Credit Derivatives Meltdown & Book Review of 'Traders, Guns & Money'

Regulars to this blog may be familiar with my preference to not comment on contemporaneous events occurring in the markets. The basic reason for this is that I'd prefer to let the dust settle before I say anything about movements in the financial markets (if I have anything to say about it at all). I am making an exception to this general 'rule,' because the credit market meltdown that we are currently experiencing in the global financial markets just happens to coincide with a book review I wanted to write for a long time.

So what is this book I wanted to review that seems ironically (or, perhaps, appropriately) to be the perfect companion to the bursting of the credit/real estate bubble? The book I want to review today is titled Traders, Guns & Money (Knowns and Unknowns in the Dazzling World of Derivatives) written by financial derivatives expert and veteran trader, Satyajit Das.

The most succinct endorsement (obviously, I will give a more detailed endorsement below) I can give to this book is by comparing this book to two of the books -- Fooled By Randomness and The Black Swan -- written by one of my favorite authors, Nassim Nicholas Taleb. In a nutshell, Das' book takes many of the ideas developed and espoused in NNT's books and applies them, in a clinical and detailed (but accessible) way, to the world of financial derivatives.

But a stronger one-line endorsement of this book was given by Frank Partnoy (author of FIASCO: The Inside Story of a Wall Street Trader and Infectious Greed) : "When 'derivatives' and 'f******' appear together on every other page, you know someone has written the truth about financial innovation." (It's worth noting that Partnoy exaggerates the amount of profanity used in the book ... but his basic point is well put.)

In Traders, Guns & Money, Satyajit Das dissects and analyzes almost every aspect of the derivatives industry with the same level of skill and care as an expert crime scene investigator combs through the scene of a crime. No part of the derivatives world escapes the attention of Das. Sell side, buy side, over-the-counter (OTC) derivatives, risk (mis-)management, 'quants,' structured products, equity derivatives, credit derivatives (much more on this later), and even more exotic derivatives (like weather and carbon emission derivatives) are covered in this fascinating book.

Das uses several underlying themes or frameworks throughout this book. One of these themes/frameworks is his use of semi-fictionalized narrative -- presumably, based on his own long career in the derivatives industry -- to highlight the dark side(s) of the derivatives world. This is reminiscent of the style used in NNT's books (Das even has his own 'Nero'; although Das' Nero is more like NNT's Fat Tony ... in fact Das' Nero would make Fat Tony look like a debutante). Das' 'war stories' are salacious, but, more importantly, they serve the purpose of exposing the real world workings of the derivatives industry to naifs.

Another theme/framework Das employs throughout his book is a somewhat Popperian one: 'knowns' and 'unknowns.' Das categorizes the workings of financial derivatives into one of four categories based on permutations of knowns and unknowns. There are the 'known knowns' -- things that we know that we know and, thus, can have a high degree of certainty about. The second category is 'known unknowns' -- things that we don't know but we know that we don't know them; this adds a degree of uncertainty but it is manageable uncertainty (similar to NNT and Benoit Mandelbrot's "mild uncertainty").

The third category is rather fascinating to me when I first heard it: 'unknown knowns.' These are things that we know but we do not realize (or, many times, we don't want to realize) that we know it! This may sound far-fetched, but I think Das is correct to articulate this category. An example that Das cites to illustrate 'unknown knowns' is the idea of greed and fear that underlies the derivatives game. No matter what people may say (and even believe, to some extent) about derivatives as a tool to hedge risk, add liquidity to markets, etc., the almost unsaid truth is that the motivation behind trading derivatives is greed and the fear of missing out on greed. This is an 'unknown' known because the players have incentives to not admit this to others (or even to themselves) because it is, at the very least, impolitic to 'know' this known.

The last category are the 'unknown unknowns' -- the "things that you did not know you did not know" (p. 12). This is the most problematic category because the degree of uncertainty in this category is virtually unbounded. This is like NNT's "Black Swan" (or "wild randomness").

