Will it take another disaster, another crisis, to actually create real reform?
I hope not.
But that seems to be the reality. I mean, that's why [chair of the President's Economic Recovery Advisory Board Paul] Volcker walked out at some point from a speech of Obama's in New York. And one of the things he said to the people around him was: "You know, it's kind of a shame the crisis didn't last longer. We would have gotten more reforms."
Well, we need it. I mean, to me, I would use the technical term it's mind-blowing that, in the wake of this disaster, we wouldn't have had the reshaping of the financial sector that was required. And again, I think that's because the irony of the bailout, which may have been necessary to preclude a depression, saved Wall Street from the true consequences of its reckless behavior.
And, you know, the fact is we look today, and the practices continue. But many of the same people who were in power in the run-up to the crisis are still there. I mean, [former Fed Chair] Alan Greenspan is gone. In many ways, he was the architect of the deregulatory philosophy that brought us down. But Ben Bernanke came out of that school and was -- he did close the lid, finally, on the worst of mortgage lending, but really after the horse was out of the barn. Tim Geithner headed the Federal Reserve Bank of New York at a time when, in fact, many of the reckless practices manifested themselves and crippled the financial system. It's really I think quite remarkable that so many of the practices and people that existed pre-crisis are still running the show today.
Is there some truth to the fact that Washington is soft on Wall Street?
Oh, is Washington soft on Wall Street? I think yes. I do think that in 2009, the Dodd-Frank bill did make some important changes that Wall Street resisted. And the administration stood up, and the Democratic leadership in Congress stood up. But, you know, it's going to take some real work to change a culture that developed over 30 years. I mean, first of all, for 30 years, many regulators approached banks on the basis that they were not so much regulated entities as partners together, when, in fact, the job of public oversight is to exercise public oversight.
In fact, if you listen to some of the testimony given to us during the commission, regulators told us time and time again that they were urged not to be confrontational with banks. But in fact, in the end of the day, what we want are regulators who are. So that culture changes slowly.
Secondly, there is a real mismatch here. I mean, we have regulatory agencies that are understaffed, where pay is not what it needs to be to attract and keep people. What I saw -- and I really wasn't aware of this before I took this position -- but I was struck by the number of people who would work for a regulatory agency for three or four years, and then it was three or four years up and out to Wall Street.
And look, unless we have the political will to back our regulators and then give them the pay and the resources to do their job, it's going to be a mismatch. Look, Wall Street is like a greased pig. It moves fast. It's always looking for the new opening. Hard to catch. And unless you recognize that mismatch, you're going to continue to have Wall Street with victories at the expense of the American people.
The fact is that in the wake of this crisis, there has been very little rethinking of the practices on Wall Street. Why is that? Generally we learn, we grow from the consequences of our mistakes. But Wall Street was spared the consequences of their mistakes. They didn't really pay a price for those kind of practices in any real terms.
And the irony of the bailout is it may have saved the financial system, but it may have done great damage in terms of our ability to have Wall Street rethink what was right, what was wrong, what was sustainable, what was not.
You talk about also ripping faces off. What was that about, and how did it become a widespread sort of culture?
This was a phrase, "ripping someone's face off," that was used on the trading floor to describe when you sold something to a client who didn't understand it and you were able to extract a massive fee because they didn't understand it. The idea was that this was a good thing, because what you were doing was making more money for the bank.
I think over time, particularly during the 1990s, bankers lost this professional ideal of wanting to service the client. They talk about their long-term reputation, but ultimately, people weren't compensated based on the long-term reputation of the financial institution. They were compensated based on whether they could jam a product down their clients' throats and make a lot of money off of it. …
So maybe as a trader, you're probably looking for the dumbest person in the line?
There's a great set of adages on Wall Street about where risk will flow. If you ask people, they're basically split between two camps: One says that risk will flow to the smartest person, the person who best understands it, and the other says that risk will flow to the dumbest person, the person who least understands it.
And at least based on my experience and my understanding of what has been happening in the derivatives market, it's the latter. It's that risk is frequently flowing to the investor, the institution that has the least capacity to understand the risk.
You couldn't do it? What?
