Turn the Page

“Everybody’s coming back to take stock of their lives. You know what I say? Leave your livestock alone.”

— Grosse Pointe Blank

One more rotation of a small blue planet on its circuit around a minor yellow star at the edge of an unremarkable galaxy in an accidental universe is flimsy justification for the importance which so many of us put on the turning of the year. But we have agreed to take this day and night as a sign of something larger, something more important than our quotidian lives. It is simple convention, yes, but it is our convention. And who is to say we are wrong?

So raise a glass: To absent friends. To present friends. To family and everyone else we love. To life, and the chance to keep on living it, if only for a little longer (who knows how long). To paths taken, and untaken. To the promise and hope of a new year. To the wishes in your heart. To the hopes of all humankind.

To the words and motions of that ancient toast:

Never above you,
Never below you,
Always beside you,
And forever in your glass.

Happy New Year.

Two roads diverged in a yellow wood,
And sorry I could not travel both
And be one traveler, long I stood
And looked down one as far as I could
To where it bent in the undergrowth;

Then took the other, as just as fair,
And having perhaps the better claim,
Because it was grassy and wanted wear;
Though as for that the passing there
Had worn them really about the same,

And both that morning equally lay
In leaves no step had trodden black.
Oh, I kept the first for another day!
Yet knowing how way leads on to way,
I doubted if I should ever come back.

I shall be telling this with a sigh
Somewhere ages and ages hence:
Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.

— Robert Frost, “The Road Not Taken”

© 2011 The Epicurean Dealmaker. All rights reserved.

Shhh!

Je souhaite dans ma maison:
Une femme ayant sa raison,
Un chat passant parmi les livres,
Des amis en toute saison
Sans lesquels je ne peut pas vivre.

In my house I wish:
A woman with her reason,
A cat passing among the books,
Friends in every season
Without which I cannot live.

— Guillaume Apollinaire, “Le Chat”

Enjoy your weekend.


© 2011 The Epicurean Dealmaker. All rights reserved.

In the Nation’s Service

“They all have husbands and wives and children and houses and dogs, and—you know—they’ve all made themselves a part of something, and they can talk about what they do. What am I gonna say? ‘I killed the President of Paraguay with a fork. How’ve you been?’”

— Grosse Pointe Blank

I.

It is a common situation in human society that we often encounter significant moral dilemmas, situations in which we must make a choice between terrible evils in order to advance some agenda. Should we continue an unjust war when immediate cessation could cause worse harm than a temporary continuance? Should we torture a prisoner for the location of a nuclear device primed to incinerate innocent civilians? Should bankers crash the entire global financial system and plunge us into recession simply to ensure a steady stream of material for journalists and pundits to write about? These are difficult choices.

Within larger, more complex societies, we often deal with such regularly recurring dilemmas by establishing and empowering groups of individuals to take care of our dirty work for us. Whether it is Seal Team Six, the United States Congress, or Goldman Sachs, many of us prefer to tut-tut from a safe distance about the naughty things these agents do to advance our interests, while secretly enjoying both the benefits they help provide and the fact we ourselves are able to maintain righteously clean hands while doing so. I leave it to you, O Thoughtful Readers, to reflect on the justice of such moral hypocrisy and, indeed, whether is it truly avoidable in any practical sense.

More to the point, however, is the question whether such groups and individuals actually provide a service to their societies. I say they do. You may not agree with their actions, or even the sociopolitical agenda which engenders such choices, but you cannot deny that society as a whole depends and relies upon such agents to do its dirty work. And there is plenty of dirty work to go around. Some claim, for example, that the entire industry of financial intermediation “is a superposition of fraud and genius” designed to trick the rest of us into taking investment risk, therefore ensuring economic growth instead of collective stasis, even if the price is unequal distribution of risk and loss and the extraction of intermediary rents by financiers. This may well be true. But it is a collective fraud which advanced societies have foisted upon ourselves, and in most instances we enjoy substantial (if not unalloyed) benefits from it. What would you propose in its stead? Lower living standards?

And even if you are skeptical that the financial industry’s actions are the moral equivalent of shooting terrorists in the head or firing remote-controlled missiles into Afghan villages—as I am—you can still acknowledge that perhaps the societal function it performs, while unpleasant, is one of more pedestrian utility, like taking out the garbage or cleaning toilets. Call it the “wrinkled nose” problem. There are lots of those jobs which need to be filled in society. In fact, one might argue that most jobs fall somewhere along the spectrum from mildly disgusting to slightly repellent in moral terms. As a wise man once observed, that’s why they call it work.

So I fear I must take exception when Princeton students exhort their peers to eschew jobs on Wall Street for more noble ones “In the Nation’s Service.” We all work in the nation’s service, children, whether you like it or not: garbagemen, IRS agents, commando assassins.

Even investment bankers.^1,2

II.

There is another, more prominent strain to the critique of Wall Street’s hiring among college students. That is, it is argued that the financial industry is so lucrative and glamorous that it has—at least for the past many years—hoovered up all the “best and brightest” among this nation’s young people, leaving too few for the really important work of innovating, inventing, producing, and addressing the truly pressing problems our society faces. The example typically used to illustrate this argument is the large number of science, math, and engineering graduates Wall Street has hired into sales and trading positions to construct, market, and trade structured products and derivatives.

Put aside, for a moment, the question whether we really face a shortage of technically trained young people in science, math, and engineering roles in this country when we can afford to devote a significant number of them to programming virtual farm animals and glorified online diaries. Put aside the question why the supposedly daunting technical problems we face are not serious enough to have created well-paid jobs for hundreds of otherwise unemployed, highly-educated PhDs in science and engineering. Put aside the fact that many of these wonderfully innovative and productive jobs are either highly risky entrepreneurial positions with no financial security or low-paid internships with charitable organizations or NGOs. Put aside, in other words, the fact that no-one has demonstrated to me that there is any real demand out there in the real economy for these supposedly “productive” positions, or at least any demand that can translate into a living wage sufficient to support a young college graduate without her having to live in her parents’ basement. No, we can address the larger argument directly with several different points.

First, there is the simple matter of demand. Wall Street and finance are currently shrinking rapidly, due to a combination of lousy cyclical market conditions and hostile secular regulatory shifts. Simply stated, Wall Street will continue to shrink over the next several years, because we can no longer make the kind of money structuring, selling, and trading securities and derivatives we did before the financial crisis. We just won’t need to hire as many people as we did in the last decade. Most of the best and brightest will have to look elsewhere for job offers anyway. Problem sorted.

Second, it is not clear that finance ever did monopolize hiring of the best and brightest among our young people, anyway. There are two components to this observation. As Bryan Caplan observes, “elite”—that is, lucrative and socially prestigious—employers like investment banks and management consulting firms tend to recruit new hires from a very narrow and select list of undergraduate and graduate schools, consisting primarily of the Ivy League and cognate institutions. Investment bankers and management consultants tend to look for new employees like themselves, and they tend to be more comfortable recruiting either from the schools they went to or from schools just like them. But, as Megan McArdle points out,

The Ivy League is full of smart, interesting people. But it is not full of all of the smart, interesting people in the country, or even a majority of them. And given the résumés required to get there, it produces a group of people who are narrow in certain predictible ways. (I include myself in this: just because I can see it operating doesn't mean I can escape it.)

The problem is that actually seeking out a wide variety of graduates would be much more expensive and time consuming. Why spend the effort searching for “best” when you can easily access “very, very good”?

This is spot on, as I can attest from my own experience. Over the years, my employers, peers, and I have been completely uninterested in recruiting the “best and brightest” from among the flower of our youth. Instead, we look for bright enough (i.e., very, very bright, but not necessarily the brightest), very hard working, and supremely ambitious. This is entirely due to the requirements of the jobs we hire for: we need young men and women with quick, flexible intellects who can pick up the tricks of the trade in very short, very accelerated apprenticeships; people who are gregarious and fun to be with at 3:00 in the morning after three all-nighters together; and people who are phlegmatic and driven enough to withstand the inhuman punishment we dish out during the early years of their careers. The nature of investment banking—and, dare I say it, management consulting, too—is not one that demands deep thinkers, brilliantly inventive innovators, or even virtuoso synthesizers of disparate intellectual strands. We want smart, fun, dedicated, aggressive youngsters who can work like animals, day-in, day-out, for as long as it takes. As you can tell, this is not a particularly nuanced or diverse set of criteria.