Lest one is tempted to think this is all idle philosophizing, as the book highlights along the way, both the 'unknown knowns' and 'unknown unknowns' seems to pervade the derivatives industry.

One of the 'unknown knowns' that Das book does a great job of exploring is the mythology of financial 'engineering.' Many business schools and economics departments would like to beatify quantitative finance by removing the messy realities of the real world and 'cleaning' (over-simplifying) it up so that it resembles something like civil engineering. Academic and industry naifs would like people to believe that Black-Scholes, Cox-Rubenstein, Miller-Modigliani, etc., turn derivatives valuation into something akin to bridge building (and, as the recent tragedy in Minnesota shows us, even bridge building is a lot messier in the real world than in textbooks).

Das does a lot to explode these myths. Yes, Das would concede, fancy quantitative models can help, but there are serious weaknesses with copulas, implied correlations, dynamic delta hedging, etc. In other words, model risk, basis risk (basically, comparing apples to oranges), marking-to-model or to a market when there is no liquid market for the instrument, liquidity risk and flight-to-quality, etc., will forever doom even the geekiest and 'greekiest' models to getting blind-sided by negative Black Swans.

Along the same lines is how Das' book exposes the dark underbelly of many derivatives contracts. Many (if not all) the textbooks and technical literature on derivatives seem to think that derivatives are created and structured by Mother Theresa's Sisters of Mercy. These other books/papers will describe vanilla call, put, forward/futures, swap contracts but will have next to nothing on 'exotic' derivatives, structured products, special purpose vehicles, credit derivatives, etc. Even books/papers that touch on OTC and exotic products tend to take an unrealistic and unworldly view of things; i.e., they seem to unskeptically accept the propaganda of sell side traders/derivatives salesmen that they are 'client-centric' and that they would 'never' try to hide anything or slip in financial equivalents of ticking time bombs into their derivatives products.

Fortunately, Das -- having been on both the buy and sell side of the business -- doesn't believe that derivatives salesmen and traders have taken a vow of chastity. Das exposes many of the hidden details in real world -- as opposed to the idealized models one sees in textbooks -- derivatives contracts/products. And, not surprisingly, these details show that derivatives aren't the seemingly innocent ways to make markets more 'efficient' as we've been led to believe. There is sketchy accounting, hidden leverage (often massive), outlandish terms, and other ugly and sordid details.

For example, one semi-fictional example of contractual shenanigans that Das gives is almost comical (if you have a mathematical bent) if billions of dollars weren't at stake. One swap contract would have had a near-bankrupt company pay $4 million a month to a dealer in exchange for the investment bank paying the company an amount based on the following formula/algorithm (adapted from pp. 10-11):

Max[0; $600 million * {7 * [(LIBOR^2 * 1/LIBOR) - (LIBOR^4 * LIBOR^-3)]} * days in the month/360]

If you know basic algebra, then you would realize that this term will always equal zero! [Hint: The LIBOR terms.]

There are many other aspects of this book that I can highlight and praise, but the remainder of this post will focus on the intersection between Das' book and the current turbulence in the markets: namely, credit derivatives. The current market meltdown -- as summarized in the current issue of The Economist -- revolves around collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), and mortgage backed securities (MBS) [for the purposes of our discussion, we can consider all three to be virtually interchangeable]. It just so happens that Das' book contains the best overview of credit derivatives that I am aware of.

The problem that credit derivatives products are causing right now in the markets are complex and hard to describe in the limited space of this blog. However, I can very briefly outline the problems below:

(1) Credit derivatives, like CDOs, are causing problems right now, in part (again, it's much more complex than what I can get into at this point), because they are basically untradeable and unhedgeable at this point. Why? Because the assets underlying these credit derivatives -- for the most part real estate mortgages (but there are other kinds of debt, like corporate debt, at play here too) -- have tanked in value because of the rising levels of defaults and the increase in the (subjective) probability of defaults.

