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…
Resource:
Satyajit Das – Extreme
Money
