In May 2007, a large French bank approached me with an emailed proposition:
“Bank of Cyprus plans to organize a pensions conference in Cyprus…as a long-standing partner of Bank of Cyprus, XYZ Bank is invited to participate to the conference and discuss about the benefits of non-traditional investment strategies to enhance pension fund positions…we were thinking that it would be great to have you participating to the conference and present your views on what you see in Europe and the potential benefits of structured solutions”.
It wasn’t hard to read between the lines and work out XYZ Bank’s agenda. ‘Structured solutions’ is a code word for selling derivatives, something the French bank was very successful at. The bank’s salespeople thought that having an unaffiliated journalist talking about derivatives would add credibility to their marketing campaign. And why not, I thought? I knew about the subject and I was curious to see Cyprus.
So I cobbled together a presentation summing up what I knew about pension funds using derivatives. All I knew about Cyprus was that it was half an island that identified itself as Greek. Just before my trip, I gained some insights into Greece. I wrote a story about how four Greek pension funds got into a fight with JP Morgan over some structured products that turned out to be worth substantially less than the price they paid for them.
Having written this story, my attitude towards pension funds buying structured products changed. It was only a year before I started writing The Devil’s Derivatives, and I was beginning to understand that most structured products existed because banks worked out how to arbitrage a client, a rating agency or regulator for profit. By the time I delivered my presentation in Nicosia, I was quite negative about pension funds buying ‘structured solutions’ and the French bankers in the audience looked at me with glum faces.
After my talk, I chatted to people from the Bank of Cyprus and other local firms. I had assumed that these would be the same kind of unsophisticated investors I had met in Athens. I quickly realised my mistake. The Cypriots seemed to view their mainland cousins as endearing hayseeds who were more comfortable with a donkey than a Mercedes. These particular Cypriots weren’t interested in buying structured products themselves. What they did want to do was earn commissions selling them to retired Greeks, Russians, British and other wealthy foreigners flocking to Cyprus.
My next encounter with Cyprus happened in June 2011. A non-governmental organisation approached me with what at first seemed an bizarre request. They were holding a conference in London on reunifying Cyprus. Would I be interested delivering a presentation on asset-backed securities?
Unlike the first Cyprus invitation, this time I was clueless. I protested that I knew very little about the tortured history of the divided island – and even if I did, why were ABS relevant? Don’t worry, the organisers said, sending me a briefing note for me to prepare from.
The NGO document explained how plans to reunify the island had foundered on the question of how to compensate Turks or Greeks who had lost land during the partition of the island 40 years ago, without evicting the current occupants of their property. One idea being floated was for certificates to be given to the original owners of the land, linked to their revenues and value. These certificates could be bundled together and securitised, raising cash from investors which could be used to develop the land for tourism. By financial alchemy, that would boost the value of the certificates enough to persuade both sides to sign up to a deal.
Then I understood why the NGO had approached me. They want to bring about the reunification of Cyprus using a structured product. I was privately doubtful about the viability of the idea, coming at a time when securitisation of even American mortgage loans was only possible with US government support. But I was touched by the motivation of reunifying a divided island, so I agreed to speak. At the conference itself, my presentation was received politely by the mix of Greek and Turkish Cypriot leaders present.
But it was the aside from a board member of a big Cyprus bank (I don’t remember which one) that stayed with me. If Greece defaults, he said, our banking sector will need a bailout of 30 percent of our country’s GDP – or about €6 billion based on the 2010 figures being used at the conference. That was nine months before Greece did default on its private sector-owned debt, and eighteen months before the crisis in Cyprus came to a head. Today we know that even a €10 billion EU bailout – 40 percent of 2011 GDP – isn’t enough to save the country’s banks and their uninsured creditors.
As I followed last week’s attempts by the Cypriots to prevent the reckoning now taking place, there was a mention some kind of repackaging and pledging of natural gas reserves lurking miles below the Mediterranean. Could it be pledged to the Russians? The ECB? After my 2007 and 2011 encounters, it seemed familiar. Another Cyprus structured product.

“The final banking crisis, which terminated in the banking holiday early in March 1933…” So begins a dark passage in Milton Friedman and Anna Schwartz’s Monetary History of the United States, which last Friday arose from ancient slumbers in the eastern Mediterranean.

The turmoil sparked by the proposed tax on Cyprus bank depositors makes it a perfect time to reflect on the responses to the financial crisis. The Bankers’ New Clothes (Princeton University Press) is a book that lays out the problems in banking revealed by the crisis and asks how to solve them. The authors, Anat Admati and Martin Hellwig draw upon accounts of the crisis (including mine) and come up with some clear prescriptions based on what they see as the biggest problem – that banks are over-leveraged. This problem is the wellspring of systemic risk, Admati and Hellwig argue, because wafer-thin equity means that bank asset problems quickly become bank debt problems, driving contagion because of banks’ liquidity needs and their linkages to one another.

A key issue is the cult of return-on-equity which is the mechanism by which senior bankers justify keeping their institution’s equity levels as small as possible. High ROE is good, trumpeted bankers such as Deutsche Bank’s Josef Ackermann and Barclays’ Bob Diamond. In fact, it’s about as good as a chemical factory that pollutes your local river to make a profit. Force banks to hold a lot more equity, and in effect you have cleaned pollution out of the financial system.

