Speaker 1: Bloomberg Audio Studios, Podcasts, radio News.
Speaker 2: Hello and welcome to another episode of the Odd Lots podcast.
Speaker 2: I'm Tracy Alloway.
Speaker 3: And I'm Joe Wisenthal. Joe Yes.
Speaker 2: In the recent episode with Kaiser Quo, you dropped at
Speaker 2: the very end because you said you were hoping that
Speaker 2: no one was listening. You dropped that you are coming
Speaker 2: round to complex financial products.
Speaker 4: You know what, I did drop a little bomb there
Speaker 4: at the very end of the episode because it's something
Speaker 4: I've been thinking about more and more, and I'll just
Speaker 4: lay it out very quickly what I think about, which
Speaker 4: is the one of the most influential episodes we've done
Speaker 4: in a long time in my mind, was episode we
Speaker 4: did with Ricardo Houseman, who were either recently talked to
Speaker 4: or about to talk to depending on when this episode
Speaker 4: comes out, et cetera. About complexity is a good thing.
Speaker 4: That's a sign of when wealthy economies are capable of
Speaker 4: producing complex products. That's usually signed they get wealthier. That's
Speaker 4: mostly discussed in the manufacturing sense. And then lately I've
Speaker 4: been thinking, you know what, there are some wealthy countries
Speaker 4: that produce really complex stuff that aren't manufacturing. The UK,
Speaker 4: the US, et cetera. Mostly much of it is sort
Speaker 4: of complex financial products. Maybe we need to rethink and
Speaker 4: maybe we need to sort of take a fresh light
Speaker 4: about why the market is willing to pay the creators
Speaker 4: of complex financial products so much. And maybe they're not
Speaker 4: as bad as sort of some of us thought, or
Speaker 4: maybe we maybe we should be more proud of our
Speaker 4: financial creations, lean into them a little bit more, lean
Speaker 4: into you.
Speaker 2: Know, complex financial products.
Speaker 3: Because if there was this.
Speaker 4: Other thing too, like in like early twenty tens, where
Speaker 4: people are like all the great minds were working on,
Speaker 4: you know, building derivatives when they should have been doing
Speaker 4: something else, and then they went and built like social
Speaker 4: media and like products to hack our attention to sell ed.
Speaker 4: Was that so much better?
Speaker 3: Anyway?
Speaker 4: I don't know, Like maybe it's like time to rethink
Speaker 4: the positives of finance in the world great financial crisis
Speaker 4: that was history. Let's remember the good at parts. Anyway,
Speaker 4: it's just been on my mind lately, all Right. I
Speaker 4: didn't know you were gonna, like to her say, like, Okay,
Speaker 4: now you have to do a whole episode defending this position.
Speaker 2: Je, Well, I'm being nice. I brought this, I brought
Speaker 2: you the perfect guest to discuss all of this, and
Speaker 2: I mean, really the perfect guest. So this is actually
Speaker 2: someone I've wanted to get on the podcast for a
Speaker 2: very very long time. I used to work with her
Speaker 2: at the Financial Times. I worked for her at the
Speaker 2: Financial Times for a while. We're going to be speaking
Speaker 2: with Gillian Tet. She is, of course a columnist for
Speaker 2: the Ft and head of King's College at Cambridge. Jillian,
Speaker 2: welcome to the show.
Speaker 5: Well, it's great to be on the show. And I
Speaker 5: think Tracy, I often felt like I was working for
Speaker 5: you at the time. You were so much smarter than
Speaker 5: the rest of us, and you really blaze into trail
Speaker 5: in many of these discussions.
Speaker 2: Well, thank you so much for saying that. I hope
Speaker 2: my boss is a Bloomberg. Are listening, Yeah, I give
Speaker 2: a bonus straight away. You, of course basically wrote the
Speaker 2: book on derivatives, Fool's Gold, which came out at a
Speaker 2: very fortuitous time two thousand and nine, So right after
Speaker 2: the two thousand and eight financial crisis. Talk to us
Speaker 2: about the genesis of that book, because I think a
Speaker 2: couple years before when you started working on it, I
Speaker 2: don't think a lot of people were thinking, oh, we
Speaker 2: need to write an entire book on how we got
Speaker 2: these things called credit default swaps.
Speaker 5: No, well, most people aren't quite as weird as me.
Speaker 5: But the reality is I'm trained as a cultural anthropologist,
Speaker 5: which might sound like it's got nothing to do with
Speaker 5: Wall Street, And in fact my PhD was based on
Speaker 5: field work looking at marriage rituals in Tajikistan, so that's
Speaker 5: not your obvious starting point. But one thing that cultural
Speaker 5: anthropology teaches you is so as human beings, we all
Speaker 5: wrap ourselves up in assumptions and ideas we inherit from
Speaker 5: our cultural surroundings, and those often make us very blind
Speaker 5: to things that we ignore in our world. Social silence
Speaker 5: really matters. It's what we don't talk about that really matters.