At most you can say that, up until now, investment banks have been aggressive employers of a particular kind of person from among the best and brightest, and they have sought their candidates from among a particular subset of educational institutions which generate them. The intense selectivity of the most elite universities in this country guarantees that there a legions of brilliant, driven, accomplished youngsters stretching their intellects and learning valuable skills outside the penumbra where Wall Street looks for its hires. Furthermore, as Megan McArdle says, the eye of the needle through which young people must pass to gain entrance to the Ivy League and other super-elite universities tends to select for just the sort of highly ambitious, aggressive individuals who make good candidates for investment banking.³ This leaves a tremendous number of highly intelligent, creative, and non-conventional individuals firmly outside the clutches of evil investment banks, whether they like it or not. Those who despair that the cream of our youth are disappearing down the maw of Mammon should take comfort that a very large number of them—probably the majority, and perhaps even the best of the best and brightest, given what we want them for—escapes permanent dissolution into ignominy.

Finally, even those who fall into the gaping gullet of finance are not necessarily lost forever. Students hired out of college are typically employed for two years at most, after which they can leave to go to graduate school or rejoin the productive economy, wiser for their scars and sporting a highly marketable work experience on their résumés. Even among those who go to business school, not all return to my industry. Ones who stay or return with MBAs don’t all stay forever, either. They get fired or laid off; they burn out under the unrelenting strain; they become disgusted with the miserable lifestyle, the continual sacrifices, and/or the moral compromises they feel compelled to make. The ones who manage to make full careers in my business are few in number, even though a “career” in my business normally lasts less than 20 years. Investment banking is a young person’s game, or the calling of an individual like me who has found nothing more exciting and satisfying to do that will actually pay him money. Some—a very few—even manage to come out the other side of the tunnel with their morals intact and the financial security and means to give back to society in a meaningful way. They go into politics, they become philanthropists, they build schools in Bolivia.

They might even write a blog.

III.

So, don’t despair. The deluded and confused flower of our youth will have broader, more socially constructive paths available to them than investment banking, whether they want them or not. Investment banks’ demand for cannon fodder is plummeting almost as fast as their social prestige, and pay is likely to follow. Eventually, unless current trends reverse, investment banking will return to what it was not so long ago: an obscure, thinly peopled backwater too mysterious for most trend-following college kids to even contemplate, and too abhorrent in polite society for their parents to recommend. The hard-core wanna-be bankers—high-functioning autistics, budding psychopaths, etc.—will always beat a path to our doors, however, as they always have done. And we will welcome them with open arms. Perhaps even motivated, intelligent candidates from non-Ivy schools will have a chance to break in, too, after the Ivy Leaguers have moved on to the next hot employment trend. That would be a good thing, since they tend to be better candidates for the long run anyway.

We don’t need or want all the best and brightest. Just the best and brightest investment bankers. Not much has changed in that regard over the past 20 years I have been in the saddle. But one thing has changed for good, and for the better. No longer can a privileged dilettante get a job at Salomon Brothers simply because Mummy knows the Queen of England. Sorry, Michael Lewis.

Related reading:
Steve Randy Waldman, Why is finance so complex? (Interfluidity, December 26, 2011)
Kevin Roose, An Orange and Black Eye for 2 Banks (DealBook, December 9, 2011)
A Hard Rain’s Gonna Fall (September 30, 2011)
Bryan Caplan, How Elite Firms Hire: The Inside Story (EconLog, November 18, 2011)
Megan McArdle, Elite Firms Fishing in a Very Small Hiring Pool (The Atlantic, November 18, 2011)
If the Phone Don’t Ring, You’ll Know It’s Me (October 1, 2011)


¹ Which is not to say, of course, that we must allow the people who do our dirty work to do whatever they want or abuse their legal and extralegal powers for their own benefit and the detriment of the greater good. After all, we empowered them. They work for us. So it is up to us to direct and monitor what they do and are allowed to do. In the case of the financial system, this means regulation and oversight. I have consistently advocated close, stringent regulation of the financial sector, for the very reason that a malfunctioning, overly self-interested financial system can cause all kinds of nasty problems. As I think we all can attest.
² Furthermore, when students such as these talk about jobs in the nation’s service, they most often mean civil service, bureaucratic, and political positions. Oftentimes, these are the very individuals who commission society’s dirty work in the first place. Who is more culpable, the commando who shoots the terrorist in his bed, or the National Security Advisor who authorized the raid? The structured products banker who sold toxic securities, or the stream of regulators and politicians who loosened the rules enough for him to get away with it? Hmm...
³ The most select schools make heroic attempts to enroll diverse student bodies, and they certainly have the numbers of applicants to make that possible. However, the center of the bell curve at any Ivy League university remains squarely in the sights of my industry, and it is arguable that pressures both within and after school tend to push everyone toward the middle. There was a humor book in the 1980s, The Preppy Handbook, which joked that 20% of each entering class at Princeton were preppies, but 80% of graduates were. One might say the same thing about students who want jobs in investment banking and consulting nowadays.

© 2011 The Epicurean Dealmaker. All rights reserved.

TED’s Greatest Hits of 2011

True, true, 2011 isn’t officially over yet, but I am happy to hurry the good-for-nothing wastrel out the door. What promised to be a busy and productive year in my business fizzled out pathetically after Labor Day, leaving me far too much time to blog for my own comfort. Readers continued to trickle in to this site over the course of the year, however, so either I must be doing something right here or there are vastly more masochists peopling the world than I ever suspected.

While the following 10 “most popular” blog posts from 2011 are not based on anything more scientific that Google Analytics page rankings,¹ they are not an unfair representation of the general tenor, topics, and tone of my work. Feel free to while away the interstitial period before the official beginning of the Mayan Year of Catastrophe by revisiting the pieces below (or diving in for the very first time). As a special, one-time, limited holiday offer, there is no charge.

Enjoy.

THE CANON, 2011 Edition

1) Jane, You Ignorant Slut (May) — In which I trenchantly and comprehensively respond to some of the idiotic gasbaggery circulating the interwebs over the pricing of LinkedIn’s initial public offering. Targets for my righteous fury include the normally sensible Joe Nocera, intermittently unhinged Jim Cramer, and former investment bank research analyst² and current blog spammer Henry Blodget, whom I take to task for promulgating “The Stupidest Analogy About IPOs Ever Conceived.”™ Due in no small part to the fact that Mr. Blodget took umbrage at my attack and attempted to paint himself out of the ridiculous metaphorical corner he had invented in a follow-on post, this article attracted by far the greatest number of pageviews of any individual post during 2011. It also reaffirmed my long-standing policy of preventing comments at this location to be the only tenable one for an individual uninterested in marinating himself in the idiocy of the legions of mouthbreathers and internet trolls which populate one of the leading business-oriented blog sites in the English language.³

2) First, Let’s Shoot All the Philosophers (April) — The head of the Department of Philosophy at UNLV argues that the study of philosophy should be supported at his university due to its practical benefits, and I counter that the salient characteristic of philosophy is exactly its radical non-practicality. Picked up like a shiny new toy for some reason by folks over at ycombinator, whose inclusion of this piece on their news feed drove thousands of unsuspecting hackers, venture capitalists, and other hapless start-up junkies to a site which they could only have been too happy to leave as quickly as possible.

3) Come Fly With Me (February) — Wherein I puncture the twin myths of the glamor of investment banking travel and the independence of Big Swinging Dicks like me. It’s a client service business, people, after all. Complete with a nifty cinéma vérité snap by your very own Dedicated Bloggist and Budding Professional Photographer.

4) Bar Nothing (January) — An autobiographical anecdote from serial confessor James Altucher forms the basis for this meditation on the attractions of “hot clients” and “hot deals,” which together reduce normally dignified, self-contained, and highly principled investment bankers⁴ to slavering crack whores desperate for a hit. Illustrated with a spiffy pic of Rita Hayworth as Gilda, sadly not taken by this Author.

5) If the Phone Don’t Ring, You’ll Know It’s Me (October) — For all those eager beavers who continue to want to break into my industry—regardless of parental advice, social opprobrium, and diligent demythologizing by Yours Truly—I lay out a few pointers which might do the silly buggers some good. Hint: an Ivy League degree in finance is not required.

6) Dan, You Pompous Ass (May) — A follow up post to my original LinkedIn IPO piece (q.v. #1, above), in which I provide more details of the IPO distribution process while simultaneously debunking the notion that the fact that investment banks treat institutional buy-side investors differently reflects underhanded or illicit behavior. As I did not bother to attack Henry Blodget again by name in this piece, pageviews were materially lower. Paraphrasing Jane Austen, I hope and suspect Mr. Blodget was so perfectly satisfied with our first conversation that he will never again distress himself by introducing the subject of it again.

7) She’s Got Legs (June) — In which I offer fashion advice to aspiring young women in my industry and similar ones. Said advice mainly boils down to the following: “sexy” ≠ professional. Period.

8) A Victim of Soycumstance (September) — Your Diligent Reporter spotlights a story on divisional infighting at Morgan Stanley to explain why the historically contentious and structurally conflicted corporate finance and sales & trading divisions of traditional investment banks do much better when they cooperate. Encompasses both management philosophy & practice and firm strategy in investment banking, which may be the first time anyone in my industry has ever actually thought about the two topics together.