I just felt like I was doing something immoral. I was taking advantage of people I don't even know whose retirements were in these funds. So I wanted -- I ended up deciding to work for the other side. By the way, it should be said that this is during the credit crisis, right. This is 2008, 2009. I mean, this is when you're seeing the world collapse around us.
Lehman fell. Lehman owned 20 percent of D. E. Shaw when it fell. It was a real event in our company's life. So the system was clearly failing. My friends were behind in their credit card bills. I mean, I saw sort of somehow the real-life consequences of the recession.
... Interestingly, I think I anticipated them a lot more than a lot of the people that I worked with. I had a lunch with people, and this was after Lehman fell but before Fannie [Mae] and Freddie [Mac] were nationalized -- or bailed out, I should say. I remember having a lunch, and I remember saying: "So how long do you guys think this recession is going to last? How long?" Actually, I think the question I asked the people -- I was [with] a bunch of quants, and most of them were junior, it should be said -- but I asked them, "How long until it's normal for normal people?" Like, "When is the economy going to get back to normal for the average person?"
And I said, "It's going to take 10 years, at least." I just felt like the mortgages, the credit cards, this is such a mess. And I remember making this little speech and saying, "It's going to be 10 years." And everyone around me said: "Oh, you're just so -- you're exaggerating so much. It's going to be two years at most. This is just a small hiccup. Everything's going to get back to normal."
And I remember thinking, OK, you're either totally out of touch with normal people, or you just can't imagine the system any other way. It's like a lack of imagination, or both. I just didn't understand how anyone could think that this crisis was going to be resolved so quickly.
Can you go through that again? Explain a little bit more what you mean by "get ahead of them" and "trade their dumb money," or take advantage of their stupidity.
Right. Well, a lot of these funds -- and one of the reasons people think of them as "dumb money" is that they're actually required by contract, by the prospectus of the fund, to trade in a certain way, to have certain kinds of things in their portfolio, especially near the end of the quarter.
So the idea would be to anticipate, like, how they would not trade at all because they're lazy for most of the quarter, and at the very end say, "Oh, oh, jeez, I should probably do some trading," and then sort of in the last three days of the quarter or something probably true up their portfolio. And that's when we would anticipate that, if we could.
And you were successful at that?
Well, actually, that's sort of -- when I was working on something similar to that, that's sort of when I realized I couldn't do it anymore, so I left.
And just to go back and take this in steps -- and I jumped ahead, sorry, into MF Global because we naturally got there. But let me go back. So you decide at some point in May of 2009 that you're going to leave D. E. Shaw. Do you have an exit interview? Do you have a last chat with [former Treasury Secretary] Larry Summers or any of the other principals there?
I did have an exit interview, yeah. I didn't get the impression that what I was saying was going to affect anything at all. A lot of the people I was hired with in the wave -- I was hired in 2007 -- got laid off after that. So in some sense I think I felt, you know, disgusted with what I was working on, but I also felt like I was inside a sinking ship.
They had hired too many quants too quickly, and the market was just not going to be fertile enough to make the amount of money that they wanted to make to not dilute the bonus pool. So, I mean, it didn't surprise me that a bunch of people left after that. It wasn't a culture that was ready to change.
There was a point at which a light bulb goes off in your own head that the money that you're trying to make is at the expense of pensioners --
-- or people with savings, and what you were witnessing was a huge amount of wealth destruction in the economy.
Right. In some sense, you know, I've thought about it a lot since then. But the way I look at it now is like, you know, how does this pension system work? We all put money into our 401(k)s. We work our lives. We're putting this money in once a month. It goes to Wall Street. Wall Street -- through these ways of managing these large funds, enormous -- I mean, I'm just one of the -- [let me] pause to say the amount of money we're talking about I measured in terms of percentage of GDP [gross domestic product]. This is an enormous amount of money, trillions of dollars.
So anyway, the average person puts this money in once a month. Wall Street takes it and skims off. With the help of hedge funds, but also with just the help of poor trading and bad decisions, it just skims off a certain percentage every quarter, so larger percentages every year. At the very end of somebody's career, they retire and they get some of that back. I mean, it just seems like such a wasteful system in the sense that this is this person's money, and it's just basically going to Wall Street.