Now this insight about dangerous leverage and ROE isn’t itself new. Bank of England monetary policy committee member David Miles has been making the point for a number of years. Back in June 2011, I published an interview with Anthony Watson, non-executive director at Lloyds Banking Group and chair of the firm’s compensation committee in which he said:

“I would argue that it’s not actually bad for banks to be less profitable. If you drive ROE down to more sensible levels, in line with the economy as a whole, banks can still be worth more because
the market perceives them as being less volatile and is therefore prepared to value them more highly. But you have to make a judgement about that because lower profits should mean lower bonuses, and many bank CEO s tend to be too arrogant to listen to such arguments”.

As Admati and Hellwig demonstrate, the fact that the ROE cult and the leverage problem hasn’t been addressed since the start of the crisis is a testament to the power of banking industry lobbyists to obfuscate the issue. Their book serves as a manual for refuting banking lobby arguments and that alone makes it an invaluable text.

The unique ability of banks to borrow cheaply is the fuel that drives leverage and that brings us back to Cyprus bank depositors. Admati and Hellwig give a good explanation of the role of government subsidies in making debt cheap, and no form of bank debt as considered as sacrosanct as deposits. Threaten the safety of deposits, the arguments go, and the entire banking system is threatened (there’s been a fair bit of commentary like that in the past few days).

Admati and Hellwig’s solution to overleveraged banks is to force them to hold more equity – between 20 or 30 percent of their assets which is an order of magnitude bigger than the equity typical banks have today. The problem is that even if hobbled Basel rules required that kind of equity cushion, many European banks don’t have enough time to raise the capital. With today’s equity levels, and with doubts about the quality of their balance sheets, these banks are barely solvent (loan accounting rules contributed to this zombie bank problem as I discussed here).

If you believe that it’s not the job of central banks to bail out insolvent banks under the guise of emergency liquidity measures, then there are only two alternatives when the probable value of a bank’s assets are less than its liabilities: either a government injects equity (and perhaps seeks its own bailout to pay for it, like Ireland did) or creditors of the bank must lose money. Owners of unsecured bank bonds are one category of creditor in the firing line. However, what happens if these bondholders are insignificant compared with depositors, as is the case in Cyprus?

The message of books like the Bankers’ New Clothes is that it’s time to take a much less sentimental view of deposits. They are no more than a form of debt, and institutions such as companies, local governments and banks – as well as wealthy individuals – invest in deposits in an unsentimental basis, making judgements about risk and reward. Banks such as Societe Generale, Barclays and Deutsche Bank similarly use deposit funding to access leverage with a view to maximising returns on equity for their shareholders while taking the risk that depositors might suddenly ask for their money back.

What about non-wealthy individuals who need a place to keep their savings? The lesson of the Great Depression and the bank holidays of 1933 was the social importance of retail deposits required some kind of government guarantee, at least up to a certain limit. However, if all deposits are perceived as sacrosanct – or implicitly guaranteed – then Admati and Hellwig would argue that such protections amount to a hidden government subsidy. Bankers are very good at sniffing out such subsidies and gambling that their bluff won’t get called.

While I have no idea how the volatile mix of Cypriots, Russians and Eurocrats will resolve this crisis, one useful outcome of the ‘Cyprus precedent’ is that the value of such subsidies is now up for discussion.

In The Devil’s Derivatives, I tried to answer two questions at the heart of the financial crisis. Why did the trading aspect of banking (the ‘casino’) get to grow so big? And why did regulators allow that to happen? My answer hinged upon something called Value-at-Risk that gave bankers and regulators confidence that risks were measurable, were small compared to trading positions and could be controlled.

It’s now the twentieth anniversary of the invention of VaR at JP Morgan in the early 1990s, and I recently had the opportunity to speak with Jacques Longerstaey, who was one of its principal inventors.

The basic story has been told many times. Dennis Weatherstone, the English-born chairman of JP Morgan wanted to understand the risks of the bank’s fast-growing trading business. “At the end of the day, I want one number”, Weatherstone told Longerstaey and the risk team. The result was VaR.

What fascinated me was that in the fullness of time, Longerstaey was prepared to speak frankly about the real business context behind VaR. An explanation was needed because having invented what was seen as a sophisticated risk management tool putting it light years ahead of other trading firms, JP Morgan decided in 1994 to do something surprising. The bank put this valuable intellectual property in the public domain, publishing what it called the Riskmetrics technical document, which Longerstaey co-authored.

“Nobody at the time really understood the main objective of the firm”, he said. “Usually when banks offer something for free there’s a reason behind it”. The reason was regulation. It’s worth quoting Longerstaey’s words in full.

“The regulators at the time were starting to think about moving on from the Basel I framework and impose capital requirements on trading books. The first incarnations were very simplistic and didn’t take into account any diversification, and therefore would have been very punitive for the bank. So Riskmetrics was more than a client tool, it was a way to popularise these methodologies so that all the banks would go to the regulators and ask to be allowed to use internal models to lower their capital requirements. This is one of those things that may have had positives and negatives”.

In other words, a regulated US bank with access to Fed liquidity and deposit insurance wanted to break into the trading casino and build up trillions of dollars of positions in swaps and other derivatives. By releasing a free tool that clients and competitors would start using to manage risk, JP Morgan would enlist an entire industry to lobby on its behalf.

The ploy was wildly successful. Only a couple of years after VaR entered the public domain, the Basel committee amended its rules to allow banks to use VaR models to calculate their trading book capital. As Longerstaey points out, there wasn’t more to VaR than a statistical significance test combined with Harry Markowitz’s theory of portfolio diversification.

