I finally found some time to finish my review of Traders, Guns and Money, Knowns and Unknowns in the Dazzling World of Derivatives, by Satyajit Das. I have discussed this book and Mr. Das several times in this blog.
First of all, this book was written in 2006, before the financial crisis hit, and what does it talks about? derivatives.
In one line, this is a GREAT book. Anyone with an interest in the markets and the financial crisis should read it.
Please note that I not affiliated to Mr. Das or his publisher!
I loved his style of writing, amusing, intelligent, captivating. Who would have said that writing about financial derivatives would be more interesting that the Da Vinci Code. Ok, some may say that's an exaggeration, but his book is about reality. If you doubt it, read the prologue.
The preface begins like this:
"In March 1977, I began working in banking. Early on I drifted into the arcane world of derivatives trading. No qualifications were required, I just bluffed my way in."[...]
"This book is for those who want an accessible introduction to this weird and wonderful world. It will perhaps confirm their worst fears and prejudices about these strange instruments, what they are used for and the people who trade them."
Here are the book chapters and their contents:
In the prologue, Adewiko, President and Director of an Indonesian firm, and Budi Titra its Director of Finance, are introduced. These gentlemen will be used throughout the book as examples of what big financial companies do with derivatives, and their evil ways of treating unsuspecting clients.
The book describes the author's initial meeting with the clients who were not happy with an investment they had made. The author was an expert witness, and the meeting was at the client's lawyer, "Morrison", also with accountants present.
"Morrison produced 4 pencils and carefully sharpened each one. He then
laid them carefully next to the thick legal writing pad on the table. It took
about 5 or 6 minutes to complete this activity. At the hourly rates of the
professionals present, I calculated that the total cost of the pencil sharpening
was $2,000, about $500 per pencil. It was truly a Zen moment".
Adewiko and Budi's company (OCM) was a noodle maker. In 1995 they decided to convert their borrowings into dollars.
And that may sound familiar to many readers.
"'Why?' I asked.
Cheaper, much cheaper", Budi said.
'What about currency risk? You have borrowings in dollar, but no dollar income.'
'No risk, no risk' Budi countered.
'Bank advise us. They tell us no risk'.
The prologue continues with fascinating details of the lawsuit against the bank.
In the end, both OCM's owners and Mr. Das leave on the same flight. The owners, in first class.
CHAPTER 1: Financial WMDs - derivatives demagoguery
This chapter starts talking about Warren Buffet and Bill Gross calling derivatives the financial weapons of mass destruction. It explains derivatives, and how leverage works, swaps, gives examples, and even how he manages to explain it to new Chinese bankers, the new capitalists; Leveraged speculation.
CHAPTER 2: Beautiful lies - the "sell" side
Anyone who has ever believed what banks say when they promote their financial products will like this chapter.
"Beautiful lies are the lies that we like to believe; we know they are notFunny that this chapter mentions Bloomberg, CNBC and others. 'Attractive, botoxed talking heads" incessantly reporting on business news. I don't think Cramer was around as a TV man in those times, I wonder what Mr. Das would say about him.
true, but everything makes us want to believe them - that is what makes them
beautiful". The derivatives business is filled with them"
Banks and dealers are knows as the "sell side". Their 'raison d'etre' is to provide services and products to clients, who are the 'buy side".
"In the early days the sales desk was staffed with people who could 'smile and dial', The typical salesperson was someone who had been voted the most popular student in their graduating class. Skills were secondary to being
'liked' and 'trusted' and it also paid to be attractive. People with bad skin,
and hair and bad breath were not prime sales material".
Her discusses tools used by the sales people, like research material. Banks produce all kinds of 'research material'. "One dealer confided to me that the whole purpose was to produce so much research that it clogged the fax lines". That would be email today.
He talks about technical analysis, also used as tools.
There is TA consisting of trying to find patterns in price movements over time, there are head and shoulders, rising and falling pennants, retracement points, resistance lines, oscillation indexes, RSIs, relative strength index, not
repetitive strain injury. There are more arcane techniques - Elliot waves,
Fibonacci series, Japanese candle sticks. The list is endless. It is a modern
version of reading the entrails of a slaughtered ox. [...]
"Hiring traders is not easy. On one occasion we were sitting with the headhunter
outlining our requirements. The headhunter didn't have a clue what a trader did
or what we were looking for. In frustration, eventually said to him:
'Look, just finds us someone who is lucky. The luckier, the better'. They looked
at me as if I was deranged".
As for the quality of research, "Investment companies made secret payments to each other to write favourable reports on companies". "The analysts helped prices defy gravity". Do you notice any similarities with today?
He also talks about Dr. Doom and Dr. Gloom, but they are earlier incarnations!
CHAPTER 3: True lies: The 'Buy' Side
The buy side is most us: customers, corporations and investors.
About the difference between sell side and buy side:
"Frank Partnoy captured the difference succinctly: 'The sell side hang up
and say 'f*** you!'. The buy side says 'f*** you' and then hang up".
He says that clients ruthlessly play the sell side against competitors.
Examples discussed in this chapter are Disney and its famous problems and not so brilliant decisions in the mid 80s. Goldman Sachs was appointed by Disney to arrange Yen funding (carry trade already?). GS came up with an innovative deal. "There was a small matter of maturity - the currency swap matured in 10 years, the yen royalty stream was much longer. Mere details!" Disney engaged in second similar deal, and paid dearly.
