Wall Street Is Totally Out-of-Touch and Has Completely Lost It

Mitt Romney at Caster Concepts (Mitt Romney photo by davelawrence8 on Flickr.)

Here is how totally out-of-touch with reality Wall Street really is and why they have zero credibility on the issue of financial regulation.

In a New York Times story about the resignation of Ina Drew, the JP Morgan executive who oversaw the trades that led to a $2 billion loss, a former senior executive told the Times:

“The bank has taken bigger losses in investment banking and elsewhere, but because of the timing, she is being piled upon as this huge failure.”

Perhaps Wall Street types simply don’t understand big numbers the way the rest of us do. It’s not “the timing” that’s the problem here. It’s the money. $2 billion is a freaking huge amount of money. $2 billion represents the median family income for one full year for 38,525 American households. At the current rate of federal support, $2 billion would keep Planned Parenthood’s 800 clinics across the country up and running for over 28 years. And this exec just lost $2 billion. On a bet. That’s a huge failure, any time it happens, any way you slice it.

And a few weeks ago, when reports surfaced that a London-based JP Morgan trader nicknamed “the London whale” or “Voldemort” had made such huge bets that it was distorting parts of the credit derivatives market, Jamie Dimon, the head of JP Morgan, just blew off the concerns as a mere “tempest in a teapot.” It turned out to be more like a tornado in a Ming vase. The breakage was significant. And the latest reports suggest that the losses could eventually reach $4 billion.

It’s these brainiacs who want us to listen to them and gut the Dodd-Frank bank reforms and go back to the good ol’ days of un-regulated derivatives trading.

Derivatives were once described by Warren Buffet as “financial weapons of mass destruction.” Derivatives are so complicated it makes your hair hurt just to read a little about them. If you’re doubtful, read this 30-page 2009 Overview by Stanford Professor Kay Giesecke. I’ll save you some time searching for the really juicy parts. Just take a gander at this:

“Assume the default times are totally inaccessible and that exp(AT ) is integrable for a fixed horizon T > 0. We use the measure change argument of Giesecke & Zhu (2010) to develop a formula for the conditional Laplace transform φ(u,t,T) = E(e−u(NT −Nt) |Ft), u ≥ 0.”

By way of full disclosure, I don’t have a clue what this means. And the overview continues like this for 30 more pages.

The kind of derivatives contract these Masters of the Universe sell to people every day can run to 600 pages, and many of the investors who buy these instruments — like the guys who run your small-town pension fund — have no idea what the CDS contracts are really worth. They have to take the word of the guy in a $3,000 suit who’s selling it to them. There’s no transparency, which simply means that Wall Street firms like to keep prices secret from everybody but the buyer, so nobody can compare one deal with another to figure out if they are about to be screwed. It’s like buying a used car without ever being able to look up what any other 2004 Ford Fusion with 120,000 miles has ever sold for in the past.

If you want to get down in the weeds a little more, read F.I.A.S.C.O. by Frank Partnoy, a former derivatives trader for Morgan Stanley. Or read The Big Short or Liar’s Poker by Michael Lewis, the hugely talented guy who also wrote Moneyball. He used to be a trader for Salomon Brothers. The books are great reads, and both Lewis and Partnoy write of a culture of people who often use the phrase: “I am going to rip their face off!” And it’s not their worst enemy that these traders are talking about like that. It’s their customers — like that guy who runs your pension fund.

And good ol’ Mitt Romney, late of Bain Capital, the guy who likes to fire people, says on his website that he’s also on the side of those who want to repeal the Dodd Frank bill. Romney, the guy who wants to be president, is squarely on the side of Voldemort and the guys who want to rip your face off. Isn’t that a comfort in these trying times?

  • Howard


    Sticking with my attempts to provide reasonable and thoughtful comments on your posts, a few observations / questions –

    1. I struggle to understand how JP Morgan’s $2 Billion loss is somehow an argument for the Dodd-Frank legislation. Exactly how would / did that already-passed legislation prevent what happened here? Perhaps this is an argument for *other* regulation – but how is it an argument for the current regulatory regime?

