The Devil's Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . an

304 Pages·2011·1.5 MB·English

by  Nicholas Dunbar

Copyright

Copyright 2011 Nicholas Dunbar
All rights reserved
No part of this publication may be reproduced, stored in or introduced into a retrieval system, or
transmitted, in any form, or by any means (electronic, mechanical, photocopying, recording, or otherwise),
without the prior permission of the publisher. Requests for permission should be directed to
[email protected], or mailed to Permissions, Harvard Business School Publishing, 60 Harvard
Way, Boston, Massachusetts 02163.
First eBook Edition: July 2011
ISBN: 978-1-4221-7781-5
For T
Contents

Copyright
Foreword
Introduction: The Siren Song of the Men Who Love to Win
ONEThe Bets That Made Banking Sexy
Introduction to derivatives. Long-term actuarial approach versus the market approach to
credit. Goldman Sachs sees opportunity in default swaps. The market approach vindicated
by Enron’s bankruptcy.
TWOGoing to the Mattresses
The advent of VAR and OTC derivatives. The collapse of Long-Term Capital Management

(LTCM). A fatal flaw is exposed. The wrong lesson is learned.
THREEA Free Lunch . . . with Processed Food
A new market for collaterized debt obligations (CDOs). Risky investments, diversification,
and the role of the ratings agencies. Barclays finds investors for its CDOs, only to fall out
with them.
FOURThe Broken Heart Syndrome
J.P. Morgan and Deutsche Bank dominate the European CDO market. Innovation outpaces
the ratings agencies. Traders make millions with the help of correlation models. Reasons
for concern.
FIVERegulatory Capture
The Fed lessens the restraints on big banks. Regulators are unable to keep pace. Banks

abuse the system. Government agencies miss the chance to rein in the abuses.
SIXBurning Down the Housing Market
A boom in the demand for CDOs. Subprime bonds and a new kind of default swap help feed

the demand. Housing bubble begins to burst. Dealers bet against their own deals.
SEVENThe Eyes of Satan
The secret history of shadow banking. Cash gets subverted by subprime. Ratings agencies
jump on the structured investment vehicle (SIV) bandwagon. Skittish investors flee the
market.
EIGHTMassive Collateral Damage
A flood of toxic assets undermines confidence in the market-based system. Goldman Sachs
takes advantage. Investors bet on the collapse of the banks. Disaster is imminent.

Governments prop up the system.
Epilogue
Appendix
Notes
Acknowledgments
About the Author
Foreword

What follows represents my interpretation of and commentary on events based
on my long experience in the field of financial journalism. The views that I have
reached and set out in this book are my own, and I have come to them based on
my impressions from the people whom I have spoken to and the documents that
I have reviewed.
Introduction: The Siren Song of the Men Who Love to
Win

It is safer to be a speculator than an investor. . . a speculator is one who
runs risks of which he is aware and an investor is one who runs risks of
which he is unaware.
—John Maynard Keynes

On a chilly winter’s evening in 2003, I went out to an exclusive nightclub in
London’s Knightsbridge district favored by bankers and hedge fund managers.
My senses were assaulted by thumping dance music as I followed my friend who
was weaving across a dance floor thronged with leggy Russian blondes and the
men who love them. There were acquaintances under the strobe lights: I spotted
the global head of interest rate trading at a big German bank shimmying up
against a pair of microskirted brunettes who towered over him. We then went up
some steps and came to the closed door of the VIP lounge—which had its own
doorman. The door swung open and we continued our way to a low-ceilinged
room, the VIP lounge within the VIP lounge. There, sprawled across low sofas
and thick cushions were bankers celebrating their annual bacchanal, which is
also known as “bonus season.”
There were a few Brits and Americans there, but most of the revelers were
continental Europeans wearing well-cut Italian suits and well-pressed dress
shirts, with their Hermes ties long ago cast to the winds. They either sipped £30
whisky sours or topped off their glasses from £400 bottles of Belvedere vodka.
This was London before the smoking ban, and the glowing tips of cigarettes
could be seen tracing formulas in the air as bankers sketched out the key details
of their wildly successful deals for one another. I knew about some of them:
there was the head of financial institutions derivatives marketing who forgot
which of his Italian supercars had been towed off to the car pound. There was
the head of credit structuring notorious for preying on female staff and having
his corporate credit cards stolen by prostitutes. These young men—and almost
all of them were young, some shockingly so—were the avant-garde of the credit
derivatives boom, enjoying their first, fifth, or tenth million; outside the door of
the VIP lounge, the Eastern European blondes were waiting to pounce on them.
There are many sobriquets for these young lions, but I like to think of them as
the men who love to win.