Speaker 5: And starting back in about two thousand and five, when
Speaker 5: I was running the lex column at the Financial Times,
Speaker 5: I noticed that newspapers and politicians talked obsessively about equity
Speaker 5: markets and sometimes credit markets and bomb markets. But actually
Speaker 5: when you looked at what was driving revenues in the
Speaker 5: city of London, whereas based at the time, it was
Speaker 5: actually things like derivatives and credit derivatives, which no one
Speaker 5: talked about because they seemed to be geeky and technical
Speaker 5: and incredibly dull. But the reality is that things that
Speaker 5: look dull and boring to a point we don't discuss
Speaker 5: them are often the most important things in the world.
Speaker 5: So I became kind of fascinated by this underbelly of
Speaker 5: the city of London and Wall Street. I used to
Speaker 5: say that they looked like icebergs, in that you had
Speaker 5: a bit poking above the surface that people talked about,
Speaker 5: which was the equity markets, and a shadowy chunk than
Speaker 5: everyone and ignored. So I dived in really, starting in
Speaker 5: two thousand and five, into the world of credit derivatives,
Speaker 5: initially to try and almost do a tourist guide to
Speaker 5: what was happening there for the wider Financial Times readership.
Speaker 5: This was a few years after the dot com boom,
Speaker 5: and in the same way that my colleagues had gone
Speaker 5: around explaining the Internet, I thought I could explain financial
Speaker 5: innovation and see what was really going on. But of
Speaker 5: course it turned out to be considerably more deceptive and
Speaker 5: challenging and ultimately more dramatic than I ever imagined.
Speaker 4: It really is extraordinary vindication on your part, because the
Speaker 4: book came out in May two thousand and nine, so
Speaker 4: at that point, like people were just getting up to
Speaker 4: speed and it was all anyone to talk about. And
Speaker 4: here you were years ahead and you already are like,
Speaker 4: here's the book then you all have to read now,
Speaker 4: which is just, I mean, an extraordinary vindication of your
Speaker 4: choice to like begin down this path of looking into them.
Speaker 4: Tracy and I were both in London in a and
Speaker 4: I loved it. It wasn't my first time there.
Speaker 3: I loved it.
Speaker 4: Extraordinary wealthy society. I know there's all this anxiety in
Speaker 4: the UK is like, oh, you can't like build stealed
Speaker 4: anymore economically all this, I get it. There are some issues,
Speaker 4: et cetera. But people are willing to pay a lot
Speaker 4: of money for the services that the city provides all
Speaker 4: around the world and make it one of the richest
Speaker 4: richest societies ever to exist on Earth.
Speaker 5: Well, I have to be honest and say that I
Speaker 5: did not originally expect to be writing a disaster book.
Speaker 5: What actually happened was I spent the summer of two
Speaker 5: thousand and seven writing the book and finished it in
Speaker 5: September two thousand and seven, went back to work, thought
Speaker 5: the whole thing was done and dusted, and at that
Speaker 5: point It was simply an account of how this tribal
Speaker 5: group at JP Morgan had dreamt up the idea of
Speaker 5: credit derivatives and taken it to extremes. And literally the
Speaker 5: day after I came back to work, Lihma Brothers collapsed
Speaker 5: and the book had to be dramatically rewritten very fast,
Speaker 5: because by then, of course, it was clear that credit
Speaker 5: derivatives had the potential to destabilize very wide swaths of
Speaker 5: the financial markets. And they weren't the source of the
Speaker 5: crisis that was the subprime mortgage lending, but they amplified
Speaker 5: the crisis dramatically. And of course, with the city of London,
Speaker 5: a lot of its growth in the preceding years had
Speaker 5: been due to its activities in the financial sector, and
Speaker 5: particularly the fact that London was a home of much
Speaker 5: of this creativity, and once the crisis hit, London not
Speaker 5: only became an epicenter of the things that were going wrong,
Speaker 5: but of course ultimately saw some of its own financial
Speaker 5: fortunes suffer as a result.
Speaker 4: First of all, the fact that you didn't go into
Speaker 4: the book expecting to write a disaster book still in
Speaker 4: my mind, vindicated the choice, because there was obviously.
Speaker 5: I should say by the way, actually, you know, I
Speaker 5: was predicting back in two thousand and five that credit
Speaker 5: derivatives were a house of cards is going to come
Speaker 5: at some point.
Speaker 2: You wrote a lot about it in the Ft repeatedly,
Speaker 2: but I want.
Speaker 4: To press further on this point that people are clearly
Speaker 4: willing to pay a lot of money for these financial
Speaker 4: services for the service of creating these derivatives. There are
Speaker 4: not many places they're not. You know, there's shen Zen
Speaker 4: for manufacturing electronics, there's a few places I don't know
Speaker 4: for manufacturing whatever else. And then there's like London in
Speaker 4: New York for manufacturing complex derivatives. And they're worth a
Speaker 4: lot of money, and people are willing to pay a
Speaker 4: lot of money for them, like you mentioned that their
Speaker 4: house at cards, et cetera. Yet around the world, clearly
Speaker 4: don't customers think there's a value in all these services.
