Reuters Magazine: Felix Salmon: The devil in the CDS

(Reuters) - The world of international finance is largely incomprehensible, even to its practitioners. Consequently, a whole industry, of which I am personally part, has sprung up to “explain finance” to the public. This makes the public think that understanding finance is something that is possible.

On top of that, finance is particularly susceptible to the kind of hubris that one finds in people who think that if they’ve made millions of dollars, they must be the “smart money,” with an edge not only over the public but even over their fellow bankers and financiers. That, in turn, sets up some very easy morality plays. When the inevitable nemesis arrives, the weaknesses of the erstwhile Masters of the Universe are exposed for all to see, and those of us whose job it is to Explain Finance take every opportunity to spell out exactly what these prideful men got wrong. They weren’t smart, they were stupid!

If very intelligent, successful, and aggressive men like Robert Rubin, John Thain, or Jon Corzine could be so stupid, then, realistically speaking, everybody was stupid. And if everybody was stupid, then, in reality, nobody was quite as stupid as we now think they were.

In the immediate aftermath of the financial crisis, a lot of books came out pointing fingers and assigning blame. We wanted to know why the crisis happened, how it happened, and whose fault it was. Inevitably, these books took on a political tinge - none more so than the final report of the Financial Crisis Inquiry Commission, which was disowned by all the Republicans on the commission for reasons that were intellectually dishonest but politically expedient. As the FCIC concluded, the crisis was avoidable. But the problem with assigning blame is that everybody tends to exonerate themselves and their friends: it’s much easier to just blame others. As a result, no one ever learns any lessons. What we really need, in the wake of the Great Recession, is less fingerpointing and more insight. Happily, there is a surplus of insight in two recent books on subjects that have left the smartest people in the room looking dumb.

Nicholas Dunbar, author of “The Devil’s Derivatives,” is that rarest of animals: A genuine expert on the structured products at the heart of the crisis who is not afraid to tell the truth about just how harmful they were. Dunbar has spent his career in the structured-finance trade journals, which sets him apart from all the authors who had to try to work out what on earth was going on only after the world started falling apart. More importantly, Dunbar was one of the best-sourced journalists in the field long before the financial crisis hit.

Lots of big-name journalists tried to understand structured finance after the fact and many of them had long acquaintances with very important executives at big Wall Street banks. But getting people to talk to you honestly after the world has blown up is pretty much impossible. To know what people were thinking in the years when the sector was booming, when the seeds of disaster were being planted, you needed to be talking to them at the time. And that’s exactly what Dunbar was doing.

Dunbar’s also special in that he wasn’t just talking to the senior Wall Street executives who tend to get wheeled out in front of the press on a regular basis. That’s lucky, because those executives, as we now know, didn’t really have a clue about what was going on. Instead, Dunbar was talking to midlevel traders and brokers and investors and regulators - the full apparatus of market participants who collectively managed to get everything so spectacularly wrong.

Dunbar’s great at taking the long view of things, and you won’t find a better explanation, anywhere, of why banks shouldn’t mark their assets to market. This isn’t an easy book to read, but it’s a necessary book to read, because it reveals the deep structure of the crisis as no one else has managed to do, using real-world examples to explain, for instance, how ultra-safe credit ratings and massive yet unpredictable market volatility were two sides of the same coin. And if you want to understand credit default swaps (CDS), this is the first and last book you should read. Dunbar explains with ease how the CDS became the perfect instrument for banks looking to engage in regulatory arbitrage: they essentially allowed banks to turn credit risk, which required lots of capital, into counterparty risk, which didn’t.

Dunbar provides old-fashioned shoe-leather reporting here, too, especially in the portions covering the New York Fed and the way it treated banks like Citigroup (regulated with a feather touch) and Goldman Sachs (which officials insisted should get back one hundred cents on the dollar in the contracts it took out with AIG). Supine regulation was a huge part of the reason why the crisis was so bad in the United States and much less severe in places like India and Canada. Dunbar names names. And he ends with a perfect epigram, from “The Master and Margarita,” by Mikhail Bulgakov:

“During your act you made bank notes float down from the ceiling. ... Today, when I came to check the till, there was nothing in it but a lot of strips of paper.”

“Oh dear, dear, dear!” exclaimed the professor. “Don’t tell me people thought those notes were real?”

If Dunbar’s focus is on highly complex financial inventions, Emanuel Derman’s “Models.Behaving.Badly.” is more concerned with the nature of reality, and how the question of what is real, and what isn’t, relates to the financial crisis. Derman used to be a “quant,” one of the nerdy rocket scientists who built models of how markets work and how they can be arbitraged. Today, however, Derman is more of a philosopher, and though this book was written to explain what went wrong during the financial crisis, it’s actually quite different: A heartfelt philosophical volume about models, their uses, and their misuses.

Derman’s book opens with a memoir of his youth in apartheid South Africa, a touching passage that immediately puts you on notice that you’re not reading a dry tome about mathematics. Apartheid was, of course, a model of the world, and it’s easy to see how Derman ended up with a lifelong mistrust of models after being forced to live with that particular one for so long. The rest of the first section of the book is a fascinating explanation of the many different types of models there are and how they can be used. It is followed by “Models Behaving,” a love letter to physics and physicists. (Like many quants, Derman is a physicist by training - as is Dunbar, curiously enough.) This section shows the awesome power of what can be done with a model when it gets things absolutely right.

By the time we come to the properly financial portion of the book, we’ve learned what models are good for and the ways in which they can fail, and Derman makes it easy to see just how stretched past their breaking point models tend to become when they’re used on Wall Street. There’s no real specificity here: Derman goes into no detail at all about the models that caused the crisis. For that kind of analysis, you’re better off with Dunbar. At times, Derman can be a bit too enamored with the elegance of pure physics, which has a tendency to take anything it can’t calculate with accuracy and simply define it as not-physics, and thus as something fundamentally uninteresting, like chemistry, perhaps, or engineering. But Derman, a quant himself, understands only too well how finance types think, and when he describes the beautiful discoveries of Newton or Maxwell or Feynman, you can begin to see the attraction of the super-precise quantitative mindset that is so very dangerous on Wall Street.

Human complexity is always best approached modestly, without the kind of certainty that is common to financiers and scientists. The lesson of these books is that we got too cocky, too sure of ourselves, and paid a terrible price for doing so. But cockiness, too, is a fundamental human trait, which is why I’m deeply pessimistic that anything will really change in the future. Just as a long history of rogue traders never seems to prevent another one from popping up somewhere, it’s equally certain that our long history of financial crises won’t be slowed down or stopped by the magnitude of the one that began in 2007-8. There will be more such crises, and they will probably be even worse than the one we just lived through. And although they might not be caused by credit default swaps or models designed by physicists, they will certainly be caused by people who are very sure indeed of what they’re doing.

Felix Salmon is Reuters finance blogger. Any opinions expressed are his own.