To pay bonuses --
To pay bonuses. This doesn't seem right.
So it takes rocket science to -- I mean, -- (laughs) -- these are very complex deals, correct?
They are complicated. But for someone who is well versed in fixed income products or who has been looking at portfolios of fixed income products for a long time, it's not that much of a leap from what they're currently looking at. So if you're looking at individual bonds and loans, already thinking about them on a portfolio basis, and then thinking about the tranches of risk isn't that much of a leap.
OK. But by that argument, why did other banks go forward when your bank and your team decided to stop? So if it's not so complicated, why did so many others keep going, marching toward the cliff?
Look, very simply, there are certainly some investors, some banks, some borrowers who are a bit greedier than they should be. And we decided to stop because the products just got more and more risky. The risk became something that we weren't comfortable with.
You talked a bit about the mentality of a trader, that you can't believe you can be wrong. It's not in their DNA.
I think fundamentally if you're going to be a trader, you've got to be highly opinionated, because you've effectively got to put a position on the table, and if you don't believe in it, it's very hard to do that. To some extent, the real trick is about controlling traders, because traders should take positions, because that's what they're paid to do if they're trading with your money.
At the same time, you've got to put some controls and make sure that they don't get too married to a position, and if it starts to lose money, that somebody decides at a certain point that enough is enough.
But in the case of, say, someplace like MF Global, when you have a charismatic and very strong-willed chief executive like Jon Corzine, the critical question is, is the board strong enough? Are the control processes strong enough to rein him in?
... Good trading is actually quite interesting. You lose money or you make money. The trick is in actually cutting your losses quickly enough and making more on the trades that are right than you lose on the trades that are wrong, because nobody's going to be right all the time.
It's about great discipline, and generally what happens is that discipline breaks down at an individual level. But most importantly, it breaks down at an organizational level. I suppose the best way to think about it is financial institutions are now so reliant on trading earnings, it's almost impossible for them not to take risk. And some of them have no capacity to control that risk taking, because if you go outside of the trading rooms and you look at the senior management, or the hierarchies of management and the board of directors, often they have no familiarity with the instrument that's being traded or with the risks except in the most general terms. ...
They think if you put a process in place this works, without understanding very deeply what the risks are. ... Then in the entire process, if they make money, they look good, and if they don't make money, they tend to sort of dismiss it as a rogue trader.
I read "rogue trader" these days as code for: "I couldn't have done anything. I as the board of directors, I as the senior executives, I as the shareholders, couldn't have done anything." And it's almost like wiping the slate clean. ...
When you look at the bet that Jon Corzine did, was he the dumbest trader yet, or did it make some sense?
I think his bet was not an uncommon one, because most people have underestimated the quantum and the depth of the European crisis. And to some extent, it's kind of a perverse bet on effectively the European bureaucrats and the policy-makers managing to get their act together to save these countries. ...
They weren't able to diagnose the problem in the first place, and going back further, they were the cause of the problem. So to some extent he was in the majority, but the majority in this case turned out to be wrong.
And bankers now believe that no matter what, there's bailouts. There's no moral hazard.
Well, one aspect of a trader's life, which is kind of interesting, is that it's always O.P.M. It's always "other people's money." ... If your bets are wrong and you lose money but you've played by the rules, what's the worst thing that can happen to you? You can lose your job.
But generally there isn't really [any] discipline in the market. So if you're a good trader and have a bad run, you basically end up ending up with a job somewhere else.
Most famously John Meriwether, who was one of the founders of Long-Term Capital Management, which had huge problems in 1998, was subsequently able to raise funds for a new fund despite the problems with Long-Term Capital Management.
Then when that second fund failed, he was actually able to basically raise funds for a third fund. ... If you look at financial markets, there seem to be second, third, fourth, fifth lives. There's no real discipline in that sense.
So under those circumstances, there is every incentive for a trader to take risks. And one of the most curious things about that is if you go around the world, it's not clear nine times out of 10 whether the trader is taking the risk with the tacit approval of management. ...
Every company has a culture. And Wall Street in general has, pejoratively, a reputation for having sort of corrupt values. What were the values that you were exposed to at D. E. Shaw? What were they?
You know, I just want to say that D. E. Shaw is sort of famous for having an academic culture. And I absolutely think that there are other cultures in other places that were a lot more cutthroat than D. E. Shaw. I think, for Wall Street, D. E. Shaw was about as nice as you could get in terms of its culture and its environment, for someone coming out of academics, especially.
Having said that, the basic cultural assumptions were not pleasant to me. The sort of most basic cultural assumption was that as a smart person, we have the right to take advantage of the system and of "dumb people." And that is sort of -- I mean, I guess I should have known, going into a hedge fund, that's what people think.
I was thinking of it naively, more like, "Oh, there's a system, and we should see what inefficiencies there are in the system and add information." I mean, I just sort of drank that Kool-Aid. But once I was inside, I realized that's not really how people think about it. They think about it, like, "Well, of course we're going to take advantage, because we're smart, and we can. Like, we have better tools, and our tools are our brains."
Take advantage of whom?
Take advantage of absolutely everything and everyone that we can, in any way we can.
How long were --
Not -- and just wanted to mention not unethically, like not illegally, although ethics --
Although perhaps maybe unethically, but that's not illegal.
Yeah, that's a good point of saying. It's -- I don't think D. E. Shaw ever does anything illegal. I mean, as far as I know, nothing illegal ever happened. But it was still not -- and yeah, still not particularly moral.
What do you mean?
I mean, I feel like if we could figure out a way to take advantage of pension funds, we would do it.
... There was an example that you gave me of discussing among your colleagues pension fund investments.
Right. So right, so one of the assumptions, one of the sort of underlying assumptions was that there's smart money, and then there's dumb money. ... And most large funds that have rules about how you can invest them are being managed by people who don't have a lot of imagination. They're not the quants. They're not very clever at trading. They're lazy.
So the idea was: "You know, this is called dumb money. Let's just -- let's take their dumb money. Let's anticipate their lazy attitude toward trading, and let's just, like, front-run them. Let's get ahead of them on the trades so we can take some of the skim off some of the pension, some of that mutual fund or whatever it is -- the large fund. Let's take some of that money."
... There are various hearings that took place in 2010 on [Capitol] Hill. Many bankers were brought in and read the riot act. How has Wall Street reacted to that?
I think Wall Street reacted with a mixture of both shock that they are seen as such villains, but in a number of the senior bankers who really think this through, after the initial shock wears off, begin to understand what the causes of the indignation, the outrage are. ...
People are angry at the whole financial system. They call it Wall Street, and they hold Wall Street responsible for engaging in risky trading, in building up lots of leverage, and then taking us all down.
They do. It's a widespread view.
It's not accurate?
I don't believe that the major banks can be held solely responsible for what happened. They played a role. So did housing policy in this country, which made no sense. So did various governmental policies, which in retrospect at least were ill-thought-through.
You don't wind up with a crisis of this magnitude because of one subset of the economy. There had to be many contributing pieces. ...
Describe [the] world of banking in the mid-70s. Is it still sort of George Bailey banking? ...
... The first image I got was when I went to work the first day, the guy I used to work for actually, when he got to work, took off his shoes and put on slippers, and he took off his coat and put on this jumper or sweater. It was a very homely affair, and we were highly regulated.
Basically the government told us or the central bank told us what rate we could pay our depositors and even who we could lend to and what rate we could charge. So it was a very limited world where our role was really like a social role.
We took deposits, made loans on the other side. We facilitated payment mechanisms. We did a little bit of trading, but it was tiny because there were limits on what we could trade and how much risk we could take. So it was almost a social utility is the way I saw it. ...
Gradually and very quickly all of those controls fell away, and so what we saw was a much more deregulated commercial business with new products, basically a completely new world of banking that opened up.
What sparked that change?
I think you've got to go back a little bit in time to the 1970s. The '70s was a period of great difficulty for the global economy. Oil prices rose, ... and we entered a period of quite deep stagnation. There was no growth; there was high unemployment; it was high inflation.
And at the end of the '70s, what happened was there was a change in the political environment with the election of Margaret Thatcher, the conservative leader in Britain. And in the United States, Ronald Reagan came to power [in] 1980, defeating Jimmy Carter. ...
Both Reagan and Margaret Thatcher started to take away controls, and the idea was that if we took away all these controls, the economy would become more vibrant and grow. And part of that was the deregulation of banking, and gradually the increased ability of banks to lend to people who hadn't traditionally qualified for ... loans became almost a catalyst for driving the economy.
I'm not sure anybody sat down in a dark smoky room and plotted this, but as the deregulations went one by one and the economy started to grow, people took this as cause and effect, that this deregulation of the financial system, deregulation of other parts of the economy, was actually generating this growth, increases in living standards and the prosperity. ...
You write in the report that we didn't build jobs; we didn't build wealth; we built a sand castle economy. Explain what you meant by a "sand castle economy" that we built and how this came to be.
Well, I think looking back on it, we're going to see that one of the great tragedies of the years leading up to the crisis, particularly from the late '90s on, is we had cheap capital available, which could have been deployed to build enterprises, to create wealth, to put people to work in this country. But what did we do instead? We created $13 trillion of mortgage securities, many of them defective, many based on loans that never should have been made, many based on loans that were fraudulent.
And in the end of the day, what did we have to show for it? No real wealth creation, but merely the use of capital for speculation and speculation only. In the end, this was not anything about an economy that was creating real value. It was about an economy of money making money all the way along the chain. And you just have to look at the whole mortgage securities industry itself. People were making money at each step in the link, taking money out of the system. And at the end of the day, when the tide came in, it washed [it] all out, and there was nothing left.
Is there an irony in your mind that the fact that who Obama brings onboard as his economic team -- [former Director of the National Economic Council Larry] Summers, [Chairman of the U.S. Commodity Futures Trading Commission Gary] Gensler is involved, Geithner -- were all in the Clinton White House, were there during the later years when they decided to deregulate derivatives, that these are the people that he relies on?
One of the things that's most striking is the extent to which in the wake of this crisis there hasn't been a fundamental rethinking of our financial system and its role in our economy. If you look at the arc of what happened, from the 1980s, 1990s through the eve of the crisis, what you see is a financial system and sector that is more and more dominant in our economy, that's taking more and more risks; in a sense, an economy that is more about money making money than capital being deployed to create goods and value and jobs for the American people.
In 1980, the financial sector represents 15 percent of the corporate profits in this country. By the mid-2000s, that has risen to over 30 percent. The amount of debt in the financial sector in 1978 is $3 trillion. By 2007 that soared to $36 trillion, very much an economy now being driven by the financial sector and by the risky practices it's undertaking.
You would think in the wake of this crisis we'd have a rethinking fundamentally. And I think one of the things that's most troubling is that here we are three years-plus after, and very little has changed. Now, Dodd-Frank [Wall Street Reform and Consumer Protection Act] has made a number of significant changes. But of course there is a fierce rearguard action by Wall Street, by its political allies, to inhibit its implementation. But here we are, three years later, and the over-the-counter derivatives market is still unregulated.
We don't know today the risks that we have in this country from the euro zone crisis. It could be that banks in this country have $100 billion of risk. It could be that it has a trillion dollars of risk. In many respects nothing has really changed in the credit rating agencies. If you look across the board, very little has changed in the nature and operation of Wall Street, and I think that is one of the more stunning aspects of this episode.
You worked very hard for the repeal of Glass-Steagall.
Took hundreds of trips to Washington, worked over many years. There's others that think that is the beginning of the problems.
Yeah, I totally disagree with it. In fact, I would argue that if we would have repealed Glass-Steagall 20 years ago, this problem may not have occurred. I'll go back to what Barney Frank said: If all financial institutions would have behaved like the insured deposit institutions, this crisis would never have occurred.
Now, Barney Frank and I don't agree on a lot -- (laughs) -- on most things when it comes to financial services. We do agree on that. The investment banks were the big problems in this. And I don't even think Citicorp would have got into the problems it did. But it was competing with the investment banks. And it gets back to, our people are going to leave us if we don't do these things.
Now, again, I am not excusing the management. You still should be able to stand up and say: "I don't care if they leave us. We're not going to do it. This is wrong to do." But it's harder to do if you see some competitors out there making a lot of money, taking your people away.
And none of us know for sure if there's a bubble. I mean, this isn't 100 -- if it was 100 percent sure, it would never occur, right? So there is some risk. And I say we're always early. As it gets later in the cycle and it still hasn't happened, I must tell you that some members of my management were questioning whether this was the right thing to do.
What did it kind of feel like at that point to sort of understand some of what was going on, and yet not a lot of people were really talking about it?
I think that at that point in time, it's not as if we all of us talk among each other on the Street. We don't really talk our books. We talk quarterly. Our CFO comes out and tells us, tells the marketplace how we're doing. So it's not as if we're all a team. We are what I would call friendly competitors, and I am always of the belief I hope everyone does well, because we're probably doing well also. Some people feel like, "Well, I'm always competing against you head-on." So everyone has a little different view of how they look at the street.
So there's not a lot of collaboration. Most of our collaboration would be we talk to our regulators, and if they decide to bring us together to have more group speech, then that's fine, but it's not as if we're reaching out to each other to talk about our risks. Actually, that seldom, if ever, would happen.
So I think that in some ways everyone didn't really know each other's risks. I mean, I can take UBS. Most people probably didn't think we were 50 times levered. Most people would not have known that a lot of our funding was overnight or short-term paper. And similarly, we would not have known that Citigroup had SIVs [also called "sieves"], off-balance-sheet [structured investment vehicles].
And I imagine in any event, it's getting pretty addictive. Maybe you can tell me the way the culture starts evolving from the kind of George Bailey banking to all of a sudden, this sort of huge money machine that's probably making everybody just go like they're on cocaine or something.
It is very much like an addiction. And the derivatives markets during the 1990s were very much like an addicted rat tapping to get more and more cocaine year after year.
As the products get more complicated, the bets become more esoteric. It starts off with just bets on interest rates. Libor, for example, the London Interbank Offered Rate, is a popular measure used in bets. Then someone comes up with the idea of Libor squared. Let's bet on Libor times Libor. And then, someone comes up with the idea of Libor cubed, Libor times Libor times Libor. The amount of craziness and the leverage in the system starts to increase. And the people who make money are like the rat tapping, getting more and more of a high from the bets that they've won. And they double down. They make bigger bets. The losers do as well.
So it becomes a market that is infused with a kind of gambling mentality -- lots of complicated bets, lots of speculation -- and also becomes a market where the kinds of bets themselves are more esoteric.
I mean, I remember there was a derivative that was based on the number of times the Utah Jazz basketball team won games during a season. That's not some fundamental economic variable. It's simply pure speculation. And so, there was this surge of risk taking and increasing complexity of the variables that people were willing to bet on.
And the other thing that happens during this period is that there's a connection between the appetite for more risk-taking and the complexity of the math. So the Ph.D. who's down in the basement at Morgan Stanley invents some new complicated way to bet on whether an interest rate will remain within a band a certain number of days in a year. And then, the sales force goes out and markets that to clients, and clients are excited, because they won the last bet. And so, they'll take on this more complicated bet. And what happens very quickly is that no one understands what they're betting on, how much it costs or what the repercussions might be.
Talk about the clients. Who's drinking the Kool-Aid here? Who's getting excited about all these side bets?
During this period, the clients vary in terms of their sophistication. Everyone gets excited about the side bets. But the motivations for taking on more complicated risk differ pretty dramatically. There are hedge funds who are quite sophisticated, and they have a view, and they want to take on a particular risk. But then, there are less sophisticated clients as well.
And one of the things that happens in particular during the 1990s is that pension funds, insurance companies -- these are not as sophisticated as hedge funds. They want to find ways to take on more risk, but do it wrapped in a safe-looking investment. So some people on Wall Street called it the wolf in sheep's clothing. They wanted to find a way to take on a lot of risk, but still have it wrapped in an AAA-rated, very safe looking investment.
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