naked capitalism

Satyajit Das is an internationally respected expert on finance with over 30 years working experience in the industry. He is also a best-selling author and a regular contributor to leading finance blogs – including our very own Naked Capitalism. His new book ‘Extreme Money: Masters of the Universe and the Cult of Risk’ is out now and available from Amazon in hardcover and Kindle versions.

Interview conducted by Philip Pilkington, a journalist and writer based in Dublin, Ireland.

Philip Pilkington: Your new book ‘Extreme Money’ is primarily a story about what our society has become — or rather: what we have become. It tells the tale of a sort of — although I hate to use jargonistic neo-English — hyper-financialised world in which money, or perhaps even the idea of money, has knitted itself into the social fabric and taken over. While there are some fascinating caveats in the book dealing with the inner-workings of this strange world, it is primarily the culture that I wish to focus on here.

So, let’s begin.

At the end of the debt-chains that blew up in the US in 2008 there was tied a mortgage-holder. In your book you describe the architecture that was built up to ensure that people who should not have received these mortgages did. It struck me that it was a remarkably cynical culture that grew up around this industry in the US — far more so than what formed in Ireland, where I’m from. Indeed, an entire dialect of fraud seems to have mushroomed in this industry during this period. Can you talk a little about all this?

Satyijat Das: It goes back to how financial institutions make money – primarily, by lending other people money (that has always been and still remains the core of banking profits). But there are a limited number of people you can lend to who will pay you back. Initially, when finance de-regulated (in the 1980s) there were opportunities to lend to people who were good credits but were restricted in their access to money. However, as banks expanded you exhausted the pool of people who could lend to and then moved onto the others – until you came to people who couldn’t ever really pay you back.

So the trick was to hide or get rid of the risk of non-payment – it became a case of ‘NMP’ (not my problem!) or as it is termed by the finance-crats: ‘risk transfer’. So you made loans that you shouldn’t and then transferred them to people who probably didn’t quite grasp the risk fully or were incentivised to look the other way. It was a culture of fraud and self delusion.

Mortgage brokers just lent to anyone they could find. Once they figured out the game borrowers just lied about their finances – this is why terms like ‘liar loans’ and ‘NINJAs’ (no assets no jobs or assets) sprung up in the mortgage industry. In a way it would have been downright unpatriotic of these consumers not to participate in this game – as remember they were now the engine of economic growth. Even minor players like valuers were complicit. There were ‘drive-by valuations’, where the valuer literally drove past the property in order to assess it. If the property value was insufficient to justify the loan, then the valuer added the required margin for kerb value.

Everybody cynically took advantage of the system that developed. Mortgage brokers didn’t disclose the risk to banks who didn’t disclose them to rating agencies who then rated them at levels inconsistent with the real risk and investors bought this whole nonsense because they were AAA securities. The whole thing took on a momentum of its own as everyone was making too much money to care how it was being made. No one was interested in that quaint thing called the ‘truth’.

The self delusion was astonishing. When the ratings proved to be egregiously wrong, chairman and chief executive Harold ‘Terry’ McGraw III defended S&P: ‘A couple of assumptions we made didn’t work out and we just totally missed on the US housing recession.’

There was the proverbial conga line of people who all participated in and deluded themselves into this the dialectic of fraud. I suppose no one cared as long as they thought it was working and they were getting richer. Predictably it ended in tears.

PP: There’s something so enclosed, so incestuous with those involved in the financial markets. In your book you document how the hedge fund industry in particular displayed this insularity to a rather remarkable degree. Some of your anecdotes remind me of a group of late-adolescent males preparing for a drinking trip or a football match. You worked in and around this industry, what do you make of this dynamic? What effects does it have on the way these people make decisions?

SD: Fraternities; ‘frat boys’ (and they are mainly boys) as the Americans would say. It’s a monoculture. They generally go to the same schools, the same universities; they have similar backgrounds and spend time with each other reinforcing their narrow worldview. Even the few outsiders who make it in – usually by dint of sheer desire and skill, usually in making money – seek to be ‘insiders’. It means that they can only see the world through the same lenses and perspectives. They can’t think outside the consensus – whatever it is at a given time. They can’t see that things could be different to what they perceive it to be.

They also see themselves as superior beings – ‘God but with a better suit’. The reason for their superiority is that they make more money than anyone else which in my view is purely accidental. But in their minds they see money and brilliance as synonymous. David Hare captured this neatly in his play ‘The Power of One’. He has a character, who looks remarkably like Gillian Tett from the Financial Times, say: “These people genuinely believe they’re masters of the universe. And why are they masters of the universe? Because they’re paid fifty times as much as anyone else. So they must be cleverer than anyone else.” Unfortunately, as subsequent events demonstrated, they weren’t that clever; they were just in the right place at the right time, at least for a while.

This culture creates a kind of ‘financial nihilism’ – those on the inside can’t see the consequences of their actions on other people at all. That’s because other people are inferior – outside the bubble. Justin Cartwright in his novel ‘Other People’s Money’ has one of his characters describe how financiers see ordinary people: “The rest of us are just the extras, without speaking parts, just fill in the blank spaces in the frame.” I think that’s accurate – these people really have a weird sense of being always right, not to mention generally superior. They can’t see what damage they have caused. They still think that they were right. The fascinating thing is that ordinary people and even powerful people like politicians actually believed that they were really special. Maybe, they still do.