Speaker 5: Well, credit derivatives and other derivatives and complex financial products
Speaker 5: exist for a reason, which is that people want to
Speaker 5: use them and buy them. And they want to use
Speaker 5: them and buy them because essentially they offer a way
Speaker 5: of expressing ideas in finance, taking bets, making investments that
Speaker 5: are dramatically more flexible, more subtle, more multifaceted, and sometimes
Speaker 5: cheaper than using other financial instruments. And the image I
Speaker 5: sometimes use to explain what they do is a bit like,
Speaker 5: you know, photoshopping a picture. You know, you can have
Speaker 5: a picture of something, you can have the actual something,
Speaker 5: or you can take a photograph and then photoshop it
Speaker 5: according to your own desires, and that, in a sense
Speaker 5: is a bit like what a derivative does. Or, to
Speaker 5: use another analogy, if you want to invest in the
Speaker 5: equity market, you can either go and buy an ETF
Speaker 5: which is like a box of chocolates. It's pre selected.
Speaker 5: Or you can go to an expensive equivalent of a
Speaker 5: chocolette where you pick a mixed chocolates you want, but
Speaker 5: that takes more money in time. Or you can just
Speaker 5: take a photograph of all the chocolates you like in
Speaker 5: the world and just a photoshop it to whichever ones
Speaker 5: you want, and that essentially is a derivative.
Speaker 2: I'm not sure how much I personally would value a
Speaker 2: photo of a bunch of chocolates, but point taken, Okay,
Speaker 2: So maybe, just as an example, let's use CDs and
Speaker 2: the invention of credit default swaps, and then how I
Speaker 2: guess they transformed during the financial crisis or running up
Speaker 2: until the financial crisis, because as you pointed out, you
Speaker 2: made the point that CDs is not necessarily the proximate
Speaker 2: cause of the crisis, but definitely amplified it. So talk
Speaker 2: us through what CDs were originally intended to do and
Speaker 2: what they ended up doing.
Speaker 5: Well. At the most basic, credit fault swaps were a
Speaker 5: way of taking out a bet on whether or not
Speaker 5: you thought alone or a bond would go into default,
Speaker 5: and they were originally created for corporate bonds, and essentially,
Speaker 5: people who thought that a company looked a bit dodgy
Speaker 5: could take out a credit a fault swap as a
Speaker 5: form of insurance or as a way to bet the
Speaker 5: company would actually default, depending on which side of the
Speaker 5: trade they were on, And that was a much more
Speaker 5: flexible way of trading that risk than actually buying the bond,
Speaker 5: because of course corporate bonds are often pretty liquid, they
Speaker 5: may not exist in the size you want, and if
Speaker 5: you'd think a company's going to default, historically the only
Speaker 5: way to express that belief in an investment trade was
Speaker 5: simply not to buy the bond. But the credit defaults
Speaker 5: what that you can actually be much more active in
Speaker 5: betting that it will default. Now, these were initially single instruments,
Speaker 5: usually attached to single companies, and they were created partly
Speaker 5: as a way of running rules around regulations, and in
Speaker 5: particular banking regulations, and it was also created as a
Speaker 5: way for banks to lessen the risk on their own
Speaker 5: books of having exposure to any particular corporate name. However,
Speaker 5: the initial group that created these instruments, which in many
Speaker 5: ways were very very clever and really clever innovation, saw
Speaker 5: the business grow and they began to bundle different credit
Speaker 5: default swats together, and then the idea got transplanted into
Speaker 5: the mortgage market. And then what happened was that masses
Speaker 5: of mortgages from different parts of America were bundled together,
Speaker 5: and then credit defaults were written onto the actual bundles
Speaker 5: of mortgages, and on top of that, the original credit
Speaker 5: default swats linked those mortgages were sometimes pulled together, chopped
Speaker 5: up into new pieces, and sometimes used to reissue entirely
Speaker 5: brand new instruments all over again. And the problem that
Speaker 5: happened at that point was that although when the original
Speaker 5: idea popped up, people could look at a company like
Speaker 5: IBM and say, yeah, you know what, I think it's
Speaker 5: got quite a high default risk or not a high
Speaker 5: default risk, and they kind of knew what they were
Speaker 5: betting on. By the time you're dealing with mortgages from
Speaker 5: gazillions of different homeowners all over the and by the
Speaker 5: time they've been chopped up and then repackaged and then
Speaker 5: repackaged again, it's very hard, indeed, to actually look through
Speaker 5: to what the underlying risks are except by taking it
Speaker 5: on trust, either from the issuer or from a credit
Speaker 5: rating agency. And at the core of what happened in
Speaker 5: two thousand and eight was that all of that complexity
Speaker 5: and opacity meant that you had the equivalent of a
Speaker 5: world where people were buying these instruments on trust, and
Speaker 5: yet that trust wasn't justified because some of them were
Speaker 5: turning bad. And when some of the underlying mortgages started
Speaker 5: to turn bad, what happened was the equivalent of a
Speaker 5: food poisoning scare. And I promise you, Tracy, I'm not
Speaker 5: going to just talk about food, but the best number
Speaker 5: I know is a food poisoning scare where essentially you
Speaker 5: had some of the bits of underlying loans and debts
Speaker 5: and the mortgage bundles went badly wrong. They dasically defaulted.
