Robert Redford: Derivative Salesman?

I was pointed by Naked Shorts to a dispiriting Bloomberg article about iffy derivative sales ("schools flunk finance"). It's a long piece; my handy summary goes as follows (to strains of the Entertainer in the background):

I. The Setup: A Pennsylvania school board is badly short of cash, its buildings are crumbling and it cannot afford new textbooks.

II. The Hook: An investment bank salesman (the "Mastermind") introduces a school board representative (the "Mark") to an independent derivatives advisory firm (the "Patsy").

III. The Tale: Together, the Mastermind and the Patsy blind the Mark with a dazzling presentation on the merit of selling swaptions for premium. Conveniently, the premium plugs the hole in current year education budget. The Patsy assures the Mark of his independence and technical competence, persuades the school board to execute a transaction with the Mastermind and provides a fairness opinion.

IV. The Sting: The Mark executes a transaction with the Mastermind, inevitably at the wrong price. The Mastermind pays the Patsy a fee out of his spoils (huh? Yup). Subsequently the transaction turns sour and the Mark loses a lot of money. The Patsy is subsequently investigated by the FBI on municipal antitrust matters, while the Mastermind has vanished to close in on the next mark.

OK so I stretched the analogy a bit. But there are a slew of issues here:

(a) the acceptability of the school board assuming a particular financial market risk (in this case, the writing of a swaption). I won't comment except to note we only hear about the trades that go wrong. The article would be less compelling if the school board had pocketed the swaption premium and the option had expired worthless.

(b) the price paid/received for the assumption of the chosen risk. Quoting Bloomberg:

"School districts don't know whether they're getting fair market values with swaps because the contracts are private; they don't know how to compare their deals with those done by other districts."

Erm, how about three quotes from different dealers on the trade date, rather than a single quote supported by a fairness opinion from a chop-shop in the pocket of the investment bank trying to close the deal? I suppose school board districts can't pay superintendents much so is it any surprise they exhibit investment grade naïveté in these sort of dealings.

(c) the gullibility of the "independent derivatives adviser". It must be exhilarating for them to be joint pitching with real investment bankers. They become playas in the big leagues! You can imagine the beer and backslapping after the deal is done, after the banker strolls off with a huge profit and coughs a paltry $60k to the Patsy. And then the angry resentment when the independent adviser's activities, not those of the bank, become the subject of regulatory scrutiny when the deal implodes.

Yes, derivatives salesmen are experts at getting deals done, any way, any how, and with an army of in-house counsel to make sure their trail is wiped clean. The traders behind them know how to extract every last cent of profitability or fees from their transactions. (OK the traders all lost money on mortgage products, but that was a warehousing decision and is a separate issue).

So let's assume you work at a Pennsylvania school board, or a Swiss private bank, an Australian life insurance company, a German corporate treasury, a UK Pension administrator or any one of thousands of other buyside entities, supposedly with sufficient expertise that an investment bank can classify you as a non-retail customer.

The more complex the structured product, the more opportunity for agents to extract fees at your expense. Do you have a handle on the investment cost and risk profile of everything you own? An interest rate swaption is a pretty vanilla instrument; could you describe all the ways banks squeeze money from, for example, a CPDO? I found eight without much thought, only half of which are explicit in transaction documentation. (For a primer on CPDOs, not particularly complex in reality, there is only one place to go.)

Admitting you don't know is pure alpha; you will not claim to have any edge and this may put you off involvement in the product. If you claim you do know where the fees are, banks want you as a customer. You don't know. Really, you don't. Hang on, I hear you shouting that you're actually smarter than that, so you do know. Read carefully: Listen. Buster. You. Don't. Know.

Still, the risk/reward profile of a particular structure might actually be useful to you, provided you are rewarded appropriately for the risk. Again, let's use a CPDO as an example. There are always more efficient ways of assuming a similar risk profile than entering into a nicely packaged transaction - simply buying a solid vanilla floater and selling enough iTraxx/CDX OTC protection for your target yield enhancement would get you close enough not to worry much. iTraxx/CDX_IG default swaps are quoted on pretty thin bid-offer spreads so you're not ceding much value. (If you got really twitchy and closed it all out when your mark-to-market was down 90%, it would would be an even closer a representation of a CPDO).

If this alternative is unavailable to you, for example, because your trustee documentation forbids trading derivatives, why on earth should it be OK for you to access those derivatives just becuse they were wrapped up in a funded structure with a pretty rating?

The derivative salesman will do anything to get the deal done. If that means spending countless evenings schmoozing you in restaurants and, ahem, afterwards, it will be done with faux camaraderie. So remember this: as you dab your sweaty upper lip while the dancer gyrates round your paunch, your investment banking "friend" is eyeing you with equal measures of contempt and avarice. As WOPR, the computer in the film War Games, eventually concluded, "the only way to win is not to play". The banking salesman exists because you exist.