9) You’re Doing It Wrong (October) — Your Humble Blogosophist loses patience, once again, with the pace and direction of financial reform in this country. I spray the landscape liberally with machine gun rounds, in hopes of winging a recalcitrant legislator or lobbyist or two, but I fear the result will once again be for naught. Pretty much summarizes the kind of regulatory regime I think would work, though. For the archives or for shits and giggles, depending on your preference.

10) A Hard Rain’s Gonna Fall (September) — Sales and trading professionals are getting fired by the thousands, in a massive bloodletting designed to shrink that overgrown side of the house back to normal after years of cheap credit, massive investment flows, and lax regulation. So, what’s a clever sales and trading manager to do? Plant stories in the gullible media attacking mergers & acquisition advisors, of course. Being one of the latter, I fight my corner. I think I win.

* * *

Let’s all hope 2012 won’t be such a pisser. Here’s mud in your eye!


¹ Approximately 185,000 pageviews came in over the course of the year to the home page of this blog and are therefore not identified with any one post. Splitting these up equally over the total number of posts this year gives a page view count per page roughly equivalent to the identified page views for the tenth-ranked post above. Which is only to say, I have no fucking idea what you people like to read.
² Who, one would think, should know better.
³ Yes, you may take that last bit as ironical.
⁴ I’m pretty sure there is more than one of these in my industry.

© 2011 The Epicurean Dealmaker. All rights reserved.

As Good as It Gets

Carol Connelly: “OK, we all have these terrible stories to get over, and you...”
Melvin Udall: “It’s not true. Some of us have great stories, pretty stories that take place at lakes with boats and friends and noodle salad. Just no one in this car. But, a lot of people, that’s their story: good times, noodle salad. What makes it so hard is not that you had it bad, but that you’re that pissed that so many others had it good.”

— As Good as It Gets

Here’s wishing all of you lots of noodle salad in 2012.

Happy New Year.


© 2011 The Epicurean Dealmaker. All rights reserved.

Walking Song

I sit beside the fire and think
of all that I have seen,
of meadow-flowers and butterflies
In summers that have been;

Of yellow leaves and gossamer
in autumns that there were,
with morning mist and silver sun
and wind upon my hair.

I sit beside the fire and think
of how the world will be
when winter comes without a spring
that I shall ever see.

For still there are so many things
that I have never seen!
in every wood in every spring
there is a different green.

I sit beside the fire and think
of people long ago,
and people who will see a world
that I shall never know.

But all the while I sit and think
of times there were before,
I listen for returning feet
and voices at the door.

— J.R.R. Tolkien, The Fellowship of the Ring

NGC 6302 is a gaseous nebula in the constellation Scorpius which surrounds an immensely hot white dwarf star. It has one of the most complex planetary nebula structures known. The cloud is unconscionably gigantic, with lobes extending out as far as two light years (12 trillion miles) from the central star. Given that it is located approximately 3,400 light years (20.4 quadrillion miles) from Earth, it is in no conceivable way a structure which I will ever have the opportunity to visit, even if someone invented fast-as-light space travel tomorrow. Add to this the fact that the photons we see today left the nebula over three thousand years ago, and it is also true that the nebula as it exists now no longer looks like the picture above.

It is both a wonder and a sadness that we humans have developed brains which can conceive of a universe so vast as to literally be forever beyond our individual grasp. I suspect we are the only species on this planet which can not only contemplate our own individual extinction—intellectually, if not emotionally—but also conceive of a future world—happy, beautiful, alive—without our own presence. We need not turn our eyes to the stars to do so, either.

What will the world be like when winter comes without a spring that I shall ever see? What will my children and grandchildren and future generations of human beings see, and do, and experience? How I should like to see what they will see.

How I should like to see just one more spring after my last winter.


© 2011 The Epicurean Dealmaker. All rights reserved.

Miss Lonely Hearts

From time to time, O Dearly Beloved, your Faithful Correspondent receives a letter in the electronic mailbag which he decides is worthy of more general airing in these pages than a simple direct reply.

Today’s specimen wends its way to the Volcano Lair from a junior investment banker of the distaff persuasion (let us call her “Tempted”). She solicits my advice on whether a workplace dalliance with a more senior colleague, one who is already in a committed relationship, would have a detrimental or indeed even positive effect on her professional advancement. She acknowledges being attracted to said individual, finding both his attentions pleasing and his person enticing.

As this situation is quite common in my industry—and, I imagine, many others—for reasons which I outline below, I thought it might be helpful to publish herewith a lightly edited version of the reply I sent Tempted earlier today.

Dear Tempted — Speaking purely from a professional perspective, which you seem to want me to do, screwing around with this guy sounds like a really bad idea. Some random thoughts:

1. Sleeping with a woman does not raise a man’s professional opinion of her. Ever. Unless she is a prostitute.
2. Sex, emotions, and relationships are messy. How would you keep this quiet at your firm? Office romances get out. You won’t be able to prevent it.
3. You say he is smart and cute, and his attentions flatter your vanity. I expect you appeal to him at least in part because he is in a position of power and authority (or at least seniority) to you. This sounds like a lousy basis for a work relationship, or indeed any sort of relationship.
4. If your firm employs more than 100 people, it will likely have explicit guidelines about intra-office romances, especially among people who work together. Check them out. You and your colleague might be violating workplace rules by proceeding.
5. Sleeping with a more senior banker will earn you a reputation as someone who sleeps your way to the top. This is a really shitty reputation to have, whether among men or women, especially if it is not true.
6. You will likely get the short end of any stick in this situation. He has a permanent job and an established reputation at your company. You don’t. If push comes to shove, you are the one who is likely to get the boot.
7. Odds are most relationships at your age don’t last. Unless both of you are truly in love—and it sure doesn’t sound that way—it will not last. How will you be able to work together in the future? Never underestimate how knowing how someone looks naked or what embarrassing little quirks they have in bed can undermine a professional working relationship.

I recommend you extract yourself gently from any real engagement with this guy. Remind him of his girlfriend, tell him you’ve met someone special, tell him you’re worried how this will affect your chances at the firm, anything. You can flirt with him—mildly—but for heaven’s sake keep your clothes on. Unless you both fall madly in love—in which case one or both of you shouldn’t care about getting new jobs elsewhere, as you will likely have to do—this is a really bad idea.

I would offer you this same confidential advice if you worked for me and came to me in person. Good luck, and be careful.

TED

* * *

Now, don’t get me wrong. I love sex. Sex is a wonderful thing, and one of the few unalloyed perks of being human, in my opinion. If I had my druthers, I wouldn’t give a rat’s ass whether all the healthy young girls and boys who work for me fucked each other like bunnies all the time they weren’t in the office. Why, I might even set up a mattress in the break room so they could sneak off for a little horizontal tango during lunch hour, just so they could work the nasty into their work schedules more efficiently.

And it is no surprise temptation is there. Throw together smart, attractive, ambitious, and energetic young men and women (or men and men, or women and women, for that matter)¹ for 16 hours a day of high-pressure, high-stakes work seven days a week, 52 weeks a year. Make sure they develop an elite esprit de corps of shared suffering and accomplishment, compounded by societal envy and disapproval of what they do, and give them rare opportunities to blow off steam together in dark nightclubs and bars and the company of way too much alcohol. It’s a wonder every female investment banker under the age of 30 isn’t pregnant all the time.

But sex is messy. Sex is tangled up with all sorts of emotions, good and bad, and sex makes for a very awkward work environment. It is the rare couple who can conduct an affair at work that does not spill over into recriminations, drama, and undermining behavior, and that is just among their coworkers. In a work environment, sex fucks things up. As a boss, I won’t tolerate it. I just have too much goddamn work to do.

So keep it in your pants, boys. Keep your legs crossed, girls. At least with each other. Because if anything interferes with getting that big LBO pitch for Yahoo! done this weekend, I swear I will fucking geld you.

Related reading:
She’s Got Legs (June 11, 2011)
Thank You for Smoking (August 6, 2010)
Fingernails that Shine Like Justice (May 21, 2007)


¹ Hey, whatever floats your boat. I don’t care. I would simply observe that gay men and lesbians tend to be even scarcer in my industry than straight women.

© 2011 The Epicurean Dealmaker. All rights reserved.

The Cold Companionable Streams

The trees are in their autumn beauty,
The woodland paths are dry,
Under the October twilight the water
Mirrors a still sky;
Upon the brimming water among the stones
Are nine-and-fifty swans.

The nineteenth autumn has come upon me
Since I first made my count;
I saw, before I had well finished,
All suddenly mount
And scatter wheeling in great broken rings
Upon their clamorous wings.

I have looked upon those brilliant creatures,
And now my heart is sore.
All’s changed since I, hearing at twilight,
The first time on this shore,
The bell-beat of their wings above my head,
Trod with a lighter tread.