Speaker 5: The problem was that, as with say sausages in a supermarket,
Speaker 5: if you hear that one or two cows in the
Speaker 5: food chain have got toxic problems and they're creating food
Speaker 5: poisoning problems, if you don't know which sausages that meat
Speaker 5: has gone into, you're probably going to refuse to buy
Speaker 5: any sausages. And if your parents at a school where
Speaker 5: kids are being fed sausage stew, you're probably going to
Speaker 5: tell your kids to stop eating school lunches, period. And
Speaker 5: what happened in two thousand and seven two thousand and
Speaker 5: eight was the financial equivalent of that, because it became
Speaker 5: clear that some of the mortgages had gone bad, nobody
Speaker 5: knew which bundles of default swaps and the rivages had
Speaker 5: gone into, and so essentially consumers aka investors fled the
Speaker 5: market completely. And it throws up.
Speaker 4: I love the analogy of food poisoning scare. I had
Speaker 4: never really thought of it in that particular terms before,
Speaker 4: but I think it sounds very apt. But it also
Speaker 4: seems like when something like a food poisoning scare happens
Speaker 4: in financial markets, you know we just call it a
Speaker 4: bank run, right, And bank runs happen every you know,
Speaker 4: several decades, or you know, big one, maybe happened once
Speaker 4: a century, and they usually take a different form, et cetera.
Speaker 4: But going back to the metaphor of the food poisoning
Speaker 4: scare in retrospect, and I'm curious your take on this
Speaker 4: now in twenty twenty five or maybe twenty fifteen or
Speaker 4: two thousand and nine when the book came out, like
Speaker 4: how much food was actually gone bad? And how much
Speaker 4: was it that a little bit had gone bad? And
Speaker 4: yet people were afraid that everything had gone bad.
Speaker 5: Well, even to this day, the actual numbers are still contested.
Speaker 3: Yeah, it's interesting, isn't it.
Speaker 5: Yes, whether it was twenty five billion, whether it was
Speaker 5: two hundred and fifty billion, we still don't know exactly
Speaker 5: how the mortgagees defaulted. And of course, one of the
Speaker 5: difficulties about trying to measure that in America, like any
Speaker 5: other financial crisis, is that when you have an initial
Speaker 5: property market bust, prices collapsed dramatically and for period of
Speaker 5: time it looks like everything's gone bad, and then subsequently
Speaker 5: some of those loans actually recover because property prices go
Speaker 5: back up again. So it's very hard, indeed to measure
Speaker 5: what the actual losses were. But what we do know
Speaker 5: was that in the run up to two thousand and eight,
Speaker 5: not only had vast amounts of derivities been written linked
Speaker 5: to the mortgage market that was going bad, but a
Speaker 5: lot of those products had been built with a huge
Speaker 5: amount of leverage, which meant that even a small loss
Speaker 5: made them extremely problematic. You had a problem of tranching,
Speaker 5: which was very, very complicated in many of these products.
Speaker 5: The credit rating agencies were for a long time, the
Speaker 5: only way of actually judging whether or not a product
Speaker 5: was good or bad, and it turned out their ratings
Speaker 5: were completely wrong. And you also had a lot of
Speaker 5: these products held by investors who had no tolerance for
Speaker 5: these kind of risks. So you put that all together
Speaker 5: and frankly, you had the makings of a perfect storm.
Speaker 5: And you know, it was very, very painful indeed, And
Speaker 5: what made it doubly painful was that, in the course
Speaker 5: of slicing and dicing all of these different mortgages and
Speaker 5: news and derivatives, many of the products had been labeled
Speaker 5: triple A, and so people thought they were safe and
Speaker 5: it paid them no attention they sat on their balance sheet.
Speaker 5: And the other problem was that people ironically had bought
Speaker 5: these products because they said they wanted to diversify and
Speaker 5: hedge their risks. And the theory was that in the
Speaker 5: old days, a bank had a bunch of loans to
Speaker 5: say a mortgage company, or a bunch of properties, and
Speaker 5: that was very concentrated on their books. If they then
Speaker 5: repackaged them as derivatives and sold them to everyone else,
Speaker 5: then you basically had a problem shared, and a problem
Speaker 5: shared the problem halved. So people thought, well, right, this
Speaker 5: stuff has been scattered across the markets. If something defaults,
Speaker 5: it might hit a lot of people to a tiny amount,
Speaker 5: but it won't wipe anybody out because it's diversified. The
Speaker 5: critical misunderstanding people made was that because the system was
Speaker 5: so opaque and complex, no one saw that all the
Speaker 5: risks were actually reconcentrating themselves back on a couple of
Speaker 5: big institutions books, because the same institution was writing credit
Speaker 5: the false wats to everybody, and in particular, AIG Financial
Speaker 5: Products was at the center of most of these trades.
Speaker 5: So instead of diversifizing and spreading risk credit, the falsewats
Speaker 5: were doing the very opposite and reconcentrating.
Speaker 4: It tracy, the idea that it's really even still impossible
Speaker 4: to know how much of these assets had properly gone bad.
Speaker 4: This has always been my frustrat with badiod dictum of
Speaker 4: lending against good collateral. Yeah, but I've never I've always
Speaker 4: hated there because like, what's good collateral. It's like it's
Speaker 4: good collateral contingent upon reflation of the economy anyway, But
Speaker 4: that's always bothered me. It's a possibility of knowing what's
Speaker 4: good or bad collateral even years after any keep going.
