Tuesday, December 9, 2014

Extreme Money – A provoking book about the finance industry

Back in 2006, Satyajit Das has written a book about the financial derivatives industry called “Traders, Guns & Money”. I really liked reading this book. It was, therefore, logic that I got also interested in reading his book “Extreme Money: The Masters of the Universe & The Cult of Risk”, published in 2011. “Extreme Money” is a pretty provocative story about the finance industry. In fact, the title fits pretty well the overarching idea of the book: Satyajit’s view is simply “extreme”. In my view, many of his thoughts reveal some truth about the industry; however, they certainly are over-exaggerated and overlook many people and organizations simply doing a good job in finance.

Here are some of Satyajit’s provoking statements that I found most interesting:

Modern economies don't make anything anymore; their major activity is investing, borrowing, and trading money. Money has become the main way to make money.”

A long time ago, money simply served as a means to pay for real goods and services. However, in the second half of the twentieth century, money became something important in its own right. It became, in itself, a way to create wealth.

Satyajit describes a three step evolution resulting in today’s “business of business”:

  • The industry consisted of making things.
  • The industry then became a business, meaning making money from producing things.
  • Ultimately, increasing financialization lead to the “speculation economy” which consists of making money from things not necessarily linked to producing things. The typical example is trading goods that you don’t produce or consume.

Why did financial engineering replace real engineering? The author’s answer is that real engineering means innovation, which is, by definition, a very risky business, contrary to pure financial engineering.

“Rather than making things, trained engineers joined banks to provide turbo-charged financial structures for companies.”

Examples of this financialization include the developments of General Motors, General Electric, and Enron.

“Dealmaking beats working, dealmaking is exciting and fun, and working is grubby. Running anything is primarily an enormous amount of grubby detail work… Dealmaking is romatic, sexy. That’s why you have deals that make no sense.”
Peter Drucker

“Finance had become the panacea for arresting America’s industrial decline.”

The study of money is a field in which complexity is used to disguise truth or to evade truth, not to reveal it.”

A good example for how complexity can evade truth is the tranching of securitized assets:

“Tranching is like buying a place to live in a flood-prone area. To protect yourself from the one-in-10,000-year flood, you buy an apartment in a tower above previous known flood levels, with a large margin of safety. However, when the flood hits, your higher situated apartment doesn’t help you because the foundations of the tower itself and the surrounding infrastructure are also hit.”

Another aspect of complexity that the author pinpoints to is the lack of responsibility of individual actors to understand complex finance products. Satyajit writes, “Everyone relied on someone else to do their job”.

Finally, complexity generates high profit margins: “Opaque and inefficiently priced financial products produced high profit margins.”

Why is complexity bad? Because it creates financial instruments disconnected from the real world and capable of damaging it: “If correlation between two loans in a normal portfolio was an educated guess, then the correlation input into a structured finance CDO, CDO2, or CDO3 was fantasy.”

“There is a strong correlation between the complexity of an instrument, its remoteness from the real economy and its likelihood to spread contagion.”

In my view, complexity in finance is, indeed, often artificial and home-made. On the other hand: Isn’t everything easy once you have understood it?

A propos complexity, the author doesn’t seem to like Alan Greenspan. Satyajit makes particularly fun of the following quote:

“I know you believe you understand what you think I said, but I am not sure you realize that what you heard is not what I meant.”
Alan Greenspan

In modern economics and finance, until something is said mathematically, it isn’t said at all.”

Today’s math based risk management techniques don’t work, because markets are not efficient and price changes not normally distributed.

“Exceptions and anomalies increasingly undermined the theory of efficient markets.”

“Risk management assumes that price changes are normally distributed. But normal distributions do not exist in practice. Unpredictable extremes of price movement, known as fat tails, were more common than theory implied.

Hedge funds are courtesans, high-class prostitutes whose clients come from the wealthy. Banks are the pimps and bordello keepers.”

Here is how Satyajit sees the culture in the finance industry:

“All successful financiers have selective amnesia, remembering what fits their current world view.”