The Proctor & Gamble case is also discussed.
CHAPTER 4: Show me the money - greed lost and regained
This chapter talks about money creation. The author says that no money is really ever made in financial markets. They merely transfer wealth. How true.
"The power of money isn't its purchasing power - it is its power to excite the public imagination. It is the titillation".
John Kenneth Galbraith: 'Nothing so gives the illusion of intelligence as personal association with large sums of money. It is also, alas, an illusion'.
Orange county is also covered. Other topics include trading, free money (arbitrage), the color of money: there is the money you made, and the money the accountants show you made...
CHAPTER 5: The perfect storm - risk management by the numbers
"Risk is a four letter word: it is more polite to use the phrase 'risk management'. 'Derivatives' is an eleven letter four-letter word"
The authors discusses risk and how risk management instruments bring their own risks. Once he had a meeting with the newly appointed 'risk manager', who told him that the company had 10,000 plus risks. Being politically incorrect, Mr. Das pointed out that that was one per employee. He offered that perhaps they should get rid of half the staff to reduce risk.
"In the long run we are all dead. LTCM also showed that the proposition also
held in the short run".
LTCM is discussed quite a bit. In September 1998, Bear Stearns, AIG, and Goldman Sachs were all involved.
Arithmophobia is fear of numbers, chrematophobia is fear of money, plutophobia is fear of wealth, photophobia fear of fear. Risk is the sum of all of them.
CHAPTER 6: Super models - derivative algorithms
"Like supermodels, financial models are idealized representations of the real
Quants are introduced and discussed here.
Traders and quants belong to different cultures. Traders are like two- orThose who use options will see Black, Scholes, and Merton discussed here. And some Greek characters. Delta, gamma, vega, theta, and rho are explained.
three-yearl olds, have very short attention spans and want instant
gratification. They are easily distracted, fortunately. Quants are precocious,
bright individuals of the same age group, entirely self absorbed an full of
their own self importance. They need constant reassurance and a fair bit of
stroking and praise to keep going. They are also prone to the odd tantrum and
hissy fit. It helps to have the skills of a kindergarten teacher to run a
CHAPTER 7: Games without frontiers - the inverse world of structured products.
The author discusses structured products. He mentions that Leo Melamed, one of its founders, explained them: "if swaps are sex, then structured products are kinky sex".
Orange County mentioned again, apparently engaged in kinky sex. Japan was also fertile ground for such activities. 'New' products appeared in the 90s: inverse floaters, arrears resets, currency linked bonds, etc.
"Dealers began to seek new ways to improve profitability and started to
market structured products directly to retails customers. [...] The logic was
compelling - you had less sophisticated clients, the margins would be richer. In
short, you could reap them off blind".
CHAPTER 8: Share and share alike - derivative inequity
This chapter is about what most of us probably trade the most: equities. Equity derivatives in the 90s were hot. Some of us will solidarize with this:
I came from a bond background where you put up your money, you know what
interest you get, and at the end, you get your money back. With shares, the only
similarity to this is that you put up the money. You have no guarantee that the
company will pay dividends or how much, if any; You don't get your [same] money back, ever. If you want your money back you need to find another punter to buy the stock from you. The company can issue new shares, reduce the value of your
holdings, they can buy back shares, they can change your rights. And if things
go wrong, everybody gets paid before you do".
Well, enough said, how true again.
The very interesting concept of self arbitrage is discussed (in part beating the banks at their own game).
Also discussed: Share buybacks, which we saw all over the place when the markets were at their peak in 2007 (why??), are discussed.
"This was the monster of all forms of insider trading, and best of all, itYeap.
was all legal. It was just a convenient way to boost earnings per share. It hid the fact that some of these businesses were struggling". [...]. Financial obfuscation was the best idea that MBA-toting managers could offer. It was the quick fix that everybody wanted".
What else? Convertible bonds.
"The most intriguing thing about convertible bonds is that everybody seems
to be getting a great deal. markets don't work that way. The question is 'who is
CHAPTER 9: Credit where credit is due - Fun with CDS and CDO
Everything you wanted to know about a good part of the cause of our current troubles.
The author discusses that credit is like glue: once you take on risk, you can't get rid of it easily. CDS are then created to sell the risk to someone else. Mr. Das also shows that the stuff can get so complicated that sometimes you do not even know whose risk you are buying...
MBS, mortgage backed securities are discussed. All the stuff you have read ad nauseum lately.
"By the mid 90s MBS became gigantic. Dealers had more ways cut and dice
mortgages than any celebrity television chef.[...] few investors understood any
Remember that this was written before any of the current financial crisis hit.
What else? Tranche war fares (ever read about the tranches in MBSs); synthetic CDOs, ABS CDOs, UFOs, ECOs, CDO2, a CDO of CDOs... There are also CDO3s (CDOs of CDOs of CDOs). Wonder if AIG had them.
"CDO logic is perverse"
I thoroughly enjoyed the book, I do like the subject. However, I also liked it because of the authors' style. There, is someone I wish I could meet one day.
Cover and where to buy (click to buy):