Assumptions and Extraordinary Personal Profits

Let's consider the simple heart of what credit derivatives are all about. A major investor has the opportunity to make an attractive-looking investment that involves taking a risk. For instance, a bank or insurance company sees an opportunity in lending to a corporation, but they are concerned about the financial safety of the corporation. They would prefer to keep most of the positive returns from the investment, but not take the risk of the company defaulting. So, as the employee of a company that creates financial derivatives (a credit swap in this case), what you do is promise – for a fee – to take the risk for them. Your company makes assumptions about how bad the risk will be, and based on those assumptions, you determine that this trade is profitable for your employer. You then personally take a nice chunk of those profits in your next bonus as a reward for having been smart enough to get your company into this lucrative transaction. And because this upfront booking of expected profits from these transactions is so lucrative, not only do you get an enhanced bonus -- but so do the other members of your group, your supervisor, their supervisor, and the president and other senior officers of the firm.

Now, this is not to say that you and the other members of your group have entirely assumed the risk away. You make some allowance for the possibility that out of all these contracts that you're entering into, you may have to actually make some payments. To cover the possibility of losses, you set aside a reserve, or buy a credit derivative from another company to cover, or both. The key to your bonus this year is the particulars of the assumptions that your group makes about what those expected losses will be in the future. The lower the assumption for expected losses, then either the greater your profits in a given transaction, or the more competitive your bid, and the greater your chances of beating out competitors who are seeking the same “lucrative" business.

For example, if your firm is being paid $12 million to guarantee payment of a $500 million loan for ten years, and your group assumes there is a 4% chance of having to pay out $250 million on that guarantee, then your expected losses are $10 million – and your firm’s expected profit is $2 million. This is shown in the top chart below, “Making Money With Credit Derivatives”.

However, let’s say that your group comes back and re-examines those assumptions. You find that if you make fairly minor and quite reasonable appearing changes to two of your assumptions, the potential loss on the derivative drops from an expected $250 million down to $225 million. Make two other minor changes in other assumptions that are also each individually reasonable, and the chances of that loss occurring drop from 4% down to 3.5%. As shown above in “Making A FORTUNE With Credit Derivatives”, rerun the numbers with a 3.5% chance of losing $225 million – and your expected losses drop to $7.9 million, while your profits just doubled, going from $2 million to $4.1 million!

Now, it quickly becomes clear to any reasonable person that if you can double the profits your firm recognizes on a transaction by keying in four small assumptions changes on a computer model, each of which sounds individually reasonable, and the end result of those changes is to double the bonus you get paid this year – then the key to making some serious personal money is making the right assumptions! Something that is equally plain to your peers at competitive firms.

The Vital Role Of Competition

Ah, competition! Competition is where the process starts to get interesting over time. Competition for credit derivatives business, for these easy profits, means that you and others in your company have powerful personal incentives to make aggressive assumptions about how low credit losses will be, and to validate your co-workers assumptions as well. If your assumptions are not aggressive enough, you don't win any business, you don't earn bonuses, your bosses don't earn bonuses, and you are quickly out of a job.

The institutional culture then very quickly becomes that if you want to keep your job – you and the other members of your group make aggressive assumptions. If you want to make big bonuses – you make very aggressive assumptions about how low the losses will be on the credit derivatives, which then translates into increased business for you. And yes, other people will need to sign off on your group’s assumptions – but they are in the same institutional culture as you are, with their own personal reward systems that are based on the company making money. Also keep in mind that even the internal (theoretical) watchdogs are put in place by senior management, who have their own incentive structure, which is based on the company making lots and lots of money this year.

In a free market, where all the employees and senior management of all the financial firms want their piece of this lucrative action, the first thing that happens is that the firms with aggressive assumptions keep the firms with conservative assumptions from getting any business. And then, because we have competition going on here, in the next stage of the cycle, the very aggressive assumptions firms take the business from the merely aggressive assumption firms. Then in the next cycle, the people making the very, VERY aggressive assumptions take the business away – and the bonuses away – from the merely very aggressive assumptions makers.

To understand this process – you have to understand just how much money there is to be made by playing the game by its own rules, which may have very little to do with maximizing long-term shareholder value. Personal bonuses can be millions per year (with far higher payouts for hedge fund managers). As an individual who is in the right place at the right time – you can make more money in one good year than a doctor or airline pilot will make in a career. Except there is none of this medical school, or being on call, or flying over the Pacific Ocean business involved, there’s just sitting at a desk and manipulating some numbers while working the phone. As a corporation you can mint profits by the billions and tens of billions, without going through that messy business of actually building things, or selling toilet paper, or drilling for oil in two miles of ocean or such.

A Real World Case Study: Subprime Mortgage Derivatives

Where does this take us? What happens when firms compete to make ever more aggressive assumptions in the pursuit of some of the most extraordinary profit levels in the history of business, in nearly unregulated markets? As it so happens, we have a pretty good case study that is still unfolding for us right now, in a real world derivatives market that is tiny in comparison to the overall credit derivatives market. In the case of the subprime mortgage derivatives market, by the time the very, VERY aggressive assumption makers had bested the very aggressive assumption makers, hundreds of billions of dollars of mortgage loans were being routinely extended to people:

1. With poor credit histories of repaying their prior loans;
2. Who put no equity into their homes;
3. Whose self-reported and sometimes unverified incomes barely qualified at the initial teaser rate; and
4. Who had no known means to come up with the additional money when the mortgage reset upwards from the teaser rate to the real rate.

Of course, you don’t need an MBA or PhD in finance to understand the problems with the loans above. That said, there are ways to make very good money through lending to subprime type borrowers – but you need a way to deal with the foreclosure losses other than just assuming that the losses won’t occur, or that when the musical chairs ends and everyone sits down, it will be the other firms who are left standing.

Because, it just so happens that home buyers of limited means with bad credit and no savings often can’t pay their mortgages when the payments skyrocket, and this leads to quite real losses that puncture all the levels of assumptions and risk passing. And these real losses do end having to be borne by investors after all, with implications that are still shaking the overall financial system. (This subject is covered in detail in the article “The Subprime Crisis Is Just Starting”.)

Sure, there were red flags everywhere – obvious, glaring unmistakable warning signs. But no one really cared. Indeed the investment banks were ignoring their own due diligence reports, because it was a party where enormous personal wealth was being “earned” – and paid out in entirely real and spendable bonuses – so long as you played your role in the game aggressively, with no rewards for those who doubted.

(Eminently respectable senior executives from the most prestigious financial institutions in the world might very well strenuously object to the content of this article, and insist they have very tight internal controls that make this treatment ludicrous. The credit derivatives market is a complex place, with a huge array of different types of derivatives, and there is more to the internal setups than we can cover in this simple article. That said, when you hear some eminently respectable senior executive on TV speaking of standard deviations and assuring you that you have nothing to worry about – do keep in mind that such assurances are being delivered “buck naked” so to speak. The subprime crisis really is in process, the mistakes made were not “Black Swans” but of the simple human greed variety, and as in the story “The Emperor’s New Clothes”, the lack of clothing is difficult to deny.)

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