“Wall Street and the City are bad judges of value. Having enjoyed the milk, in a moment of confusion they tend to over pay for the cow.”

“In risk management, you learn that you are irrelevant, despite everybody saying you are vital. In the back office, you are chained to the oars of the banking trireme, processing an avalanche of paper.”

“Banks take smart people and plug them into their dull, trivial culture where they waste their lives on the hamster wheel of corporate life. There is a mismatch between expectations and the reality of banking.”

“Banks have no strategy, only hustle. One bank decided its strategy was to have no strategy. Imitation is the only real strategy.”

“In the culture of the deal, banks endlessly copy each other’s strategies or products, chasing the same customers, competing on price and the ability to take risk.”

“Happy employees mean that you have paid them too much. Disgusted employees mean that you have paid them so little that they will leave. The optimal point is between satisfied and dissatisfied – enough to keep you but not enough to make you complacent or diminish the manager’s own bonus.”

“The financial elite is narrow and limited, too smart, too fast, wanting too much, lacking any sense of history, and reinforcing each other’s opinion.”

“In finance, flexibility and split personalities are important.”

“Empty words like governance and oversight masked a lack of adult supervision of business and markets. A culture of benign neglect presided over increasing debt, greater leverage, higher risk, lower capital, and accounting fudges.”

As I wrote above, the book is extreme…

There is no simple, painless solution: The world has to reduce debt, shrink the financial part of the economy, and change the destructive incentive structures in finance. Individuals in developed countries have to save more and spend less.”

Satyajit describes in his book how the importance of debt kept rising in the global economy over the last decades.

He defines debt as a Darwinian scheme in which only those players survive who can withstand the highest debt levels. If interest cannot be paid back, more borrowing is needed until the player, ultimately, collapses under the weight of debt. From the point of view of the entire economy, this leads to a constant cycle of credit booms and bust.

“Debt became the essential part of the modern lifestyle. Even wealthy people borrow to increase their return.”

But why is debt so attractive? The author’s answer is that the debt’s attractiveness lies in its capacity to provide instant gratification as it borrows from tomorrow to pay for today. However, this only works as long as the debt level is sustainable. Sustainable means that debt is invested productively, i.e. in a way that generates the necessary revenue to repay debt and interest. Spending debt simply to finance consumption or larger houses, to the contrary, does not generate any revenue and then ultimately must result in a financial bust.

“The best loans are made during the worst times, the worst loans are made during the best times.”

The financial system was a case of financial groupthink, the madness of crowds.”

Das criticizes more or less every institution of the finance industry:

  • “Financial journalism is superficial.” The BRIC symbol (Brazil, Russia, India, and China) that expressed the raising power of emerging countries in the global economy in the years after 2000 may serve as an example.
  • “Financial TV never bothered with plot, dialogue, or production values, focusing only on the action. Occasional outside shots on the steps of a stock exchange or outside some monumental bank headquarters interrupt the visual monotony and interviews are never longer than 5 to 10 minutes.”
  • “At Davos the diverse mix is confusing – celebrities wanting to be intellectuals, intellectuals wanting to be celebrities, and bankers wanting to be both celebrities and intellectuals.”
  • Regulators seem to be powerless: “When things were going well, regulators favored self-regulation, which bears the same relationship to regulation that self-importance does to importance.” If ever banks could not obtain self-regulation, they always ended up avoiding regulation by imposing exclusions and exemptions.

Botox economics

Let’s finish with the concept of botox economics that Satyajit uses to highlight the inefficiency of central bank / central government financial support for the economy:

“Botox is a toxin, commonly used to improve a person’s appearance by removing signs of ageing. However, the effect is only temporary, with significant side effects. As the global financial crisis rolled on, financial botox, a flood of money from central banks and governments, covered up unresolved and deep-seated problems. Tax cuts, investment incentives, and subsidies all boosted activity. Low or zero interest rate policies engineered a recovery in stocks and financial markets.”

This debate is still vivid today. Let’s wait and see…


Satyajit Das – Extreme Money