Speaker 2: I enjoy your badget rants for sure. Okay, well, actually
Speaker 2: this feeds into what I was going to ask. So
Speaker 2: the solution to the crisis proposed eventually by regulators was
Speaker 2: more transparency of derivatives and complex financial instruments, so people
Speaker 2: would have to report their positions to the DTCC and
Speaker 2: also central clearing for derivatives. Do you get any sense, Jillian,
Speaker 2: of how big a difference that's made, because when I
Speaker 2: look at the CDs market, parts of it still seem
Speaker 2: very very opaque to me. I mean things like CDX
Speaker 2: index options, swaptions. I don't think those get reported well.
Speaker 5: I think it's basically, as often been, a case of
Speaker 5: two steps forward, one back. So the progress is that
Speaker 5: when I started covering this in two thousand and eight,
Speaker 5: I couldn't get the price for a CDs on anything
Speaker 5: without calling up the brokers individually, one by one and
Speaker 5: getting a quote. I couldn't work out how the market was,
Speaker 5: and it was so opaque that at one stage officials
Speaker 5: at the BIS, a Bank for International Settlements that was
Speaker 5: one of the few institutions that was trying to monitor
Speaker 5: this and raise the alarm. They called me up and said,
Speaker 5: do I have any data? And I went, well, hang,
Speaker 5: you're supposed to have the data. This is the wrong
Speaker 5: way around, and they said, yeah, The problem was we
Speaker 5: just don't know.
Speaker 3: Now.
Speaker 5: The good news is today one you can get CDs
Speaker 5: prices for most instruments that are traded, you know, even slightly.
Speaker 5: You know, in the markets, you can get CDs prices
Speaker 5: relatively easily. Two we do have macro figures about what's
Speaker 5: going on. And three the very fact that you can
Speaker 5: get those prices in the chart form changes how people
Speaker 5: look at the financial sector. I mean, I remember very
Speaker 5: clearly the first time that I actually pushed for the
Speaker 5: ft to publish something called the ABX index, which was
Speaker 5: showing mortgage defaults. It was transformational because suddenly people could
Speaker 5: actually see it and imagine it, and that changed how
Speaker 5: people imagined finance. The same thing happened when axel Weber,
Speaker 5: not axel Weber, one of the other analysts, coined the
Speaker 5: phrase shadow banking for the first time, and suddenly everyone
Speaker 5: realized that what they thought was the financial system dominated
Speaker 5: by banks was dead wrong. In fact, the shadow banking
Speaker 5: world was huge and swelling. So then, in some ways
Speaker 5: it's a lot more transparency than there was fifteen years ago,
Speaker 5: and that's a very good thing. What is troubling is that, firstly,
Speaker 5: the transparency doesn't extend to all instruments. Secondly, the level
Speaker 5: of leverage and above all embedded leverage isn't apparent, and
Speaker 5: that really matters, particularly right now. And thirdly, I'm a
Speaker 5: strong believer that to have effective financial markets, you need
Speaker 5: to have markets where assets can actually be traded properly
Speaker 5: and people can have easy access to that quickly. That
Speaker 5: wasn't the case before two thousand and eight, because people
Speaker 5: who are creating CDOs were doing so ironically in the
Speaker 5: name of creating perfectly liquid markets, and the great buzzword
Speaker 5: back then was liquefication. We're going to use financial innovation
Speaker 5: to liquefy everything, and then we'll have the perfect nirvana
Speaker 5: where all risks surprised properly, and risks end up in
Speaker 5: the hands of people who were best suited to hold them.
Speaker 5: That was a justification for this innovation, And what people
Speaker 5: fell to notice was that the complex instruments they were
Speaker 5: creating were so darn complicated. In fact, they were barely
Speaker 5: being traded at all. I mean, the bundles of so
Speaker 5: called CDOs collateral defaultigations, which were essentially created often through
Speaker 5: synthetic derivatives, were so difficult to trade that most institutions
Speaker 5: just bought them and stuck them on the balance sheet
Speaker 5: and ended up valuing them not with market prices because
Speaker 5: they didn't really exist. There wasn't enough trading, but they
Speaker 5: ended up value in them in the so called marked
Speaker 5: and market system using implied prices from often rating agency models.
Speaker 5: And if you have that situation, all the red lights
Speaker 5: in the dashboard should be flashing, because that shows that
Speaker 5: even if you have a so called marked and market
Speaker 5: accounting system, you don't have enough markets to get proper
Speaker 5: market prices, and you don't really know what the value
Speaker 5: is of things.
Speaker 4: You know, you mentioned that, suddenly you know, someone coins
Speaker 4: the term shadow banking, and then you sort of rethink
Speaker 4: all these different elements of how you see the financial system.
