 1970s, financial economists around the globe won-dered: ‘What is Chicago’s view of this?’

Were WMDs truly a dangerous menace? WasBuffet right? Was the correct position that taken

by Greenspan?

In Chicago, Eugene Fama and his colleagues developed the efficientmarkets hypothesis Merton Miller developed theories on dividends, bor-rowing by companies and the effect of taxes Against this background offebrile activity, in 1973, three academics – Fischer Black, Myron Scholesand Robert Merton – developed a model to price options Scholes andMerton were to receive the Swedish Central Bank’s Prize for achievement

in economics (often mistakenly referred to as the Nobel Prize)

In Business Finance, there was a lecture on the Black–Scholes optionpricing model We had no clue what an option was and eventually, someoneasked about options at a tutorial ‘What good are options?’ ‘What are theyused for?’ The lecturer tied himself up in knots trying to explain theseinstruments It seemed that ‘options did what options do’ Upon beingpressed further, he advised us that ‘it was so obvious, he couldn’t be both-ered explaining what options were used for’ So, we had a vague idea ofvaluing an instrument that we did not understand and whose application

we were even vaguer about Later, in trading rooms and in my dealingswith ‘quants’ (quantitative analysts or rocket scientists), I was to rediscovermutant strains of this same virus Some of these quants were ex-academics.The lecturer had his revenge In the examination, he set us a question

on the Black–Scholes option pricing model We were asked to price anoption Assuming that no one would be cruel enough to set us a question

on this obscure model, none of us had memorized the formula

It’s all Chinese to meLike most of my generation, I learned about derivatives by trading them,mainly from making mistakes

By the mid-1980s, as derivative markets started to take off, we neededstaff for the derivatives business As people with derivative skills were noteasily available, most firms trained their own This took the form of internaltraining programmes run by the dealers We also needed to educate clients.They needed to be brought up the curve just far enough so they tradedwith us We didn’t want them to see what was really going on – especiallyhow much money we were making out of them It was a delicate balance

I was deemed a ‘good’ teacher and was frequently required to run ing sessions The internal training programmes focused on turning thesupposedly bright, well-educated people we hired into something approxi-mating useful staff on a trading desk The atmosphere was that of the