The trick was that once adopted by regulators, that single number demanded by Weatherstone became a sliver of capital underpinning enormous, complex balance sheets, creating a grotesquely over-leveraged bonus machine that eventually stampeded over a cliff in 2008, the year that Weatherstone died. “Dennis, you created a monster by asking for that one number” is how Longerstaey puts it today.

For me, the JP Morgan strategy of encasing a regulatory payload in a sugar-coated pill of a ‘free’ gift to the industry evokes examples from technology and biology. In computing we have ‘trojans’, where attractive software applications contain a hidden payload that serves some nefarious interest. Examples abound, from the Stuxnet worm that ravaged Iranian nuclear plants, to the surveillance worms that UK companies are exporting to authoritarian regimes in the Gulf.

In evolutionary biology, we have the selfish gene that hands out attractive freebies in order to perpetuate itself. Sex and orgasms are examples of fun stuff that our DNA packages into our bodies to keep itself going. You could say that JP Morgan’s VaR freebie persuaded regulators to bless marriages such as Deutsche Bank-Bankers Trust in 1998 and JP Morgan-Chase Manhattan in 2001, watershed moments for the success of giant bank DNA.

Although VaR is supposedly ‘discredited’ at a moment when regulators are ensuring it is more powerful than ever, spreading from banking into insurance and fund management. Plus ça change: Deutsche Bank is currently refining its internal model to reduce its capital requirements, while JP Morgan, having lost five billion of dollars more than its VaR a few months ago in its CIO unit, just announced some ‘improvements’ to its model that increased the VaR number by $30 million.

So what would happen if VaR was taken out of bank regulation? Immediately, the intellectual crutch for highly-leveraged complex banks would disappear. Deprived of their fancy radar screens, regulators would have to break up large banks that they could no longer pretend to understand, while increasing their capital to the level of a typical hedge fund.

That’s unlikely to happen though. Like sex and computer viruses, it’s very hard to stop stuff like this once it gets started.

I first encountered the Higgs boson in 1989 on a blackboard in an advanced quantum field theory class for graduate students at Harvard University. It was the point that I realized that the life of a theoretical physicist was not for me.

I remember the lecture theatre well. There were three blackboards side by side, and each one consisted of a continuous belt which the lecturer could pull down to expose extra space to write on. The system allowed long mathematical arguments to be written down without the need to erase them in mid-flow. As it happened, the mathematics needed to describe the Higgs boson – the electroweak theory – pushed that system to its limit.

In quantum field theory, you start out with something called a Lagrangian – a kind of balance sheet for the stuff of nature. I’ve been writing about finance for so long now that whereas I once used physics analogies to describe finance, I now use finance analogies to describe physics.

The things you think are fundamental – electrons, neutrinos, quarks and so on – are written down in this Lagrangian. There’s a lot of infrastructure built into this statement: I say ‘electron’ but you write it as a symbol for a complex-number vector that has a value at every point in space and time – a quantum field. If you want to stop reading here, don’t worry, I’m not going to go further into that sort of detail.

So let’s go back to the balance sheet analogy. Imagine a company producing and selling differing products around the world, say cars, light trucks, heavy goods vehicles. These are the ‘fermions’ that appear in the Lagrangian, the neutrinos, electrons and quarks. How do they interact on the balance sheet? Suppose you come up with a rule that the value of the company is independent of any change in exchange rates in the countries where the company does business. No matter what combination of local foreign exchange rate changes you apply, the company’s earnings aren’t affected.

In physics, that’s what would be called a ‘gauge’ and saying that a Lagrangian is locally gauge-invariant is quite a strong statement. To make it work, you have to fix the Lagrangian, adding new bits to balance everything out. In the corporate analogy, you might have to add currency-hedging contracts to keep the balance sheet fixed in the event of foreign exchange swings. In physics, these new bits turn out to be forces between the fermions, transmitted by so-called gauge bosons.

In the ‘simple’ form of gauge field theory, such as the quantum electrodynamics invented by Richard Feynman and others in the 1940s, gauge bosons have zero mass. In my corporate analogy, you could imagine a hedge accounting rule that kept the bosons out of the company’s income statement.

In 1989 I had learned how this theory worked, including lots of messy details about particles scattering off each other and how infinities were avoided in the calculations. Then the professor introduced electroweak theory. It was necessary because gauge theories on their own didn’t explain reality. For example, we knew that the neutrino had to be a fermion – so why did it have zero mass?

The answer was to combine electromagnetism and the weak nuclear force in a special way. You wrote down a long, complicated Lagrangian and combined two separate gauge symmetries within it. Then you added a separate quantum field that interacted with everything – the Higgs field. Something strange happened to the Higgs field though. It underwent ‘spontaneous symmetry breaking’, presumably back in the Aboriginal dreamtime of the moments just after the Big Bang.

In physics books, the symmetry breaking is often described using the example of a magnet where lots of particles all end up pointing in one direction as they cool below a certain temperature. The Higgs field does something like that, but more radical is the effect this has on the Lagrangian, which effectively rearranges itself.

Going back to the corporate analogy, it’s like a new accounting rule appears from nowhere – say, pension accounting – triggering a new balance sheet for the company. Whereas before you had cars, light trucks and heavy vehicles as your ‘fermions’ you now had cars, light trucks and pension liabilities.  Particles that start out being massless acquire mass. In physics, that explains a good part of the world we see.

That electroweak Lagrangian covered all three blackboards in the Harvard lecture theatre. I could barely keep up: I was still in the middle of trying to comprehend and write it all down when the professor started erasing it. There was one final term in the equation I missed completely.

