The Undertakers of Capitalism
Commercial credit is the creation of modern times, and belongs, in its highest perfection, only to the most enlightened and best governed nations. It has raised armies, equipped navies, and, triumphing over the gross power of mere numbers, it has established national superiority on the foundation of intelligence, wealth, and well-directed industry.
âDaniel Webster, US Senate speech, March 18, 1834*
NOVEMBER 2007
âHey! Whatâs going on with risk right now?â
I looked up from a row of four monitors covered in blue windows flowing with computer code, a financial matrix only a select few understood, but whose outputs made the world go round. The speaker was Jonathan Mann, âJMannâ in the trading floorâs argot. He had a golf club slung across his shoulders, his arms draped over its ends, a blasphemous image of Christ financial.
Credit spreads, the FICO scores of the largest companies in the world, were exploding, meaning the worldâs financial faith was withering. The crucifixion was an apt metaphor.
âNot sure. Weâll look into it, JMann,â I replied, barely looking up from my four computer screens. His bloodshot eyes fixed on me for a moment, then he retreated to his desk, which featured even more screens than mine.
JMann worked for Goldman Sachs trading credit indices, basically lumped-together sets of credit bets on large corporations, almost like mutual funds. Unlike in the world of stocks, prices in the credit world werenât determined by some vague premonition of future value, but on the perceived future probability of corporate death. In credit land, there were only ever funerals, no weddings or baby showers. By betting on death, we were the bookie undertakers, gambling on either this or that company living or dying.
JMannâs malfunctioning index was not my real problem, though. General Motors was my problem. Southwest Airlines was my problem. Ford Motor Company was my problem. I looked over my screens at Charlie McGarraugh, the Yale math grad who traded airlines and auto companies, and whose quant manservant I was, building sophisticated pricing models for the abstruse derivatives that paid our bonuses, and maintaining the clean flow of data that gave us a view on this cutthroat world. As per usual on days like today, he was worked up into a lather screaming price quotes, either at people on the floor or into his phone headset. Rob Jackson, his junior trader, was next to him entering trades into a risk system, to be digested by the code I wrote, producing the pricing models that let traders navigate this precarious world, and guide yet more trades.
What was the value of the full faith and credit of United Airlines? Whatever the fuck Charlie McGarraugh said it was, as he was the âmarket makerâ in airline credit for Goldman Sachs. The broker of public perception, he was both the marketâs conduit and its lion tamer, buffeted by market forces out of his control, but also warping the market according to his predatory designs.
For two years now, Charlie had been betting on the demise of Americaâs anemic auto industry, plus the death of several airlines. We were always just one Ford Pintoâesque safety recall, or several months of high jet fuel prices, away from a truly gargantuan windfall. One could easily imagine the sardonic grin on Charlieâs pale face if news of a United jet crashing into a mountain were to flash across his Bloomberg terminal. Thanks to me, he could tell exactly how much money weâd make if that happened. But even with the growing housing credit crisis, industries like cars and planes remained creditworthy. The damn planes stayed up, fuel prices stayed down, and no one figured out what a piece of shit the 2008 Pontiac Vibe was.
Even amid the perpetual convulsions of fear and greed that possessed everyone on the floor, reason would occasionally out. Like a rock-bottom alcoholic contemplating his vomit-stained sheets through the haze of another postbender hangover, you occasionally asked yourself: How did I get here? How could I do this to myself? Where was the humanity?
I joined Goldman Sachs after five flailing years in a physics PhD program at Berkeley. At the time, my graduate stipend (taxable as income!) was the princely sum of $19,000.
The average salary at Goldman Sachs in 2005 was $521,000, and thatâs counting each and every trader, salesperson, investment banker, secretary, mail boy, shoe shiner, and window cleaner on the payroll. One of the few things I took from my sordid grad student pad was a copy of Michael Lewisâs Liarâs Poker, that classic of the Wall Street trading genre, for reference.
My job on arrival?
I was a pricing quant on the Goldman Sachs corporate credit trading desk.* That means I was responsible for modeling and pricing the various credit derivatives that the biggest credit-trading house in the world traded. Weâll get into what a derivative is in a moment. More important at Goldman Sachs than the âwhatâ was the âwho.â
Goldman Sachs was unusual among Wall Street banks in that it had mostly kept a partnership management structure. Hence, every incoming employee was hired by a specific partner, and you were that partnerâs boy. My feudal liege lord was a short, balding guy with an intense stare and oddly biblical name: Elisha Wiesel. Elisha was none other than the only son of Elie Wiesel, the famous Holocaust survivor whose horrifying Night is required reading for many American high schoolers. His father may have been a Holocaust luminary and a public intellectual, but his son was a vicious, greedy little prick.â
His lieutenant, my boss, was a Caltech mathematics grad from my home state of Florida. Ryan McCorvie (âRTM,â per the three-letter acronym everyone was known by on the internal messaging system) was tall and gangly, with twiggy arms that emerged from a potbellied, ectomorphic body. His one flash of personal color was a tattoo of the infinity symbol on his forearm, studiously covered while at Goldman.*
There were other characters in this drama too.
The traders were crafty and quick-witted, but with little technical sophistication and the attention span of an ADHD kid hopped up on energy drinks and Jolly Ranchers. Their role was to trade with Goldman clients and other traders at rival firms, posting prices to buy and sell securities and their derivatives, all the while both hedging their books and making smart bets with the firmâs money. It was like juggling flaming chain saws while dancing a jig on top of a speeding train.
The sales guys were complete tools, with a collective IQ safely in the double digits. Their only role was to woo and ply clients with potential trades, presenting the glib appearance of trading savvy and market control, and then skulking away to a trader and begging for a special price for a client trade.
And the quants, called âstrategistsâ or just âstratsâ in Goldman-speak? Mostly failed scientists like me who had sold out to the man and suddenly found themselves, after making it through years of advanced relativity and quantum mechanics, with a golf-club-wielding gorilla called a trader peering over their shoulder asking them where their risk report was. We were quantitative enablers, offering the new and shiny blessings of modern computation to the old business of buying and selling. But giving sophisticated models and fast computers to traders was like giving handguns and tequila to teenage boys. The quants were there to make sure the guns were loaded, but also to make sure the traders didnât shoot themselves in the foot.
Though crucial to the drama, we werenât terribly appreciated. In fact, we were basically the tradersâ little bitches, and any quant who was honest with himself realized that. In time, we quants developed knee calluses from genuflecting to service the traders on whose profits our livelihoods depended.
The only time we quants shone was when some particularly hairy deal came up, and a befuddled trader dropped off a thick bond indenture document, pleading for help. Peering into these deals was like looking at the zoomed-in penetration shot in a cheesy porn video: you could barely tell which end was up, which part was which, or, more important, who exactly was screwing whom. The quant aspect, involving detailed matters of future risk and optionality, almost didnât matter in the end. One lacrosse-playing Penn graduate would agree on price via phone with another lacrosse-playing Cornell grad, and life would resume its speedy course to another deal.
Quants were the eunuchs at the orgy. The fluffers on the porn set of high finance. We were the ever-present British guy in every Hollywood World War II film: there to add a touch of class and exotic sophistication, but not really consequential to the plot (except perhaps to conveniently take some bad guyâs bullet).
There were some rewards. When the markets presented an apocalyptic Boschian landscape, every Goldman grunt, sergeant, and general would close ranks and form a Greek phalanx of greed. Unlike almost every other bank on the street, Goldman could actually calculate its risk across desks and asset classes out to five decimals. The partners, who had much of their net worth wrapped up in Goldman stock, held tense meetings and came up with a plan to save the foundering ship. Favors were called in. Clients squeezed. Risks very quickly hedged and positions unloaded. Despite the mayhem (and all the promises of drama in Liarâs Poker) I rarely saw anyone lose their cool for longer than two seconds. We bled, but others died, and you felt fortunate to have a front-row seat at the biggest financial show in a generation.
Whatâs a derivative? Here, Iâll create one for you. I just signed my name on a slip of paper. If my writerly reputation takes off thanks to the book that you (and hopefully a million other people) are holding in your hands, then that slip of paper becomes an autograph, and could be worth thousands in the sweet by and by. If, alternatively, I die in complete obscurity, that signature is worth zero; less than zero, youâd pay someone to dispose of it. The noteworthy details are that the derivative holds no intrinsic worth of its own, and rather derives its value completely from some other thing: in this case, my authorial renown. Also important is how wide its value can swing; a banker would call this âhighly levered.â It could be nothing, or it could be thousands. While the underlying value of my writing skill will fluctuate within a relatively narrow band even if Iâm successful, in the improbable event of literary immortality, that derivative can be worth very much indeed (or nothing at all).
Whatâs a credit-default swap (CDS) then? A CDS is like car insurance, except it protects a pile of money someone has lent, rather than a pile of glass and steel called an automobile. Some asshole keys your car and destroys $500 of value; the insurance contract pays you that amount. The thing gets stolen? The policy pays out the total value of the car. Credit-default swaps work superficially the same way. You lend someone money in the form of a bond. They donât pay you back, or pay you back only partially? The guy who sold you the CDS makes you whole again, and you recover what you lost by lending money.
Here the similarity ends, however.
Unlike with car insurance, with CDSs anyone can get a policy on your car, even if he or she has no material interest in it. In other words, people other than the car owner can insure it. Not only can they take out a policy, they can write one as wellâthat is, act as their own mini-GEICOâand offer to repay losses. If the price of insurance is too high given the risk, and badly mispriced in some way, then greedy market players will be happy to sell you some. Perhaps they know you keep your car in a garage in an otherwise dangerous neighborhood, and therefore insurance for you is needlessly expensive. Or perhaps the opposite: theyâre car thieves and plan on stealing it, and want to profit both from stealing your car and from cashing in the insurance claim on it. And so they buy a policy before they commit the theft. Wall Street does that too.
âCreditâ is the third-person singular conjugation of the present tense of the Latin verb credere, âto believe.â Itâs the most exceptional and interesting thing in the financial world. Similar leaps of belief underlie every human transaction in life: Your wife might cheat on you, but you hope otherwise. The online store you paid may not ship you your goods, but you trust otherwise. Credit derivatives are just the explicit encapsulations of such beliefs, in financial and contractual form, for corporate entities. Unlike other financial securities, such as shares of IBM stock or oil futures, a...