Unwearied still, lover by lover,
They paddle in the cold
Companionable streams or climb the air;
Their hearts have not grown old;
Passion or conquest, wander where they will,
Attend upon them still.

But now they drift on the still water,
Mysterious, beautiful;
Among what rushes will they build,
By what lake’s edge or pool
Delight men’s eyes when I awake some day
To find they have flown away?

— William Butler Yeats, “The Wild Swans at Coole”

Which is the more difficult duty: to leave too soon, or to stay behind, unable to follow? Stupid question, for each of us will assume both burdens soon enough, and likely much too soon.

Rest in peace, absent friends.

Live unwearied in love, joy, and passion, present ones.


© 2011 The Epicurean Dealmaker. All rights reserved.

Holiday Interlude

I’ve seen things you people wouldn’t believe. Attack ships on fire off the shoulder of Orion. I watched C-beams glitter in the dark near the Tannhauser gate. All those moments will be lost in time... like tears in rain...

— Blade Runner (1982)

The flesh surrenders itself, he thought. Eternity takes back its own. Our bodies stirred these waters briefly, danced with a certain intoxication before the love of life and self, dealt with a few strange ideas, then submitted to the instruments of Time. What can we say of this? I occurred. I am not... yet, I occurred.

— Frank Herbert, Dune Messiah

How can we endure? How can we ensure all our moments will not be lost, like tears in the rain? Does it help to share those moments with others, to pass the baton, as it were? Perhaps. It is pretty to think so.

Here is better advice: Occur well.

Happy Thanksgiving.


© 2011 The Epicurean Dealmaker. All rights reserved.

Sovereign Triviality

Above all else, the mentat must be a generalist, not a specialist. It is wise to have decisions of great moment monitored by generalists. Experts and specialists lead you quickly into chaos. They are a source of useless nit-picking, the ferocious quibble over a comma. The mentat-generalist, on the other hand, should bring to decision-making a healthy common sense. He must not cut himself off from the broad sweep of what is happening in his universe. He must remain capable of saying: “There’s no real mystery about this at the moment. This is what we want now. It may prove wrong later, but we’ll correct that when we come to it.” The mentat-generalist must understand that anything which we can identify as our universe is merely a part of larger phenomena. But the expert looks backward; he looks into the narrow standards of his own specialty. The generalist looks outward; he looks for living principles, knowing full well that such principles change, that they develop. It is to the characteristics of change itself that the mentat-generalist must look. There can be no permanent catalogue of such change, no handbook or manual. You must look at it with as few preconceptions as possible, asking yourself: “Now what is this thing doing?”

— Frank Herbert, “The Mentat Handbook,” Children of Dune

While I do my best to suppress such realizations, Dear Readers, I have found it increasingly difficult to deny that we live in an age of Engineering and Science triumphalism. Signs abound for all to see, from technology’s relentless conquest and absorption of everyday human interaction, to the increasingly strident complaints that my own industry has hobbled the march of civilization by luring innocent youth away from test tubes and argon lasers and perverting them to the “socially useless” worship of Mammon. It is perhaps no stronger evidence that Science with a Capital S has consumed the heart of our common narrative that so many of the culturally and intellectually dispossessed have been fighting so fierce a rearguard action in denial of its most basic claims. Flat Earthers are never more strident or dangerous than when they feel their very relevance to society is threatened.

Within the mainstream conversation, however, there seems to be a general consensus that as a country we neither possess nor produce enough scientists and engineers to meet our current and projected challenges, so many of which are asserted to be scientific or technical in nature. Climate change, pollution, adequate energy, population pressures, poverty—all these and more are asserted to be in some form or fashion reducible to technical problems. Problems which, many seem to assume, can be solved if we simply graduate more scientists and engineers to fix them (and make sure they don’t go to Wall Street). Let us birth more Steve Jobs and Mark Zuckerbergs, the argument goes, and all will be well.

Accompanying this narrative, of course, is a general wailing and gnashing of teeth that we devote too many resources within higher education to the teaching of the liberal arts and humanities, resources which could be better allocated to training the technicians, engineers, and scientists we really need. Now, as a fierce devotee of the liberal arts and humanities in my own right—and, in full disclosure, a graduate with a degree in a traditional “soft” social science—I am understandably partial to arguments which refute such heresy. Sadly, the few examples I have seen so far¹ have done little to press what I consider the strongest arguments in favor of maintaining broad and robust humanities programs in higher education.

The weakest are of a kind: arguing the instrumentalist case that liberal arts disciplines can be functionally useful to society, either in their own right or as producers of the junior partners—translators, communicators, panegyrists, and apologists—for the scientists and engineers who do the “real” work. But this will not do. That way lies intellectual stepchildren like “Applied Philosophy” and “Science Journalism,” fine professions no doubt, but hardly compelling enough societal amanuenses to justify $200,000 bachelor degrees and ongoing taxpayer subsidies.

Writing in The Economist, Will Wilkinson supplies stronger arguments. He points out that college, for most, is now a major consumption good, which students exploit because they can. He flips Alex Tabarrok’s argument of education in the service of economic growth on its head:

What is economic growth for, anyway? It’s for expanding our choices and making life better. Is it really so surprising that, as we grow wealthier as a society, more and more of our young people, when the amazing resources of the modern university are put at their disposal, choose to use them learning something satisfying and enriching and not for anything except cherishing the rest of their lives? Is it really so surprising that taxpayers are not in revolt over the existence of poetry professors?

He also makes the more germane instrumentalist point that, as Western society gets richer, we expend more and more leisure time consuming the products of artists, writers, and other creative folk. Who else but Film Studies and Comparative Literature majors will produce these entertainments, anyway? Physicists? Mechanical Engineers? Please.

* * *

But all these counterattacks miss the three most important reasons I believe broadly available liberal arts education will remain critical to our society and polity for the indefinite future. First, there is the point which Frank Herbert makes so artistically and metaphorically in my epigraph above. As the body of scientific and technical knowledge swells exponentially, scientists and engineers by definition simply must become narrowly focused specialists. You cannot be effective as a scientist or engineer nowadays if your knowledge spans too broad a field. Our collective scientific knowledge is simply too deep. But this introduces the dilemma of the expert, who literally cannot see the forest for the trees or, more aptly, for the respirative pores on the bottom of leaf #6,972 on branch #473 of tree #1,204. Who will aggregate and balance the competing viewpoints, suggestions, and research programs of all these specialists in highly complex microdomains? Who else but someone who has been rigorously educated in the general discipline of how to think, of how to evaluate competing claims and conflicting evidence under conditions of extreme uncertainty? Who has been taught not only how to analyze and synthesize disparate, incompatible, and even conflicting data but also how to judge?²

The second point to realize is that the usual suspect scientific and technical conundrums which the techdysiasts would have us address are defined and constrained far more by their social and political dimensions than by the hard science issues at their core. Fixing climate change, poverty, or even global financial regulation is not merely a problem of finding the correct solution to a thorny technical problem. These big issues are big because they entail questions of philosophy, ideology, justice, the proper form of society, and even culture. The underlying science is almost trivial compared to the value questions at stake.³ Here, again, we find that the study of liberal arts and humanities prepares a student far better to come to grips with the thorny issues at hand than, say, one prerequisite bioethics course for a pre-med major. Do we really want to turn the keys to our global future over to a bunch of narrowly-educated, really smart, culturally and historically naive technocrats? I sure don’t. Give me someone who has read Herodotus, analyzed Shakespeare, or argued over Rawls instead.

Lastly, there is the larger issue that, for all their power and demonstrable success, science and technology simply do not, cannot, will not address a host of questions and problems which are natural to the human condition. Here is Richard Feynman:

The next reason that you might think you do not understand what I am telling you is, while I am describing to you how Nature works, you won’t understand why Nature works that way. But you see, nobody understands that. I can’t explain why Nature behaves in this peculiar way.⁴

But this is simply not good enough. It may be futile, unscientific, even a cognitive mistake to ask big questions about the nature of reality (the “whys”), the proper form of relations to other human beings in society, our rights and duties to ourselves and others, and the very reasons for belief in our own knowledge (including, of course, science itself), but it is natural and ineluctable. Science will never address these questions. It doesn’t have the tools. Art, social science, literature, cultural studies, history, psychology, and soft sciences like economics do. For this reason alone we cannot, must not, will not abandon them.

To do so would be to forswear the very nature of what it means to be human.

The verifiability, the falsifiability of the sciences, their triumphant progress from hypothesis to application, constitute the prestige and the increasing domination they exercise in our culture. But in another sense, these also make up their sovereign triviality. Science cannot give an answer to the quintessential questions which possess or ought to possess the human spirit. Wittgenstein noted that point insistently. It can only deny their legitimacy. To inquire about the nanosecond prior to the Big Bang is, we are didactically assured, an absurdity. Yet we are so created that we do inquire, and may find St. Augustine’s conjecture far more persuasive than that of string-theory.⁵

* * *

I suspect Harvard’s Philosophy Department will be able to order that new laser printer next year, after all.