I spoke to the professor later in his office. He realised that I was in the lower tail of the distribution of following his class, and spoke to me frankly about the costs and benefits of theoretical physics as a career. He had just been passed over for tenure at Harvard and was slightly bitter about it. “I have given up more than half a million dollars on Wall Street by doing this job”, he said.

I didn’t anticipate that I would end up writing about Wall Street, but shortly after that encounter I began to move away from theoretical physics for good. And the last term that I missed writing down? It was interaction between the Higgs particle and the others in the theory, which made possible the discovery at the Large Hadron Collider announced last week. The Higgs particle was there on the blackboard, waving me goodbye.

In the last week, we saw major developments in two big scandals – Libor rigging and swap mis-selling in the UK – and the end of the second quarter which is likely to draw a line under a third big scandal – the ‘London Whale’ losses at JP Morgan. I have some thoughts about these three scandals and their implications for banking and regulation, and my view is that one thing connects them: the growth of over-the-counter derivatives and London’s place at the centre of this growth. I will split up my analysis into three separate questions and answers.

Q: Why did the Libor rigging happen and what are the implications?

A: Libor began as an obscure mechanism by which the cash managers at London banks agreed on the rate at which they thought they could lend each other money over short periods of time. The only reason that Libor became as important as it did was because of London’s role as an offshore market. In the 1970s, US banks were constrained by rules on deposit rates, and with the boom in middle-Eastern oil, a market in ‘offshore dollars’ grew up in the City. As a benchmark for the short-term rate on dollar lending, Libor was pressed into service.

If things had remained as a purely cash-based market, Libor might have stayed in obscurity – an innocuous benchmark that never actually traded. However, the trading soon began in derivatives, firstly in 1981 with the Chicago Mercantile Exchange’s Eurodollar futures contract. That allowed traders to bet on three-month dollar Libor ‘fixings’.  The CME future was then eclipsed over the following two decades with over-the-counter interest rate swaps, options and more exotic derivative contracts that all had Libor built into them and grew into a market hundreds of trillions in size.

Unlike futures, OTC derivatives are dominated by a handful of large banks, including Barclays. Unlike futures that are margined daily and reported to the exchange, these derivatives are mostly transacted in private and stay on the bank balance sheet. In the years before 2007, Libor became a sort of plasma in which the blood cells of derivatives flowed, yet all the time kept its archaic cash-based fixing mechanism. Given the derivative trillions at stake, it would have been surprising if the banks involved in fixing the rate had not started rigging it at some point.

As the FSA notice on Barclays shows, the contradictions within Libor really became obvious in 2007 when the pretence that it was risk-free became untenable, and investors began watching it as an indication of bank health. Today, Libor has all its lights on but no-one is at home – after all, who wants to lend to an international bank on an unsecured basis these days? Even the derivatives industry is abandoning Libor as fast as it can, with pricing now based explicitly on cost of funding and collateral.

Whatever new standard ends up being adopted, the Libor scandal is a grave threat to the reputation and credibility of London as a financial centre. After all, why should American mortgage borrowers, Asian money market funds and European corporations ever trust again a cartel of casino operators (sorry, London-based banks) as a source for their short-term borrowing and investing benchmarks?

Q: How did swap mis-selling by UK banks become such a problem and is it being addressed in the right way?

A: British small business and retail lending didn’t used to be like this. Banks might offer a range of different loan products – floating rate, fixed rate, capped etc – and if a customer needed to repay a loan early, an early redemption fee would be applied that would be capped at a few per cent of the value of the loan. That practice – and the quite reasonable assumption by customers that it hadn’t changed – played a big part in this scandal.

What changed in banking mirrored the transmogrification of Libor. The global interest rate derivatives business – rates trading – became more profitable than retail banking. As I described in The Devil’s Derivatives, the ‘men who love to win’, the Bollinger-drinking characters you meet in the Barclays Libor emails, took over the system.

Saddled with astronomical infrastructure and bonus costs, this rates trading beast needed feeding. The small and mid-sized business customers of middle England were offered up on this altar. Loan products became derivative-based in the name of risk management, with the largest profit component booked by the trading desk at the time of the loan, and the risk being hedged out in the market. Unbeknown to the customer, they were now sitting at a roulette table, and when rates plunged in the wake of the crisis, the croupier scooped up the chips and the customer paid the price

Connecting less-sophisticated clients to the trading casino for quick profit is an old trick of investment banks. As I documented in my book, JP Morgan, Deutsche Bank, Barclays and others were repeatedly accused by clients of such arbitrage in continental Europe over the last 15 years while hiding behind the ‘caveat emptor’ legal protections of UK civil law. But the sheer self-defeating idiocy of British banks treating the least-sophisticated layer of their home constituency in this way is astonishing. At least they have helpfully woken up the British public to the dodgier practices of the industry nurtured by the City for so long.

So what of the solution? The FSA settlement bans the worst products and commits the big four offending banks to some kind of restitution. Recent UK government proposals attempt to ring-fence trading businesses from traditional banking, while permitting derivatives to be sold to them. Neither step goes far enough. We need to cut the link between small business or retail lending and the trading casino. If banks want to sell loan products with fixed rates and other features, they should cap early redemption costs and manage the interest rate risks on their customers’ behalf. That requires ‘asset-liability management’ (ALM) and might involve a treasury desk trading derivatives and a tough risk management department – which takes us to our last question.

Q: What are the lessons of the ‘London Whale’ losses at JP Morgan in terms of regulating proprietary trading and the structure of banks?