(2) That's not the only problem. The other problem is that investments in these credit derivatives vehicles/products are structured into what are called tranches. That is a fancy way of saying that different classes of investors in credit derivatives will get paid in different ways. The 'equity' and 'mezzanine note' holders are taking a bath on this freefall in the CDO 'market' (I use that term loosely, since much of this is OTC) since they had lower priority in cases where some of the holdings in the credit derivatives portfolio defaulted (i.e., they took the risk in return for the rewards, and the chickens have come home to roost). The catch here is that senior note holders who had the highest priority are also taking a beating. This came as a surprise to them (but, according to Das and to my way of thinking, maybe it shouldn't have been) because most of these CDOs are structured so that the senior notes will get the highest possible ratings by credit rating agencies -- AAA. Now, the senior note holders are finding that AAA might as well be FFF.

(3) To make matters even worse -- and this happens in virtually every market crash (bursting of asset pricing bubbles) -- investors, banks, etc., are compelled to sell assets in order to limit losses and/or hedge risk. The problem is that this is either hard to do and/or makes things even worse. Obviously, they want to get rid of non-performing and/or illiquid assets, but they can't right now (if ever) because they're heading toward worthlessness. So they have to sell off 'good' assets, which means that prices of assets that at first blush seems to have little to do with CDOs, MBSs, mortgages, lending, banking, etc., also fall precipitously. I.e., correlations are created when there was little or none before!

(4) To top it all of, there is a LOT of leverage involved (both explicit and implicit). Leverage makes downturns even worse. For example, the need to meet margin calls is what is causing the sell off that I described in point (3).

That's a nutshell description of what is happening now in the financial markets. Like I said, it is much more complicated than that I'm sure, but if you can follow what I just wrote, then you're probably more knowledgeable than the vast majority of the people who bought and sold CDOs over the years.

Getting back to Das and how his book relates to the current tremors in the markets ... Das' book is the only book that I'm aware of that gives an accessible account of the workings and structure of credit derivatives, including both financial and legal issues surrounding them. Chapter 9 of his book -- considering the mess we're in -- is well worth the price of the book in it of itself (although the rest of the book is just as great if not better)! I would go so far as to say that Das essentially predicted the current crisis over a year ago (the book was published last year, 2006).

The intersection between Das' book and the market meltdown brings us back to the theme of knowns and unknowns. Goldman Sachs has admitted that its hedge funds -- keep in mind that hedge funds have been big buyers of credit derivatives -- have been "hit by moves that its models suggested were 25 standard deviations away from normal" (from The Economist article). This is, in terms of standard Gaussian mathematical statistics, akin to saying that it was impossible for these losses to take place. Guess what ... the losses took place!

Apologists for hedge funds, investment banks, credit agencies, and investors may claim that these are what Das might call 'unknown unknowns.' How can anyone think that a (negative) 25 sigma event would take place? How can anyone know that credit rating agencies' grades are not worth the paper they're printed on when you need to count on them the most? Etc.

The problem with this line of argument is that these 'unknown unknowns' were actually known .. we just didn't want to admit that to ourselves. Nassim Nicholas Taleb, Benoit Mandelbrot, and -- as this blog post outlines -- Satyajit Das, have been warning us about these kinds of Black Swans for quite a while. Chance of a 25 sigma event taking place? Impossible from a 'normal,' bell curve perspective. Quite likely, from the Black Swan way of thinking.

The lesson we can learn from the NNTs and Das-es of the world -- those rare individuals who can combine sincere humility with the courage to face and embrace inconvenient truths -- are that the 'unknown unknowns' are really 'unknown knowns.' We actually know that 'impossible' events can take place because we should know that our pretentious models and heuristics are vulnerable to the messiness of the real world. The problem is that we don't know -- or, more accurately, we don't want to know -- that we know. That kind of self-knowledge is too painful to our ego, too inconvenient, and too humbling.

But ask yourself the question: Isn't it better to feed yourself humble pie rather than having it hurled at your head as is happening to so many traders and bankers now?