By Leah Spiro
||The Devil’s Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street...and Are Ready to Do It Again |
By Nicholas Dunbar
Harvard Business Review Press
Warren Buffett got it right in 2002 when he said derivatives were “financial weapons of mass destruction.” But how do you write about derivatives without boring readers to death?
Nicholas Dunbar, a British financial journalist, has managed to breathe life into these mind-numbingly complex economic warheads. “The Devil’s Derivatives” is a story about people, as opposed to products. We meet the financiers who invented and promoted derivatives, whom he calls a “unique tribe [who] sat at the heart of the financial system for the past decade.”
These lords of finance arrogantly believed they could control risk and use the market to replace traditional banking. Yet their so-called financial innovation—comprised of the now well-known acronyms CDS, CDOs, VAR, OTC derivatives and SIVs—was essentially a takeover of conservative banks and insurance companies by market-driven, derivative-savvy investment banks and hedge funds. This nimble tribe was able to stay one step ahead of regulators until derivatives ultimately torpedoed the world financial system.
How did this happen? Starting in the late 1980s, off–balance sheet credit default swaps came into use as a new way to transfer credit risk, writes Dunbar. This move enabled banks to vastly pump up their balance sheets right under the noses of regulators. Consider this: In 1998, the world’s banks had derivatives exposures of $2.5 trillion. By June 2008, it was $20.3 trillion, while the equity market cap of the world’s banks merely doubled.
Dunbar writes with considerable mastery of his subject and a welcome global perspective. A former editor of Risk magazine, a contributor to Reuters Breakingviews and author of a book about Long-Term Capital Management, Dunbar includes his encounters with characters such as Merton Miller and Osman Semerci, the influential finance academic and Merrill Lynch subprime big shot, and occasionally accompanies his subjects to glamorous London watering holes. Interviews with such key figures as AIG regulator Eric Dinallo add credibility.
Dunbar brings an insider’s eye for detail to his story. He shows how, after the meltdown of LTCM, the industry skillfully avoided new rules by convincing regulators that techniques such as netting, collateralization and stress testing would prevent future disasters. Of course, none worked; meanwhile, the banks expanded. Dunbar skewers the academic enablers and bank risk managers who won the regulators’ trust but were actually, he says, “lackeys of powerful executives, under instructions to manipulate the statistics.” He shows how savvy derivatives salesmen catered to the ambitions and egos of their clients, mentioning hedge funds Paulson & Co., Cheyne Finance, Solent Capital Partners and Magnetar Capital.
Several damning examples—an Italian bank’s fleecing by Barclays in 1999 and Goldman Sachs’ adventures with the government of Greece—back up his views. A chapter on what he calls “regulatory capture” illustrates a kind of financial Stockholm syndrome. Dunbar has a dim view of the New York Federal Reserve Bank, pointing out that its leaders often land on Wall Street.
As the Basel III agreement is being negotiated now, there is a strong sense of déjà vu. In the past, Dunbar says, loopholes created “regulatory capital arbitrage using securitization technology.” His conclusion: “What started out as an arcane twist of high finance—derivatives—has now corrupted the entire financial world, and has set a hellish trap for taxpayers and their representatives that offers no way out.” Even Warren Buffett could not have stated the case more simply.