A: ALM, the activity that is supposed to insulate bank customers and shareholders from swings in interest rates and other market moves, was ostensibly one of the functions of Ina Drew’s chief investment office at JP Morgan. Somehow, this fairly humdrum purpose morphed into the betting on credit default swap indices that lost $2 billion in April and probably three times that amount since as JP Morgan unwinds the trades. As with Libor rigging and swap mis-selling, the London derivatives playground had a central role.

The JP Morgan unit had plenty of excess cash – over $300 billion – and this size had a corrupting influence on the bank as it led the CIO traders to believe that this muscle could create self-fulfilling prophecies. By definition such units should only be taking credit risk for short periods – three months or so – leaving longer-term credit risk-taking to the core lending functions of the bank.

The unit violated that principle by filling its boots with mortgage-backed and other investment grade securities that it snapped up at distressed levels in the market, apparently with the approval of Jamie Dimon. According to Dimon’s testimony to the House Financial Services committee on June 19, the impact of Basel banking rules prompted a re-think. “We instructed CIO to reduce risk-weighted assets and associated risk”, he said.

Instead of selling its securities at a profit, Basel permitted the CIO unit to cancel out its exposure using credit default swaps. Combine that with a team imbued with a London-bred culture for credit derivative trading, and the CIO unit carried out its ‘instructions’ by entering into complex correlation and credit term structure positions that should rightfully have belonged within a hedge fund.

Where does this leave the Volcker Rule? No doubt, the regulators charged with implementing it will add some rider to the effect of banning US banks from operating their treasury units like internal hedge funds. But as Dimon seemed to imply, does Basel-motivated hedging trump Volcker? How easy it is to tell the difference?

The scandal adds to the perception that the Volcker Rule amounts to an impossible attempt to square the circle. By permitting deposit-insured US banks to run derivatives market-making operations, regulators have committed themselves to catching proprietary trading violations as they happen. Yet, any market-making business has to involve some proprietary trading as it warehouses and matches up client trades.

Wouldn’t it have been simpler to have separated market-making and investment banking generally from deposit-insured banking? By failing to grasp this nettle, US regulators have almost pledged that they will fail.

To use a parable: the Glass-Steagall Act had a daughter, the Gramm-Leach-Bliley act, which was impregnated by bankers and produced another child, the Volcker Rule. In well-meaning reverence to its bloodline, US Congress has elevated this somewhat debased progeny into playing the role of its grandfather. A lesson from the last week is that there’s no substitute for the real thing.

Twelve years ago, in ‘Inventing Money’ I explained the principles of option pricing to a general audience. Although the maths looked complicated, the financial market that Fischer Black, Robert Merton and Myron Scholes modeled in the early 1970s was really quite simple. You bought and sold derivatives, such as options or forward contracts, and traded between the underlying assets, and a liquid cash account.

The cost of replicating the derivative was equal to its price, because otherwise traders would arbitrage the discrepancy away. With that Nobel prize-winning concept in place, bankers and regulators thought you could safely trade and hedge as many derivatives as you wanted – and that’s exactly what people did from the 1980s onwards, creating a multi-trillion dollar market.

The ‘law of one price’, enforced by replication and arbitrage , resembled a financial law of nature. It made derivative pricing particularly attractive to people from a physics background. One of the greatest achievements of twentieth century physics was Quantum Electrodynamics which described the behavior of particles like electrons and photons. QED was ‘perturbative’ in the sense that complex interactions between particles were less important than simple ones.

In the 1970s model of financial markets, complex interactions between traders involving liquidity or counterparty default were also minor corrections to derivative pricing that in practice were ignored. Once you defined the instrument – a barrier option or an interest rate swap – its price was the same for everybody in the market.

Today, the kind of market that Black, Scholes and Merton modeled in the 1970s seems quaint in the wake of the financial crisis. At a conference in Barcelona’s Hotel Arts in April, I watched quants grappling with a new landscape of counterparty risk, collateral and clearing houses, that has turned the old world upside down.

Consider the old framework of derivative pricing in which counterparties enter into derivatives contracts with one another, while buying and selling the underlying asset to hedge themselves, dipping in and out of cash accounts. The starting point today is counterparty risk, collateral and cash.

Before you take on counterparty exposure, you need to think about these counterparties’ credit spreads. How volatile are they? What’s the ‘jump-to-default risk’? That drives a crucial parameter, the credit valuation adjustment. Of course, you might default before they do, and the possibility that you might not pay out on a derivative becomes valuable as your own credit spreads widen. Enter the debit valuation adjustment. These two quantities, CVAs and DVAs, make derivative trading books at major banks lurch around like aircraft in a thunderstorm.

Then there’s the cash and collateral aspects of derivatives. For banks everywhere nowadays, cash is precious: if holding a derivative requires a cash account for its hedging strategy, that means borrowing money somewhere to fund that. Can you pledge the derivative as collateral? Can you lock in a deterioration in your own creditworthiness by using the cash to buy back bonds? That leads to another correction, the funding credit adjustment, that also needs to be added in.

One answer to the problem was supposed to be the posting of collateral to cover swings in the mark-to-market value of a derivative. That was fine when there was an unlimited supply of highly-rated bonds that everyone assumed were interchangeable – Treasury bills, Italian bonds, collateralized debt obligations. This is no longer the case as safe assets become increasingly contested, and the safest thing of all – cash – is like blood.