    2. Is the purpose of regulation to institute financial entities from risk of any losses? If so, we should ban them from trading, lending or borrowing too. Shouldn’t the real purpose of regulation here be to prevent our critical financial entities (the ones whose collapse would pose systemic risk to our economy) from collapsing? If there isn’t systemic risk involved and a bank fails due to stupid decisions, that’s the way things go… other businesses fail all the time due to bad decisions. Does a $2 Billion loss for JP Morgan rise to that level of risk? The stock price change after the disclosure would suggest not. Again, not an argument for no regulation – but I wonder why this particular loss justifies new regulation when it doesn’t appear that this rises to the level of systemic risk just as much as I wonder how it justifies that existing regulation which, again, did nothing to prevent the loss.

    3. You are doing some pretty crazy cherry-picking when you use that academic quote to explain how complicated derivatives are. One could do precisely the same thing with stocks themselves – if the math in the quote you provided makes no sense to you, try researching mathematical models of stock price forecasting. Or, for that matter, many non-financial things.

    4. I question that premise that people need to deeply understand all the fancy math one could get into before making the right decisions – in investing or otherwise. If that were true, physicists would be the best pool players. I have played pool with physicists; they aren’t particularly good by and large. My line of work involves, among other things, optimizing marketing budgets using some fancy math. My clients don’t need to understand the finer details of non-linear regression to make the right budget decisions with the summaries that I may provide them.

    5. I’m not a finance guy. While I understand the math bit that you quoted in your column (I am a math guy), I don’t understand all of the derivatives stuff at a deep level. Consequently, I do what I bet you do as well – I don’t invest in derivatives. It’s not like derivatives investing is hard for non-savvy small town pension funds to avoid. If they’re buying that stuff and don’t understand it, then the governance and regulatory problem isn’t on the seller; it’s on the buyer.


  • Barry

    Dear Howard,
    Glad you asked –
    1) The final implementation of the Dodd Frank bill has still not happened – in part because it was complicated – and in part because Wall Street has been doing everything it could think of to delay implementation – including bringing lawsuits to stall it – hoping that someone like Romney will be elected president – you can read a little about that here: http://bankcreditnews.com/news/cost-benefit-provision-could-cause-dodd-frank-implementation-delay/4080/

    2) No one has suggested that Wall Street should take no risks – that is not the issue. But there is a huge difference between an investment in something like a new manufacturing facility – that may or may not make a go of it – but will be something that creates value – and wealth if it is successful – and making a gi-normous leveraged bet on something happening or not happening. Taking giant positions in CDS’s when you don’t own the underlying assets that are “being insured” – is just like Sky Masterson (from “Guys and Dolls”) betting on which sugar cube a fly is going to land on. It can produce nothing of value even if it is successful.
    3) The crazy cherry picking is backed up the the 30 page overview – (link provided in the piece) – and extensive literature – like The Big Short – and the other books – that show that the purpose of many of these CDS instruments is not to “invest” or to “hedge” – but rather to create and impenetrably complicated instrument that is opaquely priced so that traders can “rip somebody’s face off.”
    4) You have a very interesting line of work – and you offer your clients something of real tangible value – that in a worst case scenario – is overpriced – or ineffective. Incomprehensible CDS instruments – can not only cause a loss of all the money invested – it can cause losses that are even greater than the amount invested – just the same way short selling can result in huge, ruinous and totally unexpected losses.

    5) The proposed regulation of the Derivatives market would make it more transparent – and make prices more easily discoverable – some proposed regulations would prevent people from taking large positions when they didn’t own the underlying asset – preventing them from trying to distort the market – there have been lots of proposals of just how to institute the fine print of Dodd-Frank. But Wall Street has pushed back against anything that would curb – or expose to public scrutiny – their efforts to take advantage of that small town pension fund director. Real honest to goodness free markets need both transparency and price discovery.
    Thanks for asking and congrats on being good at math.

    Barry Nolan