Speaker 4: We talk a lot on the podcast about these days
Speaker 4: about non bank financial institutions in two forms. Primarily we
Speaker 4: talk a lot about private credit. So the post DoD
Speaker 4: Frank emergence of these non bank entities that do a
Speaker 4: lot of lending, and the emergence of multi strategy hedge funds,
Speaker 4: that the post DoD Frank emergence of a lot of
Speaker 4: these funds that do a lot of what used to
Speaker 4: be called prop trading. And of course banks still have
Speaker 4: their role in the ecosystem. And so then the question
Speaker 4: of all, do these risks ultimately redound back to the
Speaker 4: banks who as these outside entities pursue leverage. But I'm curious,
Speaker 4: putting back on the head of these sort of anthropologist perspective,
Speaker 4: how would you go about, like, you know, try to
Speaker 4: see if there are real risks here in the new model,
Speaker 4: Because I don't know, like I've said on the podcast before,
Speaker 4: some of the post dot Frank changes of separating this
Speaker 4: risk taking from deposit taking seems like it maybe was
Speaker 4: a good idea, But like, where might you explore in
Speaker 4: terms of like trying to figure out where these new
Speaker 4: risks emerge?
Speaker 5: Well, I think one of the constant themes from financial
Speaker 5: history is that new risks never emerge where the last
Speaker 5: risks were. Yeah, so I think the parts of another
Speaker 5: crisis with mortgage derivatives right now is about zero. How
Speaker 5: does a crisis tend to emerge as a result of
Speaker 5: three things? One is an overreaction last time round by
Speaker 5: a bunch of regulators that end up introducing changes to
Speaker 5: try and contain the last crisis. That does stort the
Speaker 5: financial system so much that they create the next crisis.
Speaker 5: Because one of the reasons why Crode Dedrivet is popped
Speaker 5: up was partly because in reaction to what had happened
Speaker 5: during the savings and loans crisis in America in the
Speaker 5: nineteen eighties, when there was too much concentration of lending
Speaker 5: exposures on banks books. So one justification for growth derivatives was, well,
Speaker 5: let's create a tool that spreads that exposure around and
Speaker 5: the problem will be solved, which it did, but then
Speaker 5: it created new problems. So first point is look for
Speaker 5: where excessively ham fitted regulation last time around has created
Speaker 5: new distortions. The second key thing is look for what
Speaker 5: people aren't talking about, so social silence is always critical
Speaker 5: in any field. Third point is look for activity that's
Speaker 5: occurring outside silos or between silos. And by that I
Speaker 5: mean that one of the constant problems in finance is
Speaker 5: that institutions and regulators create structures set up to monitor
Speaker 5: and handle the world that existed a couple of years ago,
Speaker 5: and then the outside world moves on and the institutions
Speaker 5: are left with structures which have hardened into bureaucratic organizations.
Speaker 5: So to give you an example of what I mean, UBS,
Speaker 5: which I wrote about in my second to last book
Speaker 5: called the Sido Effect, had a massive risk management department
Speaker 5: and it spent a huge amount of time back in
Speaker 5: two thousand and five sixty seven looking at the risks
Speaker 5: that have blown up financed in the past, which were
Speaker 5: basically hedge funds and leverage loans, and it's massive risk
Speaker 5: management departments spent a huge amount of time examining every
Speaker 5: single possible danger to UBS that might come from that.
Speaker 5: What they did not do was look at this new
Speaker 5: class of activity credit derivatives and mortgage backed securities because
Speaker 5: they were label as triple A ultra safe inside the
Speaker 5: bank's accounting system, so they were ignored, but also they
Speaker 5: cut across different areas of activities inside the bank. So
Speaker 5: a mortgage back default swap was basically both a tradable
Speaker 5: security and something linked to credit and also something linked
Speaker 5: to the operational risk inside the bank as well. And
Speaker 5: UBS risk management department was split into three separate silos
Speaker 5: credit trading and liquidity or logistical risk, and they didn't
Speaker 5: talk to each other. And so on top of the
Speaker 5: fat you had geographical splits in UBS, between the New
Speaker 5: York desk and the zero desk and the London desk.
Speaker 5: You had this completely fragmented system and the new products
Speaker 5: felt in the cracks, and UBS ended up running enormous
Speaker 5: risks that almost looked up even though it had a
Speaker 5: massive risk management department. So I would say look for silos,
Speaker 5: look for what's happening between the silos, and then also
Speaker 5: look for new hidden concentrations of risk. And if I
Speaker 5: extrapolate that to the current world today, you know one
Speaker 5: area where you have a lot of activity falling between
Speaker 5: regulatory silos and institutional silos is in fintech and in
Speaker 5: additional finance, because the skills you need to understand cyberspace
Speaker 5: are very different from the skills you've historically needed to
Speaker 5: understand the world of money. And you've also got all
Speaker 5: kinds of activity happening on the edge of regulatory perimeters
Speaker 5: which are often not properly policed or understood at all.
Speaker 5: So a classic example of this is the fact that
Speaker 5: the big banks all use cloud computing a lot. They
Speaker 5: all use the same two three four cloud computing providers.
Speaker 5: There's a massive reconcentration of risks there, but groups like
Speaker 5: the Bank for International Settlements and other banking regulators can't
Speaker 5: really track that because it's outside their regulatory perimeter. The
Speaker 5: tech regulators don't track it either, and so you have
Speaker 5: a classic example of a potential risk of the future
Speaker 5: falling between the crafts.