Along with CVAs, DVAs and FCAs, the credit support annexes that govern the posting of collateral have now become equally crucial parts of a derivative contract. What kind of collateral can you post, and in what currency? Can you re-pledge or hypothecate it? How do you discount the value of that collateral? And if a counterparty defaults suddenly at a time when markets are highly volatile (which isn’t implausible), even a CSA won’t necessarily protect you.

In today’s world, the derivative that used to be the same for everybody sits on top of these new components, like a decoration on a wedding cake. Pricing has become context dependent, as CVAs and CSAs throw out different numbers depending on what positions a bank already has, and what collateral it owns, and how the market perceives its default risk. A keynote speaker at the Barcelona conference, BTG Pactual’s Tom Hyer, suggested a new paradigm for derivatives was necessary.

I would go back to a physics analogy. In particle physics, the euphoria over the success of QED wore off when the theory was adapted to account for the behavior of unseen particles trapped within atomic nuclei – quarks and gluons. That theory, Quantum Chromodynamics, was ‘non-perturbative’, in other words, the more complex interactions dominated the simpler ones. That made the physics much harder.

Derivatives today are like that. Complex interactions between banks and within portfolios dominate the pricing of derivatives, as opposed to the behavior of the assets the contracts are supposedly ‘derived’ from. Maybe that’s nature’s way of telling us to make the banks, and the market simpler.

My story (with Elisa Martinuzzi) about Italy admitting it paid Morgan Stanley billions to unwind derivatives, and the Telegraph’s superb reporting on the alleged mis-selling of derivatives by banks like Barclays to small British companies, have something in common.

Small British companies and Italy share an environment where both of them are finding it hard to access credit and roll over funding. You’d think the emergency measures by central banks to keep borrowing costs low (by purchasing government bonds or helping banks to do so on their behalf) would make things easier. Unfortunately, the benefits are being counteracted by the impact of derivatives that these borrowers purchased before the crisis, when bond yields were higher.

Put yourself in the shoes of a borrower in the years before 2007, when government bond yields were around four or five percent. In the case of Italy, you could borrow freely for periods of five or ten years – to the tune of trillions of euros. Officials at Italy’s treasury wanted to lower the repayment costs, and investment bankers offered them derivatives – swaps and options – that spread the costs over a much longer period, say 30 years. It turns out that Italy bought 160 billion euros of these things.

Small UK companies were dependent on banks for long-term loans, and the banks pushed them into buying derivatives that fixed their loan rates for 30 years or more. Like Italy, the derivatives often lasted much longer than the underlying loan.

In both instances, it took two unanticipated events happening simultaneously to turn this into a problem. On one hand, the financial crisis reduced access to funding, pushed banks to recognise their counterparty exposure on derivatives, and forced borrowers to tighten their belts with austerity measures. Meanwhile, the emergency measures by central banks caused euro and sterling swap rates (which respectively track German and UK government bond yields) to plunge. That made derivatives where banks received long-term fixed payments incredibly valuable.

Things came to a head in two ways. The UK companies had been required by the banks to enter into mark-to-market collateral agreements on their swaps. As the derivatives moved in their favour, the banks were able to immediately demand collateral, draining the companies of cash. Italy was luckier because it didn’t have to post collateral. Instead, the problem involved options or forward-starting derivatives that were reaching maturity and kicking in, increasing Italy’s borrowing costs at the worst possible time.

In Daniel Kahneman’s book ‘Thinking Fast and Slow’ (which I will be reviewing shortly) there is a section on what he calls ‘hindsight bias’: after some disaster has happened, peoples’ recollections of the probability they ascribed to it are much higher than their actual beliefs at the time. Kahneman is irked by pundits who claim that they ‘knew’ the financial crisis was ‘inevitable’.

Kahneman would rightly say that no-one knew with certainty five years ago that the interest rate derivatives bought by Italy and small UK companies would cause such trouble today. However, a better question to ask might be what probability the markets gave five years ago to the scenario that bond yields and swap rates would fall to today’s levels.

While credit default swap markets ascribed minute probabilities before 2007 to the subprime and Greek defaults that would eventually come to pass, interest rate derivatives markets priced in much higher likelihoods of a low rate world. This was driven by demand – as early as 2003, insurance companies and pension funds were worrying about how low bond yields would affect the cost of their fixed liabilities.

In 2006, I reported that Munich Re bought 12.5 billion euros of receiver swaptions (options on swaps) from Morgan Stanley for this purpose, at the same time that Italy was selling them. A few UK pension funds, such as WH Smith, First Group and HSBC, were also active at this time, contracting to receive long-dated fixed payments on swaps at the same time as small UK companies were being steered onto the other side of such positions.

In the case of Italy’s treasury, there can be no excuse for not understanding the risk of low rates when they were effectively betting with Italian taxpayers’ money. By contrast, small UK companies cannot be labeled as ‘sophisticated’, and may not have understood what they were getting into.

What Italy and the small UK companies do have in common when it comes to derivatives is a problem of secrecy. Having seen the role that derivatives played in Greece’s problems, I’ve been pushing for a while for the Italian treasury to come clean on its derivatives exposures. Fortunately, our story on Friday seems to have had an impact. In the UK, it’s a scandal that Barclays prevented its clients even from talking to the Financial Services Authority about swap contracts.

Perhaps that’s the most important lesson: secrecy breeds muppets.

