Everything has been thought of before, but the problem is to think of it again. – Goethe
Section A: Likely Developments
So what kind of products can we see in the future? One thing certain is that we will see a return to simplicity and some genuine innovations.
Markets demonstrate collective amnesia all too often and reinvent products on a regular basis. As clients get more and more sophisticated and, arguably more importantly, as the tax authorities and regulators keep up with the innovators in the market, there will be a move to genuine-need products that fulfill a real demand rather than the bank salesman’s need to generate a bonus.
Reports of the demise of plain vanilla foreign exchange trading have been greatly exaggerated. With the creation of the Euro, the trading that took place between the D-mark bloc and the Mediterranean bloc will be replaced by convergence trading between the Euro and other EU currencies and the Euro and East European currencies.
The Asian currency crises in 1997/98 showed that emerging markets are not just one pool. Furthermore, the differing impact the crises had on the various “emerging” markets showed that these markets are quite different. What holds them together is the fund manager’s risk-aversion and his trustee’s 20/20 vision. No manager wants to be caught doing something that nobody else is doing. In turbulent times the manager of other people’s money runs for cover. There is a flight to quality which spells bad news for all emerging markets.
This same instinct applies to products and banks. If a certain kind of product has led to a large loss in an organization then treasurers will think twice before exposing themselves to criticism, even if they themselves understand the product and are confident in its applicability to their organisations.
In terms of genuine innovation we will continue to see credit derivatives grow. But are these new products or are they just variations on credit insurance and asset swaps which have been around for decades?
Insurance derivatives will also continue to grow. But surely option related derivatives products are one kind of insurance product or other. They have always been explained to end users as financial insurance. The trouble was that they could not be called “insurance products” because insurance in most countries has been the preserve of insurance companies and banks have been prohibited to enter this area.
Just as insurance companies have not for some time been providers of insurance. They have been in the savings business. And banks have been in the insurance business through their derivatives and new issue underwriting businesses. I see the differences in regulation between banks and insurance companies disappearing completely early in the millennium. There will just be Wholesale Financial Companies and Retail Financial Companies.
Section B: Less Technophilia – Have Faith in Fools
The models tell you where things will be in five years. But they don't tell you what happens before you get to the moment of certainty. – Ayman Hindy, strategist, Long Term Capital Management.
Perhaps the treasury management pendulum has swung too far in the direction of technophilia and away from common sense. Value@Risk and other measures have become the be all and end all of risk management. The assumptions behind Nobel Prize winners' models are infrequently questioned. But it is not a question of barrow boy uneducated trader versus physics PhD. It is just that the balance has swung too far towards blind faith in calculations that boards do not adequately understand, and more dangerously, are too embarrassed to demand justification. It is incredible that the entire case by Kidder Peabody against Joseph Jett was that he used the management accounting system designed by them to generate performance bonuses. There should be more emphasis on the big picture. Bank and corporate boards should hire more fools. The fools should have a brief to question everything. If only Korean banks had had a few fools to question loans to chaebols …
Dealers can outwit accountants
Derivatives provide finance directors with very useful tools for managing risk or for providing clients with an enhanced service; because they are off-balance sheet and don’t require a significant cash outlay (if at all) they can quickly spell big trouble.
Every dealer worth hiring is capable of manipulating his profit and loss account to a desired level. Management accounting reports seldom accurately reflect the risk on a portfolio of complex financial instruments. Good dealers can outwit their internal or external auditors. Moreover, individual performance bonuses can encourage at best "accounting engineering" a "double-or-quit" attitude or outright fraud. Dealers have a free option. Employers don’t sue them for losses. Bonuses should be based on team performance – conspiracies seldom hold firm for long. Ensure sound character of treasury staff. This is just as important as technical ability and ensures that Treasury performance targets are realistic.
Technological over-confidence
21 August, 1998, was the worst day in the young history of scientific finance. On that day alone, Long Term Capital lost USD550 million. – Michael Lewis. Extract from "How the Eggheads Cracked", New York Times January 24, 1999
Ever sophisticated technology on its own is no solution. It has to be correctly interpreted. And the limitations of the information and output must be understood.
On the morning of 7 December, 1941 the very latest technological device alerted its operator. The place was Pearl Harbour, Hawaii and the device was the Westinghouse long-range radar. The machine detected a squadron of planes approaching but the officer assumed that the planes were American B-17s. The rest is history.
Similar human error and over-confidence in technology was the cause of the bombing of the Chinese embassy in Belgrade on 7 May, 1999. Three days before Nato bombed the embassy, a military intelligence officer told colleagues that the wrong building had been chosen. The intelligence analyst noticed surveillance photographs of the building proposed for a Nato strike did not appear to coincide with the intended target, the Yugoslav Federal Directorate of Supply and Procurement (FDSP). The analyst did not know that the building in question was in fact the Chinese embassy. Apparently, a series of errors caused the bombing.