Related reading:
Alex Tabarrok, College has been oversold (Marginal Revolution, November 2, 2011)
First, Let’s Shoot All the Philosophers (April 22 2011)
Mary Crane and Thomas Chiles, Why the Liberal Arts Need the Sciences (and Vice Versa) (The Chronicle, November 13, 2011)
Why we subsidise arts majors (The Economist, November 3, 2011)
Eugene Wigner, “The Unreasonable Effectiveness of Mathematics in the Natural Sciences” (February 1960; accessed November 19, 2011)


¹ A sample which I freely acknowledge, for the benefit of my more scientifically inclined friends, to be neither comprehensive nor statistically significant.
² I speak, naturally, of the best of liberal arts education. Expecting a specialist in 15th Century Catalan poetry to be able to make such judgments is heroic, at the least (but perhaps not impossible, even then). But there are many disciplines under the rubric of the humanities which teach such skills. I do not wish to oversell this point, but it is clear—at least to me—that in an age of increasing specialization, someone should be paying attention to the forest.
³ If only, we presume, because it may admit of a clear solution we all agree to. Questions of value do not.
⁴ Richard P. Feynman, QED: The Strange Theory of Light and Matter, Princeton, New Jersey, 1985, p. 10.
⁵ George Steiner, “Ten (Possible) Reasons for the Sadness of Thought”, Salmagundi, Nos. 146, Spring 2005, pp. 3–32.


© 2011 The Epicurean Dealmaker. All rights reserved.

Known Unknowns

[Edward Ferrars and Elinor Dashwood are baiting Margaret Dashwood, who is hiding]

Edward: “Oh... Miss Dashwood. Forgive me. Do you by any chance have such a thing as a reliable atlas?”
Elinor: “I believe so.”
Edward: “Excellent. I wish to check the position of the Nile. My sister tells me it is in South America.”
Margaret: [out of sight; laughs]
Elinor: “Oh. No. No, um... she’s quite wrong. Um... for I believe it is in Belgium.”
Edward: “Belgium? Surely not. I... I think you must be thinking of the Volga.”
Margaret: [still out of sight; appalled] “The Volga?!”
Elinor: “Of course, the Volga. Which, as you know, starts in...”
Edward: “Vladivostock, and ends in...”
Elinor: “Wimbledon.”
Edward: “Precisely. Where the coffee beans come from.”
Margaret: [revealing herself] “Ah! The source of the Nile is in Abyssinia!”
Edward: “Is it? How interesting.”

— Sense and Sensibility (1995)

It is a heartening feature of the internet that one can often determine the truth about a subject by asking for the input and advice of experts, who upon application will usually contribute their knowledge freely. In my experience, it is an even more effective method to adopt a strong and firmly argued position upon a topic you know very little about. This will flush out even more experts, who will dismantle your faulty reasoning and expose your flimsy command of the facts with fierce glee or kind patience, depending on how charitably they view your ignorance and presumption.

My recent post on the current state of counterparty credit risk in the global financial system has already elicited two excellent reponses, and I am reliably assured that more are coming. The first of these was submitted to me by email, by a mysterious personage (let us call him or her “X”) who appears to be even more skittish about his or her real identity than Yours Truly, which is saying something. X’s first messages to me assumed a higher level of knowledge on my part than I possess, and X declined to let me disseminate his or her thoughts for reasons of security. Fortunately, after X read my babbling here and discovered exactly how ignorant I am about the day-to-day finance and operations of large trading banks, he or she took pity on me and sent new material fit for publication.

I now quote M/Mme/Mlle X at length, for your education as well:

Let’s look at the example of Bank A hedging some exposure by trading with Bank B. Let’s say

(1) Bank A has bought $100mm of CDS from Bank B,
(2) The CDS is currently worth 65 points (i.e. the $100mm notional contract is worth $65mm),
(3) Bank B has posted $60mm of collateral to Bank A.

What is Bank A’s direct exposure to Bank B? I would argue that the correct number is $5mm. If Bank B were to default and have 0 recovery, Bank A would post an immediate loss of $5mm, since Bank A already has the $60mm in collateral.

The point is that direct counterparty risk only exists on the uncollateralized portion of any exposure. One term for this is “gap risk.” This is relevant because in your example, Bank A would not try to hedge out its exposure to Bank B by buying protection on Bank B from Bank C. Almost all of Bank A’s exposure to Bank B is already covered by collateral. As for the remaining part, generally the amount of uncollateralized exposure that Bank A has to Bank B is not correlated to Bank B’s credit rating, especially if there are a large number of trades in multiple asset classes between the two banks. Bank A can’t know a priori what the uncollateralized amount will be if Bank B defaults; it’s just as likely that the CDS in the above example has moved from 60 points to 55 points and Bank A actually owes Bank B collateral. Also note that since this is essentially portfolio risk, doubling the number of trades with Bank B doesn’t actually double the exposure, especially if (as is common) many of the new trades are offsetting in risk. There’s no gross buildup of residual risk; this just boils down to net risk against the counterparty.

Why was AIG different? The above is a fairly accurate stylized approximation of what happens for relatively liquid CDS (which do increasingly go through central clearinghouses anyway). Something like a corporate or sovereign CDS is a distinct product that trades and has an observable market price. In the AIG case, most of AIG’s CDS exposure came from much more bespoke deals on structured products. A typical AIG CDS contract might be on some particular complex mortgage product, for which the only CDS trade was the one in which AIG wrote the protection. It has no observable market price and has to be priced using model assumptions on the underlying. This contrasts with e.g. sovereign CDS, where a price can be observed in the market and multiple trades happen on the same CDS; i.e. where there does in fact exist an observable market price.

Why is this relevant? In the above example, we assume that banks A and B agree on the contract’s valuation. If instead Bank A believes the contract is worth $65mm but Bank B only believes the contract is worth $30mm and has only posted that much collateral, then Bank A has $35mm of exposure to Bank B, which it will need to hedge accordingly. But the point is that this is a valuation issue; if the two banks actually agreed on the value of the contract, but Bank B simply refused to post collateral, then Bank B would be defaulting outright on its obligations, and would have its positions closed out accordingly, rather than have the counterparty risk just continue to exist.

The above discusses direct counterparty exposure in the sense of “losing money if my counterparty defaults.” There is of course further risk; if Bank B defaults, Bank A is left with that $100mm of risk that it previously didn’t have. But the risk here is actually a function of Bank B’s net exposure, not Bank A’s gross exposure. If, for example, Bank B had an offsetting contract for $90mm notional with Bank C, then after a default by Bank B, you would expect that Bank A and Bank C would offset their newly acquired risk against each other, such that e.g. Bank A only ends up with a $10mm change in risk, and Bank C ends up with no change in risk. This is pretty much what happened after Lehman defaulted. In fact there was a special trading session arranged for just that purpose, though most of the risk rebalancing actually happened in normal trading after the default.

I believe points (2) and (3) in your blog post boil down to concerns regarding net risk. I agree that large concentrations of net exposure would be a cause for concern, more so in illiquid positions but even to some extent in liquid ones. One way to get more comfortable with this in CDS space is just to look at the DTCC net notional numbers. By definition no entity’s net position can exceed the total net position. This ends up giving you a cap on how bad things can be; of course not ideal, but maybe less bad than you would initially think.

* *One more thing—and you can share this too as long as it’s not attributed.

The “margin call contagion” scenario you propose is not representative of how banks operate. Just about everything in a bank’s portfolio will already be contributing to its funding. Bonds will be repoed out (i.e. for cash equal to the bond’s value, less a haircut), stock will be lent out, and collateral posted on derivative contracts will be rehypothecated.

It’s possible that e.g. repo haircuts will exceed the bid-offer on some instruments and selling a security might give me slightly more cash than repoing it, but the extra amount is small. In general the notion of “liquidating a valuable position for cash” doesn’t make sense for a bank. Of course this may be different for a buy-side firm, but it doesn’t make sense for a bank to sell a security for liquidity purposes when it’s already used to secure some cash. This is also less true for illiquid things that can’t be financed; it is however true for any collateralized derivative position due to rehypothecation.

Alles klar?

* * *

So, at the risk of having my mysterious interlocutor correct me once again, I will take the liberty of drawing a few conclusions.