Most journalism is a hit-and-run affair. We talk to sources, check facts, agree quotes, wrestle with editors and lawyers; the excitement builds up to the point the story appears…and then we drop the whole thing and move on. When I published my story on Goldman Sachs and Greece in July 2003, the almost-universal reaction was: EU member states were flouting the Maastricht Treaty with the help of investment banks – so what? We now know that what I uncovered eight years ago was a sign of the Eurozone’s rottenness. Over the last month, as Greece approached default, I’ve been lucky to have had a chance to revisit my story and uncover some new facts with the help of the BBC and Bloomberg. You can watch my BBC Newsnight film here;

the ten-minute film was directed by Mark Turner and the broadcast date was 20 February. My Bloomberg feature (co-authored with Elisa Martinuzzi) was published on 6 March and can be read here. It was the most-read story on Bloomberg’s website last week.

All the talk about Greece trying to persuade its creditors to swap some once-valuable bonds for new ones worth much less reminds me of another Greek swap that I wrote about in 2003. That deal with Goldman Sachs, designed to conceal part of the country’s ballooning debt-to-GDP ratio in order to conform to the rules for Europe’s single currency, was analysed by EU statistics agency Eurostat in a report published last year.

Although the report’s credibility is undermined by Eurostat’s straight-faced insistence not to have known about the swap until 2010, it does provide some insight into the Greek governance that got the country into its current mess. In particular, there are some telling analogies between the product that Goldman sold Greece and the mortgage products that U.S. financial companies sold to subprime borrowers during the housing bubble that ended in 2007.

The swap was structured in June 2001 and had two components. One was a series of cross-currency swaps by which Greece’s historic foreign currency borrowings in dollars and yen were converted into euro debt for accounting purposes. Normally, these contracts are transacted at the prevailing spot exchange rate, and have zero value. In Greece’s case, these swaps were transacted at a fictitious exchange rate, reducing the size of the debt by €2.4 billion. According to Eurostat’s accounting rules at the time, this was a perfectly legal thing to do.

The second part of the transaction is where it gets more revealing. Because the ‘off-market’ cross-currency swaps had a positive value for Greece, they were in effect a loan from Goldman. To repay the loan, Greece entered into a separate off-market interest rate swap which had a positive value of €2.8 billion for Goldman (this amount included a €400 million charge for unwinding some additional swaps). A payment of fixed coupons from Goldman to Greece was more than counterbalanced by a stream of floating-rate payments going the other way that would last until 2019, paying off Goldman’s loan, along with interest and fees.

There was more to this unusual interest rate swap as Eurostat pointed out. The floating rate was not a plain-vanilla money market rate such as Libor. It was ‘actively managed’ according to the report, and was tweaked several times. ‘This is a feature which does not seem to be commonly observed in normal market practices’, is how Eurostat described it. The swap also included a grace period of two years before Greece would actually have to pay any money to Goldman.

In effect, this grace period resembles the so-called ‘teaser rates’ that were popular among subprime borrowers during the U.S. housing bubble. Teaser rates typically lasted for two or three years and temporarily insulated borrowers from crippling mortgage costs that would kick in once the introductory period expired. To avoid foreclosure, subprime borrowers would refinance these mortgages before that happened, an exit route that was possible so long as house prices were rising.

Consider the similarities in Greece’s relationship with Goldman. Like a subprime borrower, Greece was overly indebted and showed little ability to get to grips with the problem. The Goldman swap was akin to a ‘liar loan’, where Greece could keep its troubles secret. The grace period on the swap made the problem briefly look affordable. The analogue of house price appreciation was the deficit, which the Greek government forecast would disappear in a few years’ time, providing enough income to eventually pay down the swap. To keep the illusion going, Greece went back to Goldman and tweaked the deal, extending the grace period for another couple of years each time round.

As with subprime loans, Greece was not really getting an interest holiday during its grace period. The interest and fees were racking up out of sight and getting added to the loan balance. With subprime, this was known as ‘negative amortization’. The Eurostat report shows what the impact was, when in early 2005, Greece refinanced the hidden loan. This time round, Goldman restructured the swap and sold it to a recently-privatized Greek bank, National Bank of Greece. This meant that the swap had to be marked-to-market, at a value of €5.1 billion.

How costly was that for Greece? In 2001, Greece publicly issued ten-year bonds that paid a coupon of 5.35 percent. If Goldman’s €2.8 billion loan had been compounded at this rate for four years, Greece would have owed €3.4 billion in 2005. To get a loan amount of €5.1 billion is equivalent to Greece paying a staggering 16.3 percent annual interest rate. This additional cost may be connected with the structured product nature of the swap which entailed Greece making bets on market moves in interest rates and inflation indexes that performed badly.

Rather than facing up to its problems in 2005, Greece extended the maturity to 2037 from 2019 in order to keep annual costs down, with a new grace period of two years. The efforts were in vain, and in 2010, Eurostat forced Greece to reinstate the hidden debt on its balance sheet.

Today, Greece is widely expected to default on its $350 billion of outstanding debt. In the U.S., $750 billion of outstanding mortgage debt is underwater, and $200 billion is in default. In both cases it was tempting to rail at the spendthrift and insist on full repayment, a position that has been exposed as being futile. Some countries, like consumers, are unable to resist financial products that play on their weaknesses and worsen their problems.

On page 277 of The Devil’s Derivatives, there is a short account of how the U.K. Financial Services Authority supervised the Royal Bank of Scotland in the spring of 2008. It’s only a small part of the book, but it caused me a disproportionate amount of trouble, including a legal threat from the FSA that caused me to change my U.K. publisher and delayed publication of the book by several months. Last week, compelled by U.K. parliament, the FSA published a 452-page report on RBS.

