% fortune -ae paul murphy

Partnoy's Complaint

You've heard of Portnoy's Complaint? - I've been reading a variation by Frank Partnoy called Infectious Greed.

The book purports to provide a history of the decline, and predictions of the inevitable fall, of the houses that Bankers Trust, Long Term Capital Management [LTCM] and various others including Bear Stearns, built on the invention and sale of financial derivatives.

According to the book this is a story featuring villainous and incompetent regulators, country bumbkins and assorted other varieties of knaves and fools masquerading as corporate (or government) treasury officials, and the conscienceless moral morons who took them for billions.

It has a Dailykos, Groklaw kind of feel to it - with the exception that it's not actually obvious either that he's wrong on the facts or in the wrong with respect to the moral outrage he brings to the descriptions of the players, motivations, and events he describes.

A sample from one of his more reasoned sections:

The various international crisises highlighted the fact that the market participants were no longer able to assess their own risks. Investments funds didn't have a good understanding of the risks in Mexico or Thailand. Executives at Barings had no clue about Nick Leeson's trading. And, worst of all, the traders at LTCM had used computer models that simply did not work. When the President's Working Group on Financial Markets surveyed financial firms to see how they were managing risks, it reached the following chilling conclusion, buried in an appendix to its report on LTCM: "Most models do not incorporate all products traded by the firm. Firms initially included products they believed presented the highest risk to them, with the intent of including other credit sensitive products at some future date, Some firms do not have the ability to calculate and monitor aggregate exposure limits across all product lines in a VAR-based environment. For instance some firms only include derivative and foreign exchange transactions, and not repurchase agreements, mortgage backed securities and forwards. A firm's inability to evaluate exposures across all product lines could considerably underestimate credit exposure during periods of extreme market volatility"

Putting aside all his innuendos and political posturing (Reagan and Bush appointed the weak or corrupt regulators) he makes three main arguments so often they constitute the main burden of an easy 50% or more of the declarative paragraphs in the book:

1. derivatives can be made too complex to value fairly and, in that process, often transcend whatever abilities customers, regulators, and traders might generally have to properly assess risks and thus the real value of whatever they're being asked to buy, sell, or assess;

2. derivatives are fancy ways of couching rather simple bets on verifiable outcomes. Thus a complex basket of risks computed on something like mortgage backed obligations and cross leveraged against a basket of seven foreign currencies can take many pages (or an APL one liner) to describe -but can fairly be summarized as a simple bet that the U.S. currency will fall relative to the other seven.

3. the players driving this, particularly those who hired and exploited "quants" to leapfrog the competition in the creation of new derivatives products, were conscienceless gun slingers looking for thrills and bucks - unafraid of regulators and perfectly happy to commit commercial crime in pursuit of higher bonuses and greater personal glorification.

He presents Wall Street's derivatives business, in other words, as a kind of giant berserk casino in which key players rig the games, ignore the rules, and conspire with the regulators to fleece the sheep.

According to the back cover blurb someone writing for "Management Today" described the book as "a breath taking chronicle of greed and stupidity on an operatic scale". That's about right - but I don't know how much of it reflects reality, how much is personal pique, how much is politics, or really anything about what's been left out of the story as he tells it.

On the other hand, it does give me an idea: if public equity market shares are really just highly simplified derivatives with daily betting structured against prospective quarterly earnings -then replacing that basis for bet closure with something more appropriately focused on long term shareholder value would make sense.

Technology companies making their own processors could, for example, quite literally use processor performance - enabling Sun, AMD, and Freescale to replace all outstanding shares with tradeable derivative products whose payoff is based on relative processor performance in their own key markets.

It sounds absurd, but it's actually a simple generalization of what already exists, gets Wall Street out of the board rooms, wipes out a bunch of market distorting trading options, and ties the issuer's market value to its actual long term performance - all of which are really pretty good things, right?