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Defusing weapons of wealth destruction

BOOKS on investing tend to fall into two camps.

At one end are the self-help books – get rich quick with nine amazing secrets for making millions – while at the other are the more serious technical tomes that cover the intricacies and entrails of various investing approaches and also serve the dual purpose of being effective doorstops or cures for insomnia.

When you pick up a book dedicated to derivatives trading you would probably expect it to fall clearly into the second category. But as we learnt courtesy of the global financial crisis you should never judge a derivative by its cover – or even its credit rating. So here we have a racy read complete with colourful expletives.

Traders Guns & Money was written by Satyajit Das, early entrant into the byzantine world of derivatives trading with a CV that includes stints at the Commonwealth Bank, Citicorp, Merrill Lynch and as treasurer for the TNT group.

The book was first published in 2006 – before the global financial crisis kicked in – but it offers an interesting perspective given all that we now know about the power of things like credit derivatives and the wealth destroying cocktail that investment bankers mixed up and sold to the world as a way of managing and diversifying credit risk.

Das paints a very unflattering – indeed chilling - picture of the world of derivatives trading. A world where the naked pursuit of money is all that matters, clients simply seen as targets to be separated from their money and a world where products were deliberately bundled into highly complex, leveraged transactions both to maximise fees and make it virtually impossible for clients to follow or understand the risks.

While writing Traders Guns & Money from an insider’s perspective Das – clearly disillusioned and frustrated with the world he was working in – was sounding a clarion call about how it would all end. Sadly he predicted it with a lot more accuracy than the world’s economic and central bank gurus.

He identified the move of investment banks into the market as the shift which really saw derivatives go into overdrive: “The entry of investment banks into credit markets provided the impetus for derivatives on credit. It was to be the biggest party since the beginning of derivatives”.

He also tells the story of a German banker from a commercial bank bemoaning the recruitment of a team of hotshot investment bankers. “The investment bankers make a lot of money. They rape and pillage our clients. Then they move. They always do. Then we will go back to real banking. Lending money. Good normal banking.”

Spoken before the global financial crisis those words resonate strongly in the aftermath today.

It is a pity more central bankers and regulators did not read Das’ book because – admittedly with the benefit of hindsight – the dangers were clearly identified, page after page, along with the motivation – unadulterated greed. Perhaps reading it in 2006 they thought it was more a work of fiction than the real world of derivatives trading.

While the former head of the US Federal Reserve Alan Greenspan saw derivatives as a modern and positive way to “unbundle risk and thereby enhance the process of wealth creation” Das makes the point that as fast as banks unbundled risk the derivatives product developers bundled it back up again and sold it to investors.

When you look at the diagrams of how CDOs were structured it is a case of wondering why anyone thought that was going to be sustainable.

In reality traders like Das knew it couldn’t – and certainly were not blind to the lies being spun around the products -  but what mattered was the next trade/bonus earned.
Our capitalist system puts a lot of faith in market power and competition. Clearly that failed us all when it came to credit derivatives so now the ball is firmly at the feet of the regulators to see what they can do to stop Das having the material to write a sequel.

For investors and advisers Das’ book is an educational read and it reinforces a fundamental lesson of investing – if you don’t understand what you are investing in keep your money in your pocket.

* Robin Bowerman is Head of Retail at index fund manager Vanguard Investments Australia. To receive this column by email each week go to www.vanguard.com.au and register with smart investing.

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