First, I think X has substantially diminished my fears about investment banks being piles of counterparty credit kindling just one counterparty default away from causing massive systemic conflagration. The daily zero-limit, two-way settlement of collateral calls between large investment banks (now current practice among most large market participants, according to this BIS study) means that, except in very fast moving markets, one should expect that changes in net margin requirements triggered by changes in the value of underlying investment contracts should be reasonably well-reflected in the risk books of most major banks. Second, the fact that big trading banks settle margin exposure on a net portfolio basis—which, Harry Markowitz assures me, should net out to less than the simple addition of each individual exposure across large, multi-market and multi-instrument portfolios—gives me some comfort that whatever residual risks accumulate on bank balance sheets should not be extreme. Third, X’s assurance that investment banks prefer to use asset positions to fund their operations rather than sell them for cash in a market meltdown leads me to discount the risk of cross-market contagion and “death spirals” triggered by collapses in unrelated markets. All these points directly address the second concern I cited in my previous post.

However, if my concerns about the risk of market collapse inherent in the structure and operations of large trading banks have been partially assuaged, I remain less confident about systemic risk in general. In particular, I worry more about investment banks’ exposure to substantial net risks created by large hedge funds, other originating banks (e.g., Dexia), and non-bank participants (e.g., AIG Financial Products). If one is to believe X, this is where the major risks are created and packaged. If Bank A trades with Hedge Fund 1, which cannot meet its financial obligations and has no counterparty assets of its own to net against A, Bank A could still be seriously fucked if Hedge Fund 1 defaults. Especially if Hedge Fund 1’s default coincides, as it well might, with a substantial gapping out of risk exposure on the underlying trade with Bank A.

Assume, as I would certainly hope we can in today’s markets, that most investment banks aspire to pretty close to zero-net present value risk books across the firm. (This is the fundamental philosophical tenet of the Volcker Rule.) Then risks to the system will be created not by the banks at the center of the markets, but rather by the risk-takers (investors, hedge funds, etc.) at the edges. And, should you need reminding, risk-takers don’t hedge all their risks to zero. Duh.

I also worry that investment banks remain seriously exposed in illiquid, hard-to-value markets now and in the future. X him- or herself hints strongly that the nifty daisy chain of traditional bank risk mitigation can get dangerously frayed under such circumstances. Sovereign CDSs may be relatively transparent, given the monitoring and data publication of the DTCC, but this is not true in every market. In particular, I worry that the next dangerous net risk exposure will be created in one of those opaque, highly-illiquid, obscenely profitable new markets which Wall Street is so fond of creating. And if there is no central repositary of trade data in a particular security or derivative market, no standardization and reporting of net and gross positions, what is to prevent the rise of yet another bunch of idiots like AIGFP to create a huge net risk position of which their multiple, competing investment bank counterparties remain blissfully unaware?

Last, I retain a nagging worry about the sheer complexity of the balance sheets, risk books, and insanely complicated credit and financing plumbing upon which modern day investment banks rely. Long-time Readers will know I am no fan of complexity, because it introduces fragility and vulnerability into any system. X and his peers may have designed a beautifully functional risk transmission system for their employers, but what happens if one of the pipes clogs or breaks, due to human error or unforseen complications? (How likely are those, I ask you? Yeah.) I have every faith that the clever gnomes of Wall Street can figure almost anything out, if you give them enough time. The problem is, that when the shit hits the fan at an investment bank, your clients are sucking funds out at a blistering pace, and the ratings agencies and your shareholders are in a desperate race to write you off forever, you have almost no time at all.


© 2011 The Epicurean Dealmaker. All rights reserved.

Methinks Thou Dost Protest Too Much

Any sufficiently advanced technology is indistinguishable from magic.

— Arthur C. Clarke

Attentive Readers will realize that I have used my durable and insightful epigraph before, specifically in a post which defended my industry against accusations of malfeasance arising from the common tendency of merchants in any economy reliant upon buying and selling to conceal the true costs and profits embedded in their activities. It was my contention then and is now that no law, human or otherwise, compels a vendor to offer buyers of its wares the “best price”—whatever that may be—or, indeed, prevents it from doing what profit-maximizing enterprises are commonly presumed to do: maximize profits. As long as said vendor is not selling faulty merchandise to inappropriate customers in a fraudulent manner, we should not expect to know nor require it to reveal all of its secrets.

This, however, is not that post.

For those of you with half a brain will (or should) realize that my idyllic little précis of laissez-faire capitalism skips lightly over two critical assumptions: that 1) all this happy buying and selling take place in reasonably competitive markets, where other vendors compete to offer the same good or reasonable substitutes therefor, and 2) the manufacture and sale of these goods does not impose intolerably noxious externalities on the society in which they are sold. The first of these can be seen as simply a special case of the latter, in which the externality which society should naturally seek to limit is economic rent-seeking in all its forms: monopoly, oligopoly, producer or factor cartels, preferential government regulation, etc. Of course, this tends to assume that the economy should be servant to society, rather than vice versa, which belief seems unhappily out of fashion nowadays.¹ Go ahead, call me a dreamer.²

A cynic might say that politics is nothing more than a neverending argument over the size and distribution of economic rents in society. But let us set that question aside for now. Instead, I would like to focus on other kinds of externalities: those corrosive and destructive injuries to society which are generated as ineluctable byproducts of the activity of certain unsavory economic actors, like arms dealers, child pornographers, and television reality show producers.

And investment banks.

* * *First, some history.

One of the principal functions of investment banks is the distribution of economic risk in society, from those who wish to sell it (and its associated productive return) to those who wish to buy. In the past, investment banks generally worked pretty well as conduits for risk, passing it from natural seller to natural buyer pretty effectively while skimming a small percentage off the top as recompense for their services. On the wholesale securities side of the house, they acted as large, temporary warehouses, buying and selling securities and derivatives on behalf of clients and maintaining minimal stocks in inventory to satisfy unforseen demand. It was a model which required little equity capital to support it, so investment banks levered up with short-term financing of their short-term assets and earned a nice return on the shareholder or partner equity they employed. Operating with so little equity entailed substantial risk, as a simple mistake or unexpected market shock could send the entire house of cards tumbling down. But because they tended to deal in liquid, easily marketed instruments, failed investment banks could be liquidated with relatively little disruption to their counterparties or the financial markets. Of course, the shareholders or equity partners got wiped out, but that was understood as part of the game. Live by the sword, die by the sword.

But then came the Great Moderation, and the industry changed. Investment banks merged and converted into universal banks, with commercial lending, mortgage businesses, and retail depositors, and they began swelling like mutant ticks on a hemophiliac dog. They began to warehouse more and more securities and derivatives to accommodate increased trading volumes on the market-making side. They began to warehouse more and more financial instruments for their own proprietary trading efforts. And they began to manufacture securities and derivatives, like mortgage-backed securities, credit default swaps, and other “structured products,” to meet investors’ insatiable demand for adequate returns in a seemingly riskless world. But as their balance sheets ballooned, these banks stuck with the tried and true risk management philosophy they had developed over decades as pure investment banks: mark your assets to market in real time, get out of losing positions early, and never hold risky assets in inventory without hedging them. Unfortunately, this is a strategy which depends at its core on operating in liquid, transparent markets, where prices are well known, trading volumes are robust, and hedging instruments are effective and liquid themselves. It also depends on a key principle which every trader knows: it doesn’t matter whether the markets are liquid or not if your position has become so large that you effectively are the market.

In addition, investment banks began to take on more and more counterparty risk as they waded deeper and deeper into such activities as leveraged lending, prime brokerage (lending and clearing for hedge fund clients), and derivatives and other structured products. And this was not the simple counterparty trading risk of old, where your primary worry was whether the party you traded with would deliver a security. It was counterparty credit risk, incurred as part of a trade in which your ultimate profit depended on your counterparty’s ability to satisfy its financial obligations, like repaying a loan, delivering an unencumbered security, or paying off a derivative. And let’s face it: investment banks have historically been lousy at credit analysis. Oh, sure, they’re fine when it’s short-term, secured lending, like a margin loan collateralized by liquid, easily-marketable securities with transparent market values. But lending money (or, what is the same thing, contracting for delivery of future economic value under certain circumstances) to counterparties subject to multiple financial risks and multiple financial obligations over a longer period of time? Not so much. And this is a big problem, because it seems that investment banks as a group have become their own biggest credit counterparties in many markets, particularly derivatives.

* * *

The problem is neatly illustrated by a recent Bloomberg article on the European sovereign credit default swap market:

Five banks—JPMorgan, Morgan Stanley, Goldman Sachs, Bank of America Corp. (BAC) and Citigroup Inc. (C)—write 97 percent of all credit-default swaps in the U.S., according to the Office of the Comptroller of the Currency. The five firms had total net exposure of $45 billion to the debt of Greece, Portugal, Ireland, Spain and Italy, according to disclosures the companies made at the end of the third quarter. Spokesmen for the five banks declined to comment for this story.

While the lenders say in their public disclosures they have so-called master netting agreements with counterparties on the CDS they buy and sell, they don’t identify those counterparties. About 74 percent of CDS trading takes place among 20 dealer- banks worldwide, including the five U.S. lenders, according to data from Depository Trust & Clearing Corp., which runs a central registry for over-the-counter derivatives.