PP: How disturbing. And this seems to reach all levels, right? In your book you portray the upper-management as vacuous clones. They come across as simply mouthpieces that spout vague jargon in order to ensure that everyone continues to ‘believe’ in whatever it is that they’re selling at a given time. Surely this isn’t the typical picture of an ‘entrepreneur’ taking risks and innovating to make money while shattering bureaucracies and truisms?

SD: It’s amazing how much money you can make just shuffling paper backwards and forwards. Malcolm Gladwell wrote a piece praising John Paulson who made a killing from the subprime disaster as an entrepreneur. But what did he make? What did he leave behind? Paul Volcker, the former chairman of the Federal Reserve, argued: “I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth — one shred of evidence. US financial services increased its share of value added from 2% to 6.5% but is that a reflection of your financial innovation, or just a reflection of what you’re paid?”

Management and directors of financial institutions cannot really understand what is going on – it’s simply not practical. They cannot be across all the products. For example, Robert Rubin, the former head of Goldman Sachs and Treasury Secretary under President Clinton, encouraged increased risk taking at CitiGroup. He was guided by a consultant’s report and famously stated that risk was the only underpriced asset. He encouraged investment in AAA securities assuming that they were ‘money good’. He seemed not to be aware of the liquidity puts that Citi had written which meant that toxic off-balance sheet assets would come back to the mother ship in the case of a crisis. Now, if he didn’t understand, others would find it near impossible. And I’m talking about executive management.

Non executives are even further removed. Upon joining the Salomon Brothers Board, Henry Kaufman, the original Dr. Doom found that most non-executive directors had little experience or understanding of banking. They relied on board reports that were, “neither comprehensive … nor detailed enough … about the diversity and complexity of our operations.” Non-executive directors were reliant “on the veracity and competency of senior managers, who in turn … are beholden to the veracity of middle managers, who are themselves motivated to take risks through a variety of profit compensation formulas.”

Kaufman later joined the board of Lehman Brothers. Nine out of ten members of the Lehman board were retired, four were 75 years or more in age, only two had banking experience, but in a different era. The octogenarian Kaufman sat on the Lehman Risk Committee with a Broadway producer, a former Navy admiral, a former CEO of a Spanish-language TV station and the former chairman of IBM. The Committee only had two meetings in 2006 and 2007. AIG’s board included several heavyweight diplomats and admirals; even though Richard Breeden, former head of the SEC told a reporter, “AIG, as far as I know, didn’t own any aircraft carriers and didn’t have a seat in the United Nations.”

PP: Okay, you say that it’s impossible to tell what’s really behind many financial assets. I think most people would accept that. But a lot of things in this world are uncertain and most of us seem to get by fairly well. Are you sure we’re talking about simple ignorance here or are we talking about willed ignorance? I mean, there’s a fine line between the two but still, at some level these executives must say to themselves, “Wow! I really have no idea what’s going on here! I have responsibility for a great deal of societal wealth, of pension funds, of taxpayer guaranteed money — and yet, I have no idea what I’m doing.”

I don’t want to make it out that they’re all engaged in fraud — I don’t believe that, although some undoubtedly are — but if a doctor can tried and convicted for criminal negligence, then surely we are not dealing with simple ignorance. You’ve worked in the industry; you’ve met these people; what do you think?

SD: It’s silly to think that everybody in finance is ‘evil’ or engaged in fraud (though there are people who assert that). Most people involved are very smart, diligent, hard working and passionate about what they do. Ironically, so were most of the people who created great social upheavals – the Chinese Cultural Revolution, Pol Pot’s Year Zero project, pogroms etc.

It’s ‘groupthink’. They have ways of thinking about the world. They think it’s the right way so they keep trying it again and again. At least until there is a horrendous disruption and then they go: “Oh dear! There’s a problem.”

Take Alan Greenspan. He thought deregulated markets were the solution. He thought that any problem could be fixed by flooding the system with money. He was wrong, but even today he doesn’t really see that his world view is erroneous. They are very good at rationalisation and don’t tolerate dissent.

As for responsibility, they are doing what is accepted practice – they think they are doing the best for their stake holders. Galbraith’s observation is very accurate: “The conventional having been made more or less identical with sound scholarship, its position is virtually impregnable. The sceptic is disqualified by his very tendency to go brashly from the old to the new. Were he a sound scholar… he would remain with the conventional wisdom.”

As you long as you follow convention you are unlikely to be successfully prosecuted or made liable. Ultimately that’s the only purpose of corporate governance – to ensure that by following a set of accepted practices you make yourself and your organisation litigation proof.

That’s what is really interesting about this period of history. I think you parsed it accurately when you said that extreme money changed the world by altering the way we think about money; by embedding it into the social fabric. I would go further though; it changed our ways of approaching problems and thinking. That’s the most interesting thing about it – some would say sinister.

