Lehman is now history. But the simultaneously minutely specified and impenetrably unclear web of legal obligation is simply accumulating, year by year. Wall Street firms continue to sell complex derivatives and weirdly challenging structured products. Each time, the spreadsheets make sense. Each time, the legalities are carefully, painfully executed. And the next time there is a major bankruptcy on Wall Street or in the City of London, it’ll be the exact same thing. Every little detail will make sense when you look at it up close—but when you climb to the nearest mountaintop and look down at the lines of battle below, you’ll realize that once again you know nothing at all about how the conflict will play out. That’s Wall Street in a nutshell: very smart guys who do very stupid things.
Settlement risk
Finally, we have two arcane and tedious-sounding risks to deal with. Tedious, that is, until you remember that the global financial collapse of 2008 came about because of things so tedious you never read a word about them until all of a sudden they saddled you with debt, halted your pay rise, and threatened your job.
First up, settlement risk. If your job requires you to drive a Ferrari fast round twisting mountain switchbacks, you’d probably take care with the boring things before you set out. Brake checks. Wheel joints. Tire treads. Bearings.
Boring, sure. Life-saving, definitely.
Wall Street isn’t like that. Those guys drive Ferraris all right, but their garage services are in a mess. When securities are traded, they are, most of the time, traded by telephone. A trader at a brokerage calls up some counterparty, pitches a deal, agrees a price, agrees a trade. In the old days, traders would physically scribble a note of that trade on a piece of paper and fling it at the backroom boys to deal with. These days, the note is normally electronic, but the principle is the same. The trader agrees a deal and moves on to the next thing; the back office staff have to execute the trade. Specifically, a security needs to be delivered to the buyer, funds have to be remitted to the seller. The normal settlement lag, the time between delivery of the security and remission of funds, is between one and three days.
That process is unbelievably simple. It’s in principle no more complicated than you buying a pound of tomatoes. The seller hands you the tomatoes. You hand the seller a dollar, or a dollar fifty. That’s it. That’s all there is to any trade.
And Wall Street regularly screws up. According to The Economist, in 2010 America’s primary dealers (a group that comprises about two dozen large banks and brokerages) generated an average of $128 billion worth of failed trades per day.25 That’s roughly 50% more than their combined net capital at risk. And that’s only the average. In fall 2008, the daily value of failed trades spiked to over $500 billion. That’s half a trillion dollars’ worth of failed trades. Per day. In the US markets alone. Including only the primary dealers, the guys who ought to know best.
The same article quotes a report put out by the Kauffman Foundation, an outfit aimed at promoting entrepreneurship, commenting: ‘Every fail introduces a cumulative and potentially compounding liquidity risk into the orderly process of settling the $7.5 trillion of security transactions completed each day.’ That’s precisely right. Mistakes of this sort don’t cause much harm when markets are orderly and the interbank market feels confident. But what happens when times turn sour? Let’s say a firm runs into trouble. If it’s already short of liquidity, a few failed trades could amplify those problems, thereby aggravating the underlying problems and advertising its plight across the financial system. The initial problem doesn’t even have to be huge for the compounding effect to cause rapid, unpredictable, and almost random destruction. Those liquidity issues have killed firms before now and will do so again.
Once again, we start out with an issue that sounds dry and technical and emerge with a fact that ought to send sane people screaming for the hilltops. Maybe those folk who fill their cellars with bottled water and shotgun shells aren’t so crazy after all. At least they’re thinking about the risks that might lie ahead. Wall Street appears to have lost that habit altogether.
Market vulnerability
On May 6, 2010, the US financial world faced meltdown. Starting at 2.42 p.m., the Dow Jones stock market index dropped 600 points in five minutes. Given that it had already fallen by 300 points that day, by 2.47 p.m. the market had dropped almost 1,000 points since opening that morning—the biggest intraday point decline in the history of the Dow Jones. And then the slide stopped. Prices rallied. By 3.07 p.m. the market was back pretty much where it had been twenty-five minutes earlier.
What had happened? That sickening lurch was not triggered by some major world event. In fact, for a long time no one really knew what had set it off. There was a cute theory around for a while that some trader with a ‘fat finger’ had accidentally added a zero or two to a sell order for Procter & Gamble shares, and everything else had followed from there. A cute theory, but completely false. Procter & Gamble shares did not, in fact, lead the fall, nor was their decline particularly pronounced.
Fortunately, there followed a detailed investigation by the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC). Their report makes shocking reading. (The document, available online, is entitled Findings Regarding the Market Events of May 6, 2010.) For one thing, to state what happened to the Dow Jones index is, in effect, to state what happened to the average major stock. Startling as those average movements were, they were dwarfed by some of the more extreme movements that took place. In the words of the report:
Over 20,000 trades across more than 300 securities were executed at prices more than 60% away from their values just moments before. Moreover, many of these trades were executed at prices of a penny or less, or as high as $100,000, before prices of those securities returned to their ‘pre-crash’ levels.