Speaker 2: So I want to bring us up to speed even more,
Speaker 2: I guess, and talk about current events. You've been writing
Speaker 2: a lot about geonomics, which I guess is this idea
Speaker 2: that I guess economic policy is becoming more intermingled with
Speaker 2: state craft, and the idea that you're going to have
Speaker 2: more activist measures from governments when it comes to solving
Speaker 2: particular choke points in the economy. So obviously we have
Speaker 2: Trump and the tariffs as one example, but we also
Speaker 2: had industrial policy on the rise in the US under
Speaker 2: the Biden administration even before that. And I guess I'm
Speaker 2: curious what the rise of geonomics, or maybe the progress
Speaker 2: of protectionism or the slow retreat from globalization. That's a
Speaker 2: big assumption that it's all happening, but I'm curious what
Speaker 2: it means for a financial industry, which, as we've discussed
Speaker 2: on previous episodes, has very much grown in concert with
Speaker 2: globalization and liberalized financial flows and things like that.
Speaker 5: Well, in some ways, genomics is just a posh word
Speaker 5: for political science or political economy, or if you like
Speaker 5: life beyond the balance sheet. And by that I mean
Speaker 5: that most of your listeners grew up in the late
Speaker 5: twentieth century in the West in an era, or if
Speaker 5: they didn't grow up in the West, they want to
Speaker 5: grown up if they're listening to Bloomberg podcast in parts
Speaker 5: of the world which were subject to the missionary zeal
Speaker 5: of the CFA exams, and that essentially implied a certain
Speaker 5: mindset and the mindset arose from a combination of three factors.
Speaker 5: One was the growth of neoliberal free market ideas after
Speaker 5: the nineteen seventies and eighties. The second was the explosion
Speaker 5: in computing power, and the third was explosion in the
Speaker 5: financial industry. And those three things came together to create
Speaker 5: a voracious demand to use the new digital tools in
Speaker 5: computing to model finance and free markets supposedly free markets
Speaker 5: to create a set of instruments that the fast expanding
Speaker 5: ranks of financial professionals could use to price securities, predict
Speaker 5: the future, place trading bets, etc.
Speaker 3: Etc.
Speaker 5: Around the world, backed by groups like the CFA, which
Speaker 5: were a bit like the American financial equivalent of the
Speaker 5: Catholic Church in that they went around the world evangelizing
Speaker 5: and spreading the creed right around the world. Now, that mindset,
Speaker 5: which we all grew up with, and as an anthropologist
Speaker 5: would say, we're all creatures of our own cultural environment,
Speaker 5: seems to us to be normal, natural, and inevitable, and
Speaker 5: it doesn't just useting pan to predict the future. It's
Speaker 5: also marked by a certain amount of tunnel vision, because
Speaker 5: it assumes that if you put the right inputs into
Speaker 5: an economic model or put the information that matters onto
Speaker 5: a balance sheet of a company, you've basically got the
Speaker 5: key to model and forecast what's going to happen next.
Speaker 5: And in some ways that worked really well. But the
Speaker 5: problem is that there are always things that you leave
Speaker 5: out of your economic model. There are always things that
Speaker 5: you leave out of your balance sheet or just footnotes,
Speaker 5: and those things tend to be things like politics, social conflict,
Speaker 5: tech change, environmental risk, medical risk, or what groups like
Speaker 5: the World Economic Forum coily call interstate conflict better known
Speaker 5: as war. And the story of the last two decades
Speaker 5: is that everything that wasn't on the balance sheet or
Speaker 5: in the model is what's really blown up everyone's forecasts
Speaker 5: and become increasingly important. So what we're seeing now, in
Speaker 5: my view, is really the fifth big swing in the
Speaker 5: intellectual zeitgeist since nineteen hundred, and by that I mean
Speaker 5: that between up until nineteen fourteen, you really had imperialist
Speaker 5: free market capitalism in the world. Then between the wars
Speaker 5: you had protectionist, populist nationalist visions of the economy. Then
Speaker 5: after World War II you essentially had Canesianism took root
Speaker 5: the idea the state could jump in and direct things
Speaker 5: for the good of all, and that was really sort
Speaker 5: of international Knesianism. Then you had the neoliberal age really
Speaker 5: start in the nineteen eighties, and now you've got a
Speaker 5: swing of the pendulum back towards effectively geoeconomics, where there
Speaker 5: was woken up and discovered what they always knew back
Speaker 5: in the nineteen twenties, and they also sort of knew
Speaker 5: back in the canes In period, which is that power matters,
Speaker 5: politics matters. It's not all about free markets, and free
Speaker 5: markets are often something of a canard or a falsehood,
Speaker 5: and that actually, well, when you want to make sense
Speaker 5: of the world, you have to combine economics and political analysis,
Speaker 5: social analysis, tech analysis, look at a much wider range
Speaker 5: of things. Get lateral vision, not tunnel vision. And I'm
Speaker 5: not saying in any way, shape or form that that
Speaker 5: means economic doesn't work anymore. But what I say is
Speaker 5: you have to look at your economic models and all
Speaker 5: the lovely tools that the financial industry has developed as
Speaker 5: being a bit like a compass. And if you're stuck
Speaker 5: in the dark wood at night, you don't want to
Speaker 5: throw away your compass because it's incredibly useful. But if
Speaker 5: you only stare down at the face of that compass
Speaker 5: and walk through that wood at night, you're probably going
Speaker 5: to walk into a tree or trip over a tree
Speaker 5: root because you have to look up and around beyond
Speaker 5: your compass to see what's actually happening. And that's really
Speaker 5: what geo economics is trying to do.