First, CIA staff were using old maps and databases which did not show that the embassy had moved location. Then an analyst made a mistaken assumption about the FDSP's location based on its address. Finally a second analyst noticed discrepancies between the FDSP's supposed location and that of the target building. This middle ranking officer called another middle ranking officer in Europe and conveyed his concerns, and at the same time he tried to fix a meeting within the CIA to relay his concerns. But he failed to arrange the meeting at the CIA. He then went off for scheduled training and when he returned on 7 May he found that the raid was planned for that night. According to The Washington Post he was told: "The bombers are in the air. It's too late."
Such a mix-up can happen in war. It can also occur in technologically-dependent financial management.
Technology-generated risk management outputs have to be correctly interpreted in a very short time. And the assumptions behind complex derivative models and inputs must be carefully examined and agreed to by controllers and management. And the outputs should be examined with a certain degree of cynicism. Have conditions in the markets changed since the models were developed? Have the models been adapted from a completely different market? The models may work very well in the US or the UK but do they apply in an illiquid emerging market? If your dealers cannot explain a third-generation derivative to you in simple terms and, in turn, you cannot demystify the products in front of shareholders at an Annual General Meeting, ask yourself the questions:
Is it appropriate to this business? Do we really need to do it?
If the answers are Yes and Yes, make sure you understand it.
Probabilistic models have to be understood for what they are. I remember hearing at maths class at high school. “A man can drown in a lake three feet deep on average.” There is now empirical evidence to this effect. In September 1997 in Detroit, a 41-year-old man got stuck and drowned in two feet of water. He had squeezed headfirst through an 18-inch-wide sewer grate to retrieve his car keys.
Trading decisions nevertheless have to be made. There is a risk associated with every decision. Some years ago the head of human resources at a US bank in London had a really bright idea for hiring new staff. The HR head observed that the bank’s dealers spent all day in front of computer monitors. “Who else does that?” he wondered. The bank hired several bright air traffic controllers as dealers. They very soon picked up the technicalities of foreign exchange spot and forward. But as proficient air traffic controllers they had been trained to avoid risk at all costs. They just sat in front of their screens neither buying nor selling.
Where is the wisdom we have lost in knowledge? Where is the knowledge we have lost in information? – T.S. Elliot
Mathematical ability and familiarity with computer screens is not enough to make a good dealer. According to a study by Elizabeth Brannon and Herbert Terrace of Columbia University, published in the journal, Science, November 1998, even monkeys can grasp the concept of numbers. Two rhesus monkeys named Rosencrantz and Macduff were taught to count using touch-sensitive computer screens of images that each contained from one to four objects. First, the monkeys were taught to touch the screens in order, from the image with one object to the image with four objects. "A monkey learns by trial and error," said Brannon, a graduate student. If the monkey touched all four pictures in the right order, he got a banana treat. If the monkey made an error, the screen blacked out.
The rhesus monkeys were more than happy to make mathematical decisions and make errors in the pursuit of banana flavoured pellets. And the air-traffic controllers just would not trade.
Liquidity and chaos
A cynic is a man who knows the price of everything, and the value of nothing. – Oscar Wilde
In December 1997 The International Monetary Fund criticized Korean banks for relying on short-term foreign loans “leaving the nation vulnerable to a liquidity crisis”. So true. As I wrote in The Financial Times of 5 December 1997, “Continental Illinois and so many other cases have shown that contrary to the text-book view, efficient liquidity management is not about holding a certain percentage of government bonds. It is about diversifying liabilities. Rather than get fixated over macho exotic options, bankers the world over should study history.”
Many young investment bankers are highly proficient at pricing anything and everything. They can price any financial instrument, strip away a conversion option from a fixed interest component and then combine it with another structure in a third currency. But markets often just don’t play according to the rules. Continental Illinois and even the expertly run Long Term Capital Management found that in their hour of need the realization value of their sophistically priced investments was nowhere near their theoretical value.
These “Pricers” who know the price of everything religiously believe that everything has a price implied through received mathematical formulae, independent of market value. And then risk managers are led to believe their own theoretical valuations and use these derived prices to manage risk. But the valuation of a security is only really necessary and therefore meaningful in times of chaos. And in times of chaos conventional models just do not work.
Chaos theory was first discovered, perhaps, by a meteorologist named Edward Lorenz. In 1961, working on a weather forecasting model, he had a computer set up, with a set of twelve equations. He identified a particular pattern which he wanted to see again. To save time, and remember this was way before the advent of Pentium III’s, he started in the middle of the sequence, instead of the beginning. He entered the reading at the half way stage from the earlier series and left the computer to churn out the series again.