Gross exposures are many multiples higher, of course, but the banks like to advertise their net exposures instead. The problem is that net exposures are not the clean, unassuming things a layperson might think they are. Take the following scenario: Bank A sells a $100 million credit default swap on Underlying Company or Country X to Hedge Fund 1. Then, in order to hedge itself, it buys an identical $100 million CDS on X from Bank B. Bank A has completely eliminated its exposure to X and can sail off into the sunset, happily counting the money it made in spread between the two transactions, right? Wrong. Bank A has not eliminated its risk exposure at all, it has merely introduced a credit risk exposure to Bank B, which is now on the hook to pay off the CDS if X craters. But what if B craters? Bank A is still on the hook, and now it is completely naked short a $100 million CDS. Now Bank A could try to protect itself against Bank B’s default by buying a CDS on Bank B from Bank C or Hedge Fund 2, but I think you must begin to see that that merely introduces a credit exposure to Bank C or Fund 2. Of course in real life all these counterparties try to ameliorate this exposure by requiring frequently refreshed margin collateral on these trades, with the objective that any party’s true risk exposure at any point in time is simply the difference between the value of the collateral held (usually cash) and the net cost to replace the instrument in question.

The challenge to global financial stability posed by investment banks conducting these activities is threefold, in my humble opinion. First, the daisy chain of trades illustrated above clearly demonstrates that investment banks never completely eliminate the residual risk involved in buying and selling investment contracts like CDSs and other derivatives. There will always be some risk attendant on any transaction which has not been completely immunized (like, e.g., Bank A buying an offsetting CDS from Hedge Fund 1, which would have the effect of cancelling the original trade), whether this is direct credit exposure to your counterparty or basis risk introduced by trying to hedge counterparty credit risk indirectly, like via short-selling its stock. Each such trade adds residual risk to the bank’s balance sheet and, given the tremendous aggregate volume of gross derivative trades investment banks do, these residual risks can accumulate to a very large and scary extent.

Second, because most big banks have overall margin agreements (Credit Support Annexes) in place with each other that aggregate offsetting daily margin requirements across all trades outstanding between the firms, the collateral protection mechanism itself can trigger contagion both within and across tightly linked firms. A bank or large hedge fund faced with a substantial margin call in one market or security might liquidate positions in other, more liquid securities in order to meet its obligations. If substantial enough, this can cascade through the markets and the trading books of interlinked investment banks, causing broader market sell-offs and further associated margin calls. This sensitivity is exacerbated by the highly leveraged financial profiles of most major financial market participants, especially the large trading banks and derivatives dealers.

Third, the ineluctably bilateral nature of many of these structured products and derivatives means that, no matter how careful and conservative any one investment bank is in structuring and managing its risk profile, nobody can be assured they are not transacting with another AIG Financial Products or, less dramatically, that systemically dangerous net exposures are not accumulating in disturbing quarters. The chief reasons that AIGFP’s collapse exacerbated the financial crisis were because it did not post collateral (due to its AAA credit rating), it transacted in difficult-to-value, illiquid markets, and it accumulated huge net exposure to mortgage-backed securities. And yet investment banks and others gleefully piled into counterparty credit exposure with AIGFP (the “dumb money”) until it cried uncle. Wall Street piled into copycat trades and lending relationships with Long-Term Capital Management, too, in a 1998 dress rehearsal for 2008’s systemic collapse. The very nature of secretive, cutthroat competition in my industry means that none of us want to share information that might reveal the existence of unsafe concentrations of credit risk in the system.³ How else can one explain why French-Belgian bank Dexia was able to write so many interest rate swaps that it required a government margin call bailout to the tune of $22 billion? Last month.

* * *

The practice of counterparty risk management on Wall Street has improved mightily since the Panic of 2008. Given that disaster, it damn well better have. But given the nature of massively connected, highly leveraged investment banks acting as conduits and collectors of the risk of the financial system, and their historical blindness to risks like counterparty exposure and risk concentration which were the very risks which nearly killed them (and us), I am loathe to take them entirely at their word that everything is hunky-dory now. Short of requiring all derivatives and structured products to be cleared through global exchanges (with associated net position limits and centralized margin posting) and sharply limiting overall financial leverage at trading banks, I do not see a failsafe solution to this conundrum. Investment banks are bred in the bone to be highly competitive and take substantial risks. Their competitive risk taking added materially to the accumulation of dangerous stresses and vulnerabilities preceding the crisis, and there is no reason to believe it will not do so again.

I would be delighted to be proved wrong about this by those who know much more about the plumbing of the financial system than I do.⁴ What is to prevent the occurrence of another AIG Financial Products? How can existing system controls prevent or dampen the cascade of credit failures through the system? Are potential leverage-induced death spirals limited to markets with illiquid, opaquely valued securities? If so, what prevents them from spilling over via contagion into other markets? What is to prevent a major securities or derivatives market meltdown from forcing another massive government bailout?

And if you are brave, knowledgeable, and/or foolish enough to try to answer these questions, please keep in mind the admonition of another very clever man whom few now trust:

There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don't know we don't know.

A wise man learns to plan for all three.

Related reading:
Committee on the Global Financial System, The role of margin requirements and haircuts in procyclicality (BIS CGFS Papers No. 36, March 2010)
Selling More CDS on Europe Debt Raises Risk for U.S. Banks (Bloomberg, November 1, 2011)

An early response:
Brandon Adams, Response for @Epicurean Deal (November 5, 2011)


¹ An economy is simply the set of organizing principles and rules which a society establishes to allocate and employ resources for the benefit of its members. How these rules are established and maintained is politics. To assert otherwise, or claim as some do that society and politics have no proper claim on the organization or maintenance of economic activity (e.g., via regulation or taxation), is the height of folly or disingenuousness.
² Those among you who cannot comprehend this concept and who would prefer to call me much less flattering names than “dreamer” are welcome to stock up on canned peaches and armor-piercing ammunition and join your fellow nutcases in Galt’s Gulch. The rest of us will come annihilate you when we can spare a moment. (Or just let you starve to death.)
³ For example, my best and most comprehensive source to-date for understanding the intricacies of the issues under discussion would not allow me to share them directly, in part because (s)he believed some of the generic information (s)he provided could provide a competitive advantage. And you people think I’m secretive.
⁴ All reasonable, informed, and specific responses are heartily welcome. I may publish or link to the most informative and interesting of these here. Please direct your responses to the email address found on this site, or notify me on Twitter (@EpicureanDeal) or by email if you have published it on another site. Please indicate if you would prefer no attribution.


© 2011 The Epicurean Dealmaker. All rights reserved.

Tort Reform

Overheard this morning at breakfast:

Lawyer #1: “Being a litigator is like cleaning the Augean Stables: it’s not particularly pleasant work, but you know you’ll always have a job.”

Lawyer #2: “That’s nothing. You should try representing investment bankers. It’s like being a streetsweeper in the Rose Parade: you have to deal with a neverending parade of horses’ asses, and you’re always cleaning up their shit.”

I love lawyer jokes. Especially when they’re told by lawyers.

Happy Friday.


© 2011 The Epicurean Dealmaker. All rights reserved.

She Blinded Me with Science

Science has not changed the laws of social growth or betterment. Science has not changed the nature of society, has not made history a whit easier to understand, or human nature a whit easier to reform. It has won for us a great liberty in the physical world, a liberty from superstitious fear and from disease, a freedom to use nature as a familiar servant; but it has not freed us from ourselves. It has not purged us of passion or disposed us to virtue. It has not made us less covetous or less ambitious or less self-indulgent. On the contrary, it may be suspected of having enhanced our passions by making wealth so quick to come, and so fickle to stay.

— Woodrow Wilson, A Commemorative Address, October 21, 1896

No matter what technology and science bring us, the dystopias of our future will always be of our very own, all-too-human design.


© 2011 The Epicurean Dealmaker. All rights reserved.

You’re Doing It Wrong

And he sampled the time-winds, sensing the turmoil, the storm nexus that now focused on this moment place. Even the faint gaps were closed now. Here was the unborn jihad, he knew. Here was the race consciousness that he had known once as his own terrible purpose. Here was reason enough for a Kwisatz Haderach or a Lisan al-Gaib or even the halting schemes of the Bene Gesserit. The race of humans had felt its own dormancy, sensed itself grown stale and knew now only the need to experience turmoil in which the genes would mingle and the strong new mixtures survive. All humans were alive as an unconscious single organism in this moment, experiencing a kind of sexual heat that could override any barrier.

— Frank Herbert, Dune

There is something deeply wrong with this country, O Dearly Beloved.