If that snippet doesn’t make your jaw drop, you’ve got a problem with your reflexes. Twenty thousand trades made at prices that were 60% or more awry? Just imagine the stunning amounts of value being destroyed in those few minutes. Commenting on these things, the Wall Street Journal commented that the report ‘portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral.’26
So what did happen? The detailed answer is complex—you’d need to read the Findings report to get the full story—but the key ingredients were:
market nervousness, causing an ordinary, orderly decline in the stock market;
an increase in volatility (a measure of price variability)—again, of the sort which is common enough when market conditions are uncertain;
a sharp decrease in the liquidity of certain stock market based derivatives contracts;
a large sell order placed in that derivatives market, via a computer-based selling algorithm, followed by
further computer-based trading that effectively sucked the liquidity out of (a) the relevant derivatives market and (b) the markets in the underlying stocks.
Although there have been a few regulatory changes since the report was published, there has been almost no fundamental change. Market nervousness is likely to increase over the coming months and years. Volatility will increase. Liquidity will prove to be exceptionally fragile, just as it was in the dark days of 2008. And of course, derivatives markets are still vastly powerful, as is program-based trading.
Indeed, putting those regulatory tweaks to one side, I’d argue that the fundamental position has grown worse, not better, since 2010. I don’t want to get too technical, but exchange traded funds—effectively, mutual funds that boast a stock market quotation—are, in many ways, following the trajectory of the mortgage market. A fundamentally good, useful, and value-creating idea is being gradually transformed—via ceaseless ‘financial innovation’—into a darkly menacing shadow extending over an ever larger section of the financial system.27 That shadow is spreading extremely fast: today the total asset value of ETFs runs to $1.5 trillion, up
almost 50% in eighteen months. What’s more, the quality and fundamental liquidity of ETFs are declining all the time. Our weak-willed regulators know these things but aren’t taking the forceful steps that would be needed to control them.28
In short, if that ‘flash crash’ could happen in 2010, it could happen again now: the markets of 2011 and 2012 remain highly vulnerable. As a matter of fact, the same thing already has happened again, and worse. In November 2010, the sugar market saw a 20% collapse in prices over two days. Cotton prices are also exceptionally volatile.29 The same has been true of cocoa futures.30 By good fortune, none of these flash crashes have yet caused much damage, but poorly maintained levees didn’t do much harm to New Orleans until 2005. The mortgage market looked to be working fine, until it came close to destroying the international financial system.
In 2010 we were fortunate that the flash crash happened when the markets were still being buoyed up by ultra-low interest rates, by quantitative easing, by massive fiscal stimulus, and by a broad sense of returning security in the financial markets. Those props (disastrous as they’re proving in the longer run) were enough to stop the meltdown. But just suppose the next crash happens when another major financial institution is on the brink. When nerves are shredded. When panic is only half a rumor away. Under these circumstances, a flash crash could easily precipitate failure on a Lehman-like scale. And, with some minor exceptions, all the circumstances which allowed the market to fail in 2010 are still in place today, some of them to an even greater extent. Disaster lies just round the corner.
It’s extraordinary that regulators do not pursue these matters more aggressively. Take the relatively simple matter of the $128 billion worth of failed trades each day. If the regulators simply fined both parties to a failed trade 0.5% of the transaction value, irrespective of fault, the failures would vanish, almost overnight. Why on earth are regulators not imposing such sanctions with all possible haste? It would be an unbelievably simple fix and would completely cure a potentially lethal problem. Yet it’s not being done.
Even more stunning than the lethargy of regulators, however, is the complacent inertia of market participants themselves. At least the regulators will still be in a job if things go disastrously wrong. The same cannot be said for many bankers. Why are they so ready to place their jobs, their banks, and the very financial system itself at risk? That sad tale is the story of the next chapter.
11
Collecting nickels in front of steamrollers
The previous chapter looked at the monumental risks that have built up in a system dedicated to the management, dispersal, and efficient pricing of risk. There’s quite a paradox here. Financial markets are often said to come as close as is possible to the economists’ ideal of a competitive, well-informed, frictionless market. If neoclassical economic theory made any kind of sense, financial markets should be its showcase: the best possible example of markets in action.
Unfortunately, markets don’t follow theory; they prefer reality. And reality is messy, full of compromise and skewed, absent, or contradictory incentives. As long as those incentives are so badly flawed as they are now, the system will always create risks that threaten to destroy the entire capitalist system. In this chapter as in the previous one, I’ll limit myself to identifying the half-dozen most outrageous incentivization issues. There are many more, but we have to stop somewhere.
I should make it clear that I don’t exempt my own industry from these problems. As we’ll see, hedge fund managers, like myself, are incentivized both excessively (on average, we’re paid too much) and wrongly (we’re paid for the wrong things). I personally benefit from these misalignments. Some readers will want to criticize me for this. You may think that I should either refuse my current levels of compensation or just take the money and accept the system.
I don’t believe either criticism is appropriate. In the first place, almost no one turns down money which is freely and legally offered. Why would they? More to the point, though, it’s not as though individual choices are the issue. I personally strive to behave in an ethical and honorable manner. That involves making money for my investors—because that’s the task they give me—but it also involves staying a long way away from investments that I see as little better than Ponzi schemes. (I stayed a long way away from mortgage products and routinely turn down investments which I regard as their contemporary successors.) But so what? A system can be profoundly flawed even if most of its participants behave with honor. What’s required is a system that encourages and enforces good behavior. The current setup does the opposite.
As for the idea that I should keep silent about the flaws in the system just because I’m a beneficiary—I think that’s crazy. It’s those of us who are active within the system who are best placed to diagnose its faults. Indeed, I wish that far more financial insiders would speak up about the faults they know to exist. There were plenty of insiders who grew anxious about the mortgage market collapse before it tipped over into disaster, yet those anxieties were seldom heard outside a narrow, technocratic circle. The topics addressed in this book affect all of us. Literally everybody on the planet. If financial catastrophe hits the world again—and hits it at a time when governments are already at the limits of their financial capacity—the consequences will be profound and universal. The world faces few issues that are more urgent or more pressing. We insiders have a duty to speak up, to attract attention, to solicit change.
That’s the preamble. Now for the problems.
The market
Any market has two halves: buyers and sellers. On Wall Street, the sellers are typically large firms—Goldman Sachs, Morgan Stanley, JP Morgan, Barclays, Deutsche and so on. They’re selling securities to investors (the buy-side), a group which includes pension funds, hedge funds, insurance companies, high net worth individuals, and plenty of others besides. Naturally, because sell-side firms are also traders, they often buy securities as well as selling them. Nevertheless, it’s conceptually useful to look at the specific incentives faced by sell-side salespeople and traders, because those incentives lay the foundation for much of what’s wrong with the system.
Before we look at the sell-side, however, it’s worth starting with the basics: the kill-or-be-killed nature of the market itself. I’ve said before that the equity market is very transparent. You can check equity prices on your computer screen right now. If you call a broker to buy or sell some equities, that broker will be looking at the exact same prices as you are. If he rips you off, you’ll know about it, and he’ll know that you know. That doesn’t make cheating impossible, but it does make it a whole lot harder. Add to that the fact that the equity market is highly regulated and attracts much more media attention than any other, and it forms a fairly safe playground for investors.
The bond market isn’t like that. Michael Lewis describes it in The Big Short, his excellent book on the mortgage market, in this way:
Bond salesmen could say and do anything without fear that they’d be reported to some authority. Bond traders could exploit inside information without worrying that they would be caught. Bond technicians could dream up ever more complicated securities without worrying too much about government regulation—one reason why so many derivatives had been derived, one way or another, from bonds. The bigger, more liquid end of the bond market—the market for US Treasury bonds, for example—traded on screens, but in many cases the only way to determine if the price some bond trader had given you was even close to fair was to call around and hope to find some other bond trader making a market in that particular obscure security. The opacity and complexity of the bond market was, for big Wall Street firms, a huge advantage. The bond market customer lived in perpetual fear of what he didn’t know. If Wall Street bond departments were increasingly the source of Wall Street profits, it was in part because of this: In the bond market it was still possible to make huge sums of money from the fear, and the ignorance of customers.1
Just pause there for a moment. Those neoclassical ivory-tower economists who believe that Wall Street has to work perfectly because it’s a market haven’t understood one of the Street’s most essential aspects. Markets need a number of things to work, of which one of the most basic requirements is transparency, equality of information. Take, for example, the used car market. Sellers generally know exactly what state a given vehicle is in. Buyers are largely ignorant. It’s easy for sellers to rip off buyers; hard and expensive for buyers to protect themselves. That’s something that has been understood by economists for decades—it’s been one of the hottest topics in the subject—yet they’ve almost universally failed to apply the same logic to the financial markets. So let me be clear: most bond markets are exceptionally one-sided. So are most derivatives markets. The idea that these things somehow function with unique excellence is the precise reverse of the truth. To quote Michael Lewis again: ‘An investor who went from the stock market to the bond market was like a small, furry animal raised on an island without predators removed to a pit full of pythons.’2
So let’s look at the pythons.
The sell-side
Willie Sutton was one of America’s best-known bank robbers. When asked by a journalist why he robbed banks, Sutton replied simply: ‘Because that’s where the money is.’
A good answer, but wrong. Yes, banks are where the money is, but you need to be an idiot to rob them. If you want to get rich, you need to work in one, ideally on Wall Street or in the City of London. If you head for one of the right banks and get the right sort of job (whatever you do, avoid the back office), you’ll make plenty of dough, no matter what niche you end up in. But if you want to get ridiculously wealthy, ridiculously young, then the bond market—or the derivatives market—is the place to go. Greg Lippmann, for example, reputedly made an annual bonus of between $4 million and $6 million in the years leading up to the mortgage crash. As his bets against that crash started paying off, he was supposedly offered a $50 million bonus.3 That kind of money was insufficient to retain him, however, and he walked out on Deutsche Bank, his employer, taking several of his team with him. Such stories are exceptional, of course—most traders are not offered $50 million bonuses—but they’re also indicative. No other industry generates even exceptions like these.
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