When Lorenz returned an hour later, the sequence generated proved quite different. Instead of being identical to the previous pattern, the new series ended very different from the original. He eventually worked out what had occurred. His computer’s memory stored the numbers to six decimal places. But to economize on paper, he only had it print out the results to three decimal places. In the original sequence, the true number at the half way point was .506127. But the output stored was only to the first three decimals showing .506. It was this truncated number that was input as the starting point for the second computer run.
Lorenz proved that a small difference could make a huge discrepancy in outcome. This effect came to be known as the butterfly effect. "The flapping of a single butterfly's wing today produces a tiny change in the state of the atmosphere. Over a period of time, what the atmosphere actually does diverges from what it would have done. So, in a month's time, a tornado that would have devastated the Indonesian coast doesn't happen. Or maybe one that wasn't going to happen, does." (Ian Stewart, Does God Play Dice? The Mathematics of Chaos)
Nick Leeson just before his fall was supposed to be arbitraging tiny differences between Japanese stock market Nikkei indices quoted in the Tokyo and Singapore futures exchanges. The Kobe earthquake put paid to his strategy and he ended in jail. Long Term Capital Management’s “Hedge Fund” suffered because of the crisis in Russian financial markets, which resulted from the East Asian crisis.
Believing one’s own models is a certain recipe for disaster. A healthy dose of scepticism is needed for survival.
The evil that men do lives after them
Shakespeare pointed out a common director's dilemma: whilst errors of judgment stand out to be criticized in hindsight, 'the good lies interred with their bones' – although it seems unlikely that a derivatives dealer will meet the fate of Julius Caesar. However, we can recall with some irony the voters' support for Orange County's Treasury in the days when it was making money and lowering taxes; and consider that Barings' board was taking its full share of the jailed Mr. Leeson's profit before his fall. Would Nick Leeson have been jailed if he had continued to make money for his masters? In my opinion, not very likely! But such are the inevitable perils of managing other people's money! Plenty of friends in times of plenty but hand washing when losses arise.
Few boards understood what treasurers were doing
A derivative is like a razor. You can use it to shave yourself and make yourself attractive to your girlfriend. You can slit her throat with it. Or you can use it to commit suicide. – Anon, Financial Times, 4 March 1995
Finally, it is incumbent on the boards of directors to understand and use appropriate derivatives. Shareholders have successfully sued when they have not been used. They might eventually get very annoyed if they are misused. The Financial Times’ Lex column of 9 March 1995 said: "The retreat by industrial companies is also sensible given that few boards really understood what their corporate treasurers were doing. But derivatives are still valuable tools if used to hedge risks rather than speculate. The longer term answer is for boards to do their homework rather than to impose a ban."
But the lessons learned from the demise of the so-called “hedge” fund Long Term Capital Management, a firm managed by Wall Street’s "masters of the universe", suggest that it is not just corporate boards of directors that need to do their homework. How many senior bankers or regulators really understand the risks that banks or their clients are carrying on their books? There is a touching blind faith in the computer outputs produced by the rocket science mathematical modeling of financial derivatives. And this extends down to the use of financial calculators, which I forbid in my training programmes. Most financial calculations can be effected on a simple high school scientific calculator. And know the answer before running your computer programme. Common sense “foolish” guesstimates are not always made.
I was recently asked by a client bank to analyze a complex structured cross-currency swap with embedded third currency and term options. An investment bank offered my client USD0.3 million to close out the transaction. Without any mechanical aids I guessed a figure of USD6 million. Using a scientific calculator I produced a valuation of USD6.55 million. Developing and testing a computer simulation model, I refined the answer to USD 6.42 million. No high technology was needed to realize that my client’s investment bank was attempting “ignorance arbitrage”.
Innovation by banks in new financial instruments is necessary as it is in any industry to avoid being left behind in the competitive marketplace. And there will be a number of genuinely useful products that meet customers’ needs. These needs may be fiscal or regulatory; or the packaged return or cost of a bond issue or loan plus a structured swap may be more favourable; or because they have been engineered to generate a specifically required exposure; or because they neatly hedge an asset or liability exposure. But if the bank selling the products or corporation buying these instruments does not understand why they are entering into such transactions and how to measure and control the risks generated by them, it would be better to steer well clear of them.
And finally...
Let us be thankful for the fools. But for them the rest of us could not succeed. – Mark Twain
Ralph, my father-in-law’s dog, was included in my dedications at the beginning of this book. Let me update an old story:
I heard that in view of the emerging markets financial crisis the dealing room of a major bank is being down-sized. There will be a total crew of three: a computer, a man, and a dog. "What is the dog going to be dealing?" I asked. "Don’t be a fool” I was told. “The dog is the back office. He is there to make sure nobody touches the computer”. “And the man?” I asked. “Stupid question. He is the middle office. His job is to feed the dog." Corporate and bank presidents should follow the example set by mediaeval kings and emperors. They would do well to hire a few fools to ask stupid questions.