We seem to have painted ourselves into a corner from which we cannot escape. Grass roots movements as diverse as the Tea Party and Occupy Wall Street implicitly recognize this fact and have sprung up in response to it. People from a broad spectrum of Americans less committed, strident, and/or crazy than these activists have shown themselves to be largely sympathetic to their discontent. Depending on where you stand, and which hobby horse you happen to be riding at the moment, our predicament can appear in any number of guises: corrupt crony capitalism, grossly overbearing and inefficient government, a broken financial system deeply riddled with self-interest, or a society-wide breakdown of personal responsibility and uprightness.¹ Our so-called leaders—the very men and women we elected to get us out of this mess—cannot seem to tie their own shoes, much less offer a solution or even a direction in which to begin marching. Politicians are the only group of individuals more despised and less respected than investment bankers nowadays. Believe you me, as one of the latter, I can attest that that is a pretty damning indictment.

A common feature of many of our ills is the unmanageable size and complexity of our institutions and practices. This is certainly true of the government itself, our regulatory and tax systems, and our financial system. Part of this problem—size—may be an ineluctable outgrowth of the sheer mass of our nation and economy. One can certainly argue that size itself can lead to myriad ills. One can credibly entertain the notion that perhaps governing over 300 million people and managing a $14 trillion economy may be beyond the collective ability of any group of people, however intelligent or dedicated. Size certainly seems to have flummoxed the captains of my industry and their regulators in the most recent crisis.

But the bigger culprit, in my opinion, is complexity. Complexity makes things more difficult to manage. Complexity imposes substantial extrinsic costs, which must be expended simply to deal with complexity itself, apart from any underlying issues at hand. Complexity increases uncertainty, introduces distortions, and encourages mistakes. Want examples? Just think of the tax code, or the current state of the global financial system.

And yet we cannot seem to hit the rewind button on complexity. The latest example of this is the appalling complexification that the Volcker Rule—which was included in the Dodd-Frank financial reform act in order to prevent risky proprietary trading by government-backed depositary institutions—has undergone at the hands of those drafting the final regulations. The Beltway rulemaking sausage factory has turned what was a three-page initial proposal and a ten-page section in Dodd-Frank into a 300-page monster. A monster which, by all accounts, nobody loves.

Now, without a doubt a substantial portion of blame for this complexification can be laid squarely at the feet of industry lobbyists and banks themselves. They were the ones who lobbied so expensively and extensively for exemptions and extensions. They were the ones who no doubt insisted that the simple premise of the Volcker Rule was too simplistic to impose on a complex, interconnected industry without causing unacceptably expensive and potentially dangerous disruptions to established business practices.² I’m sure they offered all sorts of eminently reasonable objections to straightforward implementation of a separation between proprietary trading and depositary lending, while simultaneously missing or pretending not to understand that THAT IS THE VOLCKER RULE’S ENTIRE FUCKING POINT. That these dickwads and their hired guns were able to impose their will to neuter this piece of legislation you may credit to another virulent contagion in our polity: the pervasive and poisonous influence of corporate and individual money on politics and regulation.^{3, 4}

* * *

But the more general contributor to this legislative abortion is a structural one. Too many (all?) of the people writing these rules—both on the regulatory side and the industry itself—are lawyers. And lawyers have strong professional and cognitive biases against simplicity when drafting rules, laws, contracts, or indeed any sort of document designed to govern behavior. In all such situations, it is lawyers’ job, objective, and desire to minimize interpretation. They do this because they want to forestall future disputes and potentially expensive litigation by exhaustively codifying behavioral rules and spelling them out under every conceivable circumstance. Since when have you not seen a lawyer sorely tempted to insert a “provided, however” phrase into the simplest contract? Yeah, me neither.

A charitable reader like yourself might understand this impulse as a natural outgrowth of the pervasively litigious culture in the United States. For whatever reason, this tendency to sue first and ask questions later has led to a preponderance of rule-based, as opposed to principle-based regulation in this country. Nevertheless, codifying a principle as clear and straightforward as the Volcker Rule into a 300-page cookbook of recipes for what is and is not allowed in the financial sector is a wrongheaded exercise in futility. For one thing, exactly no-one can possibly anticipate how the financial markets and their constituent banks will change over the forseeable future. The global financial system is just too dynamic, and the likelihood that a piece of regulation penned in 2011 will be able to effectively anticipate and regulate financial market developments over the next several years is simply ludicrous. Investment banks themselves don’t know what kind of opportunities and threats they will face—and hence what they’re actually going to be doing—next quarter, much less in 2012 or 2015. How can we expect a static document drafted by a bunch of underpaid, cover-your-ass government lawyers who couldn’t recognize a proprietary trading desk if they were sitting at it to do so?

Because of this, regulators must have the ability to flexibly interpret and respond to changing conditions in the financial markets and the businesses of their regulatees.⁵ The relentless, rapid evolution of finance requires that financial regulation be principle-based, not rule-based. Reformed quant Emanuel Derman makes the case persuasively that we cannot understand financial markets using rigidly codified models. If that is true, how, then, can we ever hope to regulate them with a framework based on rigid, over-codified rules?

No points for guessing: we can’t.

* * *

So what does that mean for the Volcker Rule and financial reform in general? Well, one might argue that the best solution is to scrap that overlawyered piece of toilet paper and go back to the author of the eponymous rule’s own suggestion:

“I’d write a much simpler bill. I’d love to see a four-page bill that bans proprietary trading and makes the board and chief executive responsible for compliance. And I’d have strong regulators. If the banks didn’t comply with the spirit of the bill, they’d go after them.”

Of course, this would be principle-based regulation. As Mr. Volcker points out, such a regulatory regime would require strong and well-informed regulators. I have made the same point, too many times to link to here, over and over in the past. Professor Derman is with me too. You would want ex-bankers, experienced in sales, trading, structured finance, and derivatives, who would work closely with regulated banks to monitor, understand, and control the changing nature of risks, activities, and opportunities in the markets. You would create performance incentives which completely insulate them from the results of their regulatees, and you would impose strict prohibitions on them returning to the industry before their active market and industry knowledge has gone stale.

Such regulation would demand close, realtime cooperation and consultation between regulators and industry participants. But if it is done properly, it should work out to everyone’s benefit. Regulators would get realtime information on risk exposures and market practices from their regulatees, and regulatees would receive realtime feedback and guidance from regulators on overall market developments and trends in risk management. Done properly, this model would not stifle innovation or profit-making. It would enhance it, while simultaneously reducing systemic risk and giving regulators early warning of developing threats to global financial security.

* * *

The Dodd-Frank legislation at over 2,000 pages is an abortion. The Volcker Rule at 300 pages is an abortion. They cannot succeed. If we cannot empower intelligent, experienced regulators to monitor and control the wholesale financial system using heuristic principles, we are fucked. Under the current financial regulatory system, and its proposed rules, we are all fucked. I will leave it to my Loyal and Long-Suffering Readers to decide whether that is a state of affairs which can be corrected. I suspect these pearls will be trampled like all the others into the muck of the pig wallow. Only time will tell.

In the meantime, we need to reinvent our rulemaking processes. Currently we make laws and regulations like oysters make pearls, except instead of starting with a tiny grain of sand and covering it with precious nacre, we start with a tiny pearl of sensible principles and cover it with layer upon layer of sand, grit, and detritus. This makes for ugly pearls, and lousy legislation.

When are we going to wake up?

Related reading:
Paul Kingsnorth, This economic collapse is a ‘crisis of bigness’ (The Guardian, September 25, 2011)
Grains of Sand (August 10, 2007)
James Stewart, Volcker Rule, Once Simple, Now Boggles (The New York Times, October 21, 2011)
Emanuel Derman, Maybe markets need more principles and less regulation (Reuters, October 21, 2011)


¹ For the avoidance of doubt, just in case you do care, I believe all of these things to be true. In my opinion, we are in deep doo-doo, and I see no-one on the horizon with a shovel.
² The premise behind these shenanigans is faulty. It is not the obligation of regulators to adapt, weaken, and modify regulations to minimize disruption to regulatees’ current business practices. It is the obligation of regulatees to modify their fucking business practices to comply with regulation. Jesus.
³ There is a part of me that hopes the Volcker Rule is implemented in its currently bastardized form so mega-banks will be forced to expend ridiculous amounts of shareholder money and management attention complying with the Frankenstein’s monster they have helped create. Karma can be a bitch.
⁴ As an aside, SCOTUS’s decision in Citizens United was an abortion of American jurisprudence. Just sayin’.
⁵ My focus throughout this piece is on regulation of the wholesale financial sector; that is, investment banks, commercial banks, and other entities which provide services to corporations, institutional investors, hedge funds, and other such non-retail customers. I have nothing to say about retail financial regulation, since that is neither my area of expertise nor my day-to-day concern. Perhaps more rule-based regulation makes sense for consumer finance, since I suspect that field is less changeable and dynamic than the wholesale sector. But I defer to others with better knowledge on that topic.

© 2011 The Epicurean Dealmaker. All rights reserved.