naked capitalism

One of the continued frustrations of the post-crisis period is the lack of discussion of looting, which as described in a seminal paper by George Akerlof and Paul Romer, is when executives find it more profitable to gamble on bankruptcy, as in lever up their companies, pull out too much in cash (usually with the help of overly flattering accounting) and leave failed businesses in their wake. Akerlof and Romer noted that businesses with explicit or implicit guarantees were particularly well suited to this sort of extractive behavior, and they argued the savings and loan crisis was a prototypical example. In ECONNED, we argued that the producers and management of major capital markets players were engaged in a looting 2.0 in the runup to the crisis.

Roger Ehrenberg, who had a long career in derivatives and now runs an early stage venture firm. He describes how easy it is to, as he puts it, “rob a bank” or loot. His formula:

1. Go to a fancy college, do well in math, CS and stats, and study those brain teasers that trading desks love to give applicants. If you didn’t go to a fancy college, work yours and your parents connections to try and secure a position. Absent connections, leverage your alumni network. Do whatever you need to do to get an interview.

2. Trade a little on your own, so you can say “I trade my own book” when asked, and have a trade idea in mind when you go for the interview. You will be asked this question.

3. Once you get the interview impress, show passion, intensity and how you are laser focused on making tons of money for your firm (and yourself). Take chances, be brash, stand out from the crowd.

4. Congratulations, you did it! Join the trading desk as a go-fer, indentured servant, whatever. Ask lots of questions without being annoying, and make sure you are studying the mechanics of how trades get done and how they get reflected in the firm’s risk systems.

5. Gain the confidence of others, build reputation, and position yourself for securing your own book. This can take a little time but be patient: It’s worth it.

6. When you get your book, really understand how P&L recognition works. If P&L is calculated on concepts like “inception gain” or “theoretical profit,” you’re in good shape. Also figure out the implied cost of capital. If your firm is charging you LIBOR flat, yippie! Another good fact. If it’s LIBOR plus a credit spread for the duration of the trade, less good but you can live with it if your P&L has the right revenue recognition characteristics.

7. What you’d now really like to do is enter into a large notional amount of longer-dated, short volatility trades. Book profit as theta decays, assuming you don’t blow up. if you do, well, your downside is zero and you can get a job at another firm for even having been in the position to take such massive risk. If you don’t, well hey now, all that time decay flows right to your bottom line. And with a large enough notional amount, your 8-12% of P&L can add up to some serious coin.

Did you create value? No. Did you trade well? If being lucky counts, then yes. And if you get paid and shortly thereafter the chickens come home to roost and your book blows up? Well, you’ve just robbed the bank!

Note that this strategy is all about trading against your employer, as in understanding and exploiting deficiencies in its management information systems. And it would also be easy to BS management about it. Short vol is a classic dealer trade, usually a bet on mean reversion when mere mortals get nervous about risk. It normally works out pretty nicely unless markets get more freaked out and you lack the capital to ride out the losses from having gone short vol too early and/or too heavily levered (which is exactly what did in LTCM).

I bet savvy readers have other formulas for fun and profit at the expense of the house.