The passage in my book focuses on an FSA employee called Clive Adamson. He was what my sources called a ‘good old-fashioned bank examiner’, who had been brought over to the FSA from the Bank of England in 2000. By 2007, he was involved in supervising RBS, as part of an FSA division called ‘major retail groups’.

Towards the end of 2007, and early in 2008, as the crisis progressively worsened, Adamson is said to have become frustrated about the poor quality of disclosures that RBS was providing about its capital position. However, Adamson’s ability to act on his concerns was constrained by other forces within the FSA. In the decade since its formation, the FSA had accumulated a hierarchy of risk experts, many of whom worked on the mathematical modelling required for the Basel II regulations. RBS legally exploited Basel rules to the full in order to hold the bare minimum of capital and deliver the maximum return to its shareholders.

Adamson’s critique of RBS, the FSA risk experts said, was tantamount to admitting that the regulator had made a mistake on Basel II, in which it had invested thousands of hours of analysis and negotiation. The tensions between Adamson and the risk experts broke into the open at an FSA internal meeting in the spring of 2008, in which Adamson supposedly described the RBS Basel-mandated disclosures as a “pack of lies” and was reproved for it by a colleague I shall call X. Feeling that the senior management of the FSA was not sufficiently supportive of their position, some FSA staff took it upon themselves to informally contact the U.K. Treasury to discuss how British banks might access capital in an emergency.

The FSA told me that my account was ‘inaccurate’ and not only warned me that naming X would be defamatory, but said that FSA senior management reserved the right to sue me as well. Worse still, the FSA threatened me with criminal prosecution citing provisions in the Financial Services & Markets Act of 2000 intended to protect confidential information passed by banks to regulators. Faced with such a threat, I couldn’t take the risk. I had wanted to make more of Clive Adamson, who I thought was something of a fine fellow, but doing so would have risked either exposing me to legal action or would have exposed my sources.

Eighteen months later, the report itself does provide some indirect corroboration for the passage in my book. There is the context of light-touch, under-resourced regulation of large banks and over-allocation of resources to Basel II. There’s evidence of the poor risk disclosures and defence of the status quo which irked Adamson. We see it in an exchange over RBS’s liquidity that took place in November 2007, where the supervision head of department demanded more information, and a specialist FSA team went back to visit RBS and appears to have been fobbed off.

We also see it in the account of what the FSA calls ‘Pillar 2′ supervision — where banks and regulators engage in dialogue to determine capital levels on top of the ‘Pillar 1′ standard rules.
In late 2007, RBS’s Pillar 2 submission to the FSA was deemed to be of ‘insufficient quality’ by the supervision team, because the bank insisted on estimating capital using a 1-in-40 worst case scenario rather than the 1-in-1000 standard laid down by Basel rules. If RBS had followed the guidelines properly, it would have needed an additional £7 billion in capital, the report says. That calculation didn’t allow for the acquisition of ABN AMRO, which the FSA now admits should never have been allowed to proceed.

So why wasn’t RBS forced to increase its capital by £7 billion in late 2007? Because the FSA would have had to have admit that the Basel rules were wrong. ‘A significant departure’, the report quotes the supervisory team saying, ‘takes some explaining as to why we so massively underestimated the capital impact of the risks facing the group under Basel I’. If I was Adamson, I would have been feeling peeved at this point.

In early 2008 we see the FSA start getting slightly tougher, pushing RBS to focus on a stricter definition of capital – core Tier 1 rather than the arbitrage-friendly Tier 1 – giving the bank a year to increase the ratio to 5.25 percent (for comparison, the European Banking Authority now wants banks to exceed a core Tier 1 ratio of 9 percent).

These capital targets, incredibly weak by modern standards, were too much for RBS in the spring of 2008. In March, the bank admitted falling below the FSA required level, and did so again in April. That month, an internal FSA paper noted RBS’s ‘poor capital planning and forecasting’.

It is the first week of April when things really pick up. According to the report, the FSA’s managing director of retail markets, Clive Briault, left on 7 April, and Adamson was immediately promoted to become acting director of retail groups. Now I don’t want to be unfair on Briault, who took the blame for the Northern Rock fiasco and was forced to quit the FSA as a result. Briault rightly says that the main reason for Northern Rock’s failure was lack of liquidity, something his team was not required to regulate. A similar argument about liquidity is made in the RBS report, and it would be wrong to pin the blame on Briault for the failure of RBS.

That said, his departure and Adamson’s elevation are correlated with a striking change in the FSA’s supervision of RBS. Only 48 hours later, on 9 April, FSA chief executive Hector Sants met Sir Fred Goodwin, and demanded that RBS pursue a rights issue. It is hard to imagine a greater slap in the face for Goodwin, who up to then had thought he was walking on water, unchallenged by regulators or shareholders. After 9 April, he was offering his resignation to the RBS board (they declined to accept it) and the bank was apologising to analysts in conference calls.

The report acknowledges that the £12 billion rights issue and pledges of asset sales by RBS in April 2008 were not enough. Outside the remit of the report are the conversations that took place at the Treasury and Bank of England about RBS during this time. All the report says is that the FSA updated these authorities through the official ‘tripartite’ channels. But were there unofficial discussions between FSA staff and the Treasury as my sources suggested?

Today, Adamson is the head of supervision for the entire FSA, and he is likely to return to his old home as a prudential regulator at the Bank of England when the FSA shuts down next year. Unfortunately, many of the Basel experts whom he jousted with are likely to move over with him.