The Back Alley Archives

I've been trying to catch up on some reading of late and thought I'd pass along a couple of titles I found useful.

The first of these is F.I.A.S.C.O by Frank Partnoy, which tells the story of the author's experience working as a derivatives salesman for Morgan Stanley. MS forgot to get Partnoy to sign a non-disclosure agreement so he's able to be very honest about what he saw there.

Partnoy started out fresh out of law school, selling derivatives for First Boston, got enough experience working on Latin America deals to qualify as an "expert," and from there moved on to MS. He describes the types of deals they would do, starting out with his initial work in Latin America. A lot of this involved financial engineering by which they would magically turn crappy debt into high grade debt by moving bonds into an offshore trust, sticking some Treasury bonds in with them, and paying a fat fee to the ratings boards for the rating they wanted.

Later he moves on to Japanese deals, where the deals they would structure were created basically as vehicles for companies to hide losses on their books for a given fiscal year. He describes a typical deal as such (watch the moving parts):

MS creates a trust account into which it deposits two buckets of U.S. bonds: Bucket A, which consists of bonds with a face value of $70 million and a duration of 30 years; and Bucket B, which consists of bonds with a face value of $30 million and a duration of 30 years.

They then produce a legal opinion utilizing a loophole in Japanese accounting standards, which states that this trust is composed of two pools of bonds, each of which has an average face value of $50 million. MS then issues trust certificates for this trust and sells them to a Japanese company.

A week or so later, the Japanese company withdraws Bucket A from the trust and cancels half the trust certificates. The company then sells those bonds back to MS at face value. Because they have a legal opinion stating that the bucket had an average value of $50 mill and the company sells the bonds for their face value of $70 mill, the company is able to book a profit this year of $20 mill.

What about the loss that will then be taken from Bucket B? Partnoy says the attitude was "Who cares?" That won't happen for thirty years, so A. those losses are now someone else's problem and B. Morgan Stanley's sales guys have already collected the fat fees they collected on the deal and will be long gone. The long and short is that they were committing accouting fraud.

Very eye opening book. Partnoy eventually became disgusted with the biz and retired to teach law. While the book follows his career, first at FB then at MS, he gives a history of derivatives during his overall time in the biz. This includes Bankers Trust getting caught with their traders on recorded calls, joking about how they were ripping their customers off; and Orange County, CA being bankrupted by derivatives deals they got into with Merrill Lynch which involved betting on which way interest rates would go years down the road. Some of this stuff is just literally crazy.

Unbelievable.

The other book I've read recently that's worth checking out is Traders, Guns, and Money by Satyajit Das. Das worked as a derivatives trader for several decades--in fact, he started in the industry when derivatives were just beginning to be used and has written text books about derivatives. Das worked both the buy and sell sides of the biz and as a consultant during his career before retiring. Das structures his narrative around a gig he takes on, advising an Indonesian noodle maker that has incurred severe losses due to a derivatives deal an American bank convinced them would be risk free and is now going to court with the bank (Das didn't get out of any non-disclosures, so he can't name names, only countries). From there, he goes on to describe his experience in the business and the different types of deals he saw.

One of the biggest points Das makes is that derivatives use mathematics from the physical sciences and engineering to predict how things like currencies, interest rates, etc will behave in the future. The problem, of course, is that things like interest rates or the value of a basket of currencies change because of the behavior of humans, not some law of nature, and humans tend to become greedy, euphoric, depressed, unpredictable. There are manias and there are panics.

At one point, Das produces a table of events, all of which are Black Swan events--events so rare that, according to modern finance, they should only happen once every two hundred or so years, if that often. Problem is, these types of events happen all the time. The Asian crisis, the collapse of the hedge fund Long Term Capital Management, Russia defaulting on its debt, Argentina defaulting on its debt, the collapse of the NASDAQ bubble, the collapse of the housing market, the collapse of the credit bubble. All of these happened in the past fifteen years.

Das also observes that derivatives and so-called "financial innovation" seem to him to exist for only a small number of actual reasons: 1. To allow businesses and banks to get around existing regulations; 2. To allow insurance companies to do things they're not allowed to do by law, i.e. bet on currencies; 3. To allow companies to hide losses through fraudulent accounting.

Also a read I would recommend.

Great write-up a1...I might have to read FIASCO...sounds awesome.

I'm continuously amazed at the seemingly ubiquitous problem of the lack of any moral compass within high finance during the boom years. Maybe these guys thought they were doing what was best for their clients, but I don't see how anyone can accept the fact that they broke the law anytime it created a profit. I realize plenty of the folks doing most of the work didn't understand what exactly they were doing, but somewhere at some level these companies decided to flaunt the rules of organized society.

And when one jig is up, they move on to the next field like locusts after consuming an entire crop. They find some law that's not effectively enforced and they go to work eating capital while everyone around them says, ohhh they're making good money and helping their clients be more productive all at the same time, but nothing could be further from the truth. They're nothing but parasites.

The problem is you can't tell the honest ones from the lying fucks. I wish everyone in the world would boycott any deal that they don't personally understand. Unfortunately humans have the unique ability to combine greed with stupidity to breed pure evil's kid brother--hubris.

Das also observes that derivatives and so-called "financial innovation" seem to him to exist for only a small number of actual reasons: 1. To allow businesses and banks to get around existing regulations; 2. To allow insurance companies to do things they're not allowed to do by law, i.e. bet on currencies; 3. To allow companies to hide losses through fraudulent accounting.

I sense a theme... ;D

Kinda makes me never want to use a bank or participate in the market in any way ever again. That's not very realistic for me just yet...but I can dream.

Great write-up a1...I might have to read FIASCO...sounds awesome.

I'm continuously amazed at the seemingly ubiquitous problem of the lack of any moral compass within high finance during the boom years. Maybe these guys thought they were doing what was best for their clients, but I don't see how anyone can accept the fact that they broke the law anytime it created a profit. I realize plenty of the folks doing most of the work didn't understand what exactly they were doing, but somewhere at some level these companies decided to flaunt the rules of organized society.

And when one jig is up, they move on to the next field like locusts after consuming an entire crop. They find some law that's not effectively enforced and they go to work eating capital while everyone around them says, ohhh they're making good money and helping their clients be more productive all at the same time, but nothing could be further from the truth. They're nothing but parasites.

The problem is you can't tell the honest ones from the lying fucks. I wish everyone in the world would boycott any deal that they don't personally understand. Unfortunately humans have the unique ability to combine greed with stupidity to breed pure evil's kid brother--hubris.

The irony, aa, is that MS was once very selective in who they would take on as clientele, as they had a reputation to protect. Then came outfits like Drexhel Burnham in the 80's. Drexhel had rep as a dirtbag firm early on, for good reason. But they made a shitload of money and firms like MS and Goldman felt they had to make that kind of change. They lowered their standards to chase the paper.

Of course, Drexhel eventually got rung up on criminal charges and their people went to prison. And where are we now?