Speaker 3: I love that.
Speaker 4: I love the compass forest analogy. You know, it's easy,
Speaker 4: and I've engaged in it myself. But it's easy to
Speaker 4: look back at the nine these and the sort of
Speaker 4: the end of history optimism, you know, and some of
Speaker 4: the predictions of you know, mid nineties, which is kind
Speaker 4: of where the where their story much of it starts
Speaker 4: in your book Fool's Gold with some of the early
Speaker 4: iterations on this stuff, and it's easy to look back
Speaker 4: and it's like talk about the naive take, but I
Speaker 4: get it. I mean, like we the West had just
Speaker 4: won the Cold War in like really decisive fashion, and
Speaker 4: this is something you talk about in your book and
Speaker 4: you just mentioned it. Now it's like we really did
Speaker 4: suddenly also have this emergence of really powerful tools to
Speaker 4: price risk and price.
Speaker 3: Various events in the future.
Speaker 4: So at the same time that like everyone sort of said, okay,
Speaker 4: liberalism and capitalism, democracy are vindicated, and suddenly like we
Speaker 4: have these incredible calculators or computers that can do a
Speaker 4: reasonably good job pricing risk. Outside of the emergence of
Speaker 4: some of these trees that you run into, like I
Speaker 4: have a lot of sympathy for the characters of that time,
Speaker 4: thinking like, oh this is things are going.
Speaker 3: To be really good.
Speaker 5: Well, I completely ad sympathy. And the reality is that
Speaker 5: humans basically move in pendulance wings and whenever it's a
Speaker 5: new innovation, we're all dazzled by it until we see
Speaker 5: the downside. And just as we learned about the upside
Speaker 5: of derivatives and then learned about the downside, we've all
Speaker 5: learned about the upside of economic models, and there are
Speaker 5: huge economic advantages to using them, and now we see
Speaker 5: the downsides. And I should say, the other thing that
Speaker 5: makes it dangerous to use this kind of neoliberal mindset
Speaker 5: is that you've got governments in the world moving away
Speaker 5: from a liberal mindset themselves. And Donald Trump epitomizes that.
Speaker 5: But he's as much a symptom as a cause of this,
Speaker 5: in that for the Trump administration, economics doesn't sit in
Speaker 5: a separate box, which is distinct from tech, trade policy,
Speaker 5: military stuff anymore as far as the Donald Trump administration
Speaker 5: is concerned. And you can see this in the way
Speaker 5: they approach negotiations of other countries. Tech issues, tree issues,
Speaker 5: cultural issues, finance issues, trade issues are all jumbled up
Speaker 5: together as part of a whole, and it's horrifying to
Speaker 5: most governments read in that near liberal mindset. But I
Speaker 5: suspect it's probably going to be the trend for quite
Speaker 5: a while.
Speaker 3: Yeah.
Speaker 4: I joked on Twitter the other day that in every
Speaker 4: foreign election, I just like, just tell me which one
Speaker 4: is the Trump and which one is the Liberal. Then
Speaker 4: I figured there's I don't really see the world that flatly,
Speaker 4: but kind of. But you know, going back to anthropology
Speaker 4: and back to the nineties and back to these new
Speaker 4: tools and the internet and computers, etc. You say in
Speaker 4: your book that the incoming cohort of bankers who are
Speaker 4: really like, you know, native to this new technology, did
Speaker 4: they sneer? Did they look down to some extent at
Speaker 4: the older generation that might have been more inclined towards
Speaker 4: conservatism about banking because they didn't have the sort of
Speaker 4: skills of the natural inclination to sort of use the
Speaker 4: wonders of technology.
Speaker 5: Well, almost every big innovation that we've seen in the
Speaker 5: last one hundred and fifty years has been driven by
Speaker 5: a bunch of kids. And since I'm sitting in king
Speaker 5: smolishing Cambridge, anyone under the age of who know, thirty
Speaker 5: looks like a kid to me. But a bunch of
Speaker 5: you know, young kids coming in having the mastery of
Speaker 5: knowledge of a new technology that often the older generation
Speaker 5: doesn't understand, full of excitement about how they can innovate
Speaker 5: and break all the rules. And they essentially usually get
Speaker 5: together and do exactly that very rapidly, and you know,
Speaker 5: bring about great benefits, but often end up bringing about
Speaker 5: great harm too. And they often have a messianic zeal
Speaker 5: and belief, although they tell themselves that they are somehow
Speaker 5: saving the world or bringing good for humanity. We've seen
Speaker 5: that happen in life science, We've seen that happening computing,
Speaker 5: in AI, in social media when that was first created.
Speaker 5: The same thing happened with finance and a generation of
Speaker 5: kids who I profile in my book at JP Morgan,
Speaker 5: but not just JP Morgan, who stumbled on the idea
Speaker 5: of creating credit derivatives, did so very fast, did so
Speaker 5: in a way that their bosses often didn't understand and
Speaker 5: let rip. And that's