This is also why it’s so difficult to fix. It’s like a shift in our views of the cosmos – does the sun spin around the earth or vice versa? It took a few centuries to change that – despite evidence as to the correct view. I think David Hume was right when he noted: “All plans of government, which suppose great reformation in the manners of mankind, are plainly imaginary.”

PP: One much commented on phenomenon in the financial markets is that they’ve started recruiting very highly educated people, such as physicists. This seems like a total waste of resources – Fukushima melts down, as physicists help create turbulence in the markets. Maybe you could say something about this? But also, in the book you give the impression that, even though these people are highly educated, perhaps even overly educated for their role, they still engage in groupthink. I’d love to get your perspective on that.

SD: Finance has led to a serious misallocation of resources. The best and the brightest moved from real engineering into financial engineering. If you believe that real growth comes from innovation, improvements in productivity etc. then this was a serious issue.

The reasons were also interesting. The supply of jobs in science, for example, decreased as the Cold War wound down and the research jobs in academic institutions and things like the Bell Labs became scarcer. Another reason was the disproportionate rewards available in finance. It wasn’t related to the value created by finance. It was really the fact that financial products were sometimes mispriced because of complexity and lack of transparency and also because it was possible to measure contributions more directly. How do you measure a surgeon’s or nurse’s value in terms of the work they do? In contrast, a trader can tell you immediately what they think they made.

Scientists applied their approaches to modelling to markets. The problem is that it is much more difficult to model financial outcomes than people think because we don’t really understand the process very well. Former Goldman Sachs’ quant Emanuel Derman, a trained physicist, was right when he observed that : “In physics, a model is correct if it predicts the future trajectories of planets or the existence and properties of new planets… In finance, you cannot easily prove a model right by such observations.” Derman concluded that: “Trained economists have never seen a really first-class model.” Most financial models are wrong, only the degree of error is in question. Differential equations, positive definite matrices or the desirable statistical properties of an estimator rarely determine the price of traded financial instruments. So this was all an egregious waste of resources.

Of course, it begs the question why people used these models and spent so much money on them.
The answer to this is quite troubling: it was for a significant part a gigantic fudging exercise. The models were really created to package up relatively simple products and make them more complicated to allow banks to earn economic rents – that is, excess returns – from them. They were designed to arbitrage capital rules and increase leverage. They were also useful in helping banks’ upfront earnings. Everybody appeared very clever, but it was all kind of a fake sophistication. Why would anyone want to trade a dollar/yen double barrier digital knockout with Elvis pelvic thrusts?
None of this appears productive to me, but a lot of resources went into the process. And as everybody was making a lot of money doing this stuff it was hardly in anyone’s interest to stand up and point out the reality of what modern finance had become.

PP: It’s really interesting that you mention the lack of scientific funding after the Cold War. The eminent economic historian Philip Mirowski has noted this time and again. In his books he writes about how scientists found themselves increasingly in oversupply as the Cold War ran down and spending on military research dwindled. He contends that much of the ‘mathematicisation’ of modern economics – that is, the move away from realistic theories that help the public purpose and into ‘pure’ models that don’t really do or say anything – was due to this emigration from the hard sciences. Clearly without the threat of the ‘Evil Empire’ Western governments no longer see as much need to spend on expensive research. I mean, while I’m not hugely keen on the military-industrial complex, at least a lot of this research ended up serving the public purpose when it was released by the military.

Now we’re seeing less interest in real innovation and more interest in releasing our best and brightest into the toxic waste dump that is the financial sector. Without the government to spend large outlays on serious research, these people have moved into the private sector. And since the private sector is geared toward nothing but making a quick buck the results are catastrophic. While it’s difficult to make prognostications do you see any evidence of this changing? In your experience were the scientists you encountered in the finance sector in any way disillusioned with what they were doing? Especially so after the 2008 crash?

SD: You probably need to ask the ‘quants’ that question. After Traders… came out, I was outed as “anti-quant” (whatever that means!).

My observation would be that most people who are honest think the science is trivial. Many really don’t quite get the impact of what they do – it’s a sort of ‘cogs in a machine’ syndrome. I know a few who find their work less than satisfying – it’s a lot like Stfan Zweig’s observations of chess in The Royal Game. “Thought that leads nowhere, mathematics that adds up to nothing, art without an end product, architecture without substance.”

But they have their consolations. They get paid a lot for what they do, certainly more than they could ever make in their scientific pursuits, unless they struck it really lucky. They have also created a fascinating tribal culture – awards, societies, tribal leaders and, naturally, critics (most notably Nassim Nicolas Taleb). The culture would excite anthropologists and ethnographers and you wouldn’t have to go to the Gobi desert to do the fieldwork.

As for changes. It’s hard to make the types of changes that you need. Keynes hit it on the head when he observed that: “the difficulty lies not so much in developing new ideas as in escaping from old ones.” Unfortunately, finance generally approximates what John Kenneth Galbraith astutely predicted does happen: “faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.”

Part II coming soon, in which Satyajit Das and Philip Pilkington discuss carnivalesque ‘money shows’, the function of the financial system, ‘haves and have nots’ and much more…