How derivatives traders hoodwink their bosses

The Sunday Times

How derivatives traders hoodwink their bosses; A former banker lifts the lid on how greed eclipses prudence

MY ALARM went off at 5.30am and I stumbled into the kitchen to make a coffee, knowing it could be the last day I went to work for an investment bank.

It was September 15 last year and Lehman Brothers had just gone under. As a result, I had lost my bank about $1 billion (EUR 800m). Would they let me through the door? After 13 years in banking, it looked like my number was up.

The worst thing was none of it had come as a surprise. I had inherited the risky trades a year earlier and warned my bosses about the size of the potential losses, but they wouldn't let me get out of the positions. In an investment bank, nobody wants to hear about risks in their business — not while they are making money.

Until the end of 2008, I worked in a large investment bank, managing risks for the derivatives business. I was the guy who was supposed to mop up everyone else's problems. I looked at complex trades, worked out what the losses could be, then found a way to protect the bank. That was the theory. I saw every trade and could work out every trick employed by these "Masters of the Universe" to line their own pockets, whether the bank made money or not.

Derivatives are what really confuse everyone. It's a term that covers a whole range of contracts but, basically, they are bets on the future value of something — whether that's a share, a shipment of iron ore or even the creditworthiness of another bank.

I once tried to block a large derivative deal because the maths didn't make sense. It just wasn't going to make enough profit to justify the 30 years of credit risk on the balance sheet. But the head salesman, who was behind the trade, would be paid his bonus in one year, not 30.

I tried to face him down with my boss, but his appreciation of derivatives was weak. He lost the point in my first sentence and, by sentence two, the salesman sensed his moment and calmly said he would ensure we would be fired if my analysis turned out to be wrong. My boss backed down, and I left the room in disgust.

High finance had been decided by playground politics. The client in question went bust shortly after, brought down by complex derivatives sold to it by the investment banks. Shareholders lost out everywhere.

Bonuses were paid everywhere.

When you turn up for a job interview at an investment bank there is only one real answer to the question, "why do you want to work here?", but it is rarely answered truthfully.

While bankers give many reasons as to why they do the job, they are driven by nothing but money. Whether the bank actually makes any money is a secondary consideration.

Often the banks themselves have no idea if they are making money or not. The regulation of derivatives has been so weak, and the speed of innovation so fast, it has left a void on the trading floor. Cowboy traders have been taking advantage of a flawed system, knowing there is almost no chance of anything coming back to hurt them. So long as they can make it look like they have made a profit, they get their bonuses.

This is the financial equivalent of the Wild West, yet only those on the inside realise this.

When trading in complex credit products exploded into life a few years ago, a host of financial products were created with acronyms for names.

These are the same products that went on to blow up investment banks as the sub-prime crisis emerged.

In the early days, two big banks picked up that they had been dealing with each other on a regular basis in very large volumes. After a while they each enquired what the other was up to. Both thought they were making money on the trades — bank A was selling something to bank B, yet both reckoned they were making a profit on it. So both booked a profit in their accounts, and both sets of traders got bonuses..

You don't need to be a genius to see the problem here. Ultimately, only one set of shareholders will benefit.

Every few years there is typically a market blow-up, and issues like this get conveniently washed away as over-inflated assets are then deliberately marked down below their true value in preparation for the next boom. That's the point in the cycle we have reached now.

Many senior managers have been as clueless as the outside world as to how to value these trades. They are simply sitting at the top of the pile, praying they have timed it well to enjoy a couple of good years and allow themselves the chance to cream off the mother of all bonuses.

It is wrong to think that all investment banks are the same. Some institutions have been getting to grips with these problems; others have not.

My old bank is far from unique. My exposure to Lehman came through credit insurance we had sold to investors. If Lehman defaulted on its bonds, we were one of the institutions asked to pay up. Bizarrely, we held these positions as part of a strategy designed to reduce the damage if one of our big clients went bust.

The problem I had spotted suggested that all of the bank's derivative trades could be valued incorrectly. This was more than just a minor hitch. But nobody wanted to listen or make a decision. I sent e-mails; no response. I asked the chief executive to sign off on the strategy himself, but I never heard back from him. Most of the other banks accounted for these trades in the same way.

So I was not the only guy who came unstuck last September, thanks to Lehman's collapse.

That was the event that turned the credit crunch from a crisis into a disaster.

When I arrived at work, they let me through the door as usual.

I took the decision myself that enough was enough. I suggested to my boss that I be made redundant and that my team be spared. Ironically, this was the only time the bank ever listened to me.


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