SOMEONE DIDN'T GET THE MEMO ABOUT BLAMING THE UNDESERVING POOR AND BARNEY FRANK:

#OWS: one insider's view on how banking lost its way (and what to do next) (Fred Destin, 10/27/11)

Whilst I understood (and liked) what we were doing as risk management, the endless innovative capabilities of financial engineers and greed had already started polluting the system.

At the heart of it all was AIG Financial Products.  You've seen from above that counterparty credit risk was always going to be central to derivatives.  Whoever provides you with a derivative hedge, you get exposure to.  Well, a savvy team of hungry ex Drexel Burnham Lambert (remember junk bonds) guys had understood this early and went out hunting for an indestructible AAA balance sheet that they could leverage to put themselves at the center of the credit puzzle.  That turned out to be the large and venerable AIG.  Junk bond guys meet the unsuspecting insurer, good things are bound to happen...

Well these AIG FP founders went to work with a black box they simply called "the System" and started making money.  "We were all kind of artists," one of the founders said recently. "The excitement of it wasn't the money. The money was the scorecard. The drive behind it was creating something new."  AIG became the "unsinkable balance sheet" that stood behind so many of the transactions that creative minds at Bankers Trust, Merril Lynch et al.  They priced the type of credit risk that no one else would.

Early on, the potential of derivatives (and their beautiful complexity) was used to generate highly profitable transactions for the investment banks by fashioning investment products that offered ever higher yields (or ever lower borrowing costs).  Want to buy some Luxembourg bank exposure coupled with a barrier option on a given foreign exchange pair ?  We can do that for you !  And if you get in trouble, we'll restructure the instrument and make it even more impenetrable. [...]

By the time I decided to leave the City, here's roughly what was going on:

    Banks had securitized pretty much everything and their balance sheet was generally fully optimized though hard to comprehend.  The risk had been shifted to institutional investors and no one really knew where it sat anymore
   
Insurers then reinsurers got involved (aka greedy).  First we shifted risks away from the banks, then we shifted it from insurers to reinsurers.  Entities like Centre Re were lauded for taking on all sorts of creative risks. Everyone was looking to create "their" AIG FP, which by that time was a money making juggernaut.
   
And really everyone got greedy -- investors would buy principal guaranteed exposure on basket of hedge funds instead of bonds, equities or straight hedge funds investments.  Borrowers would use increasingly fragile offshore funding structures to optimize tax and so on.  Asset managers no longer felt that buying straight assets and a few simple volatility instruments was enough.  Everyone was into structuring by that stage.
   
The banks had become impossible for the regulators to control.  The regulators were outgunned on modelling firepower and whenever they surfaced a strong exec, said person would be hired illico presto by one of the investment banks.

   
The entire industry was built on disguising risk, contrary to the capitalist insight that markets function efficiently thanks to the free flow of information.

Posted by oj at October 30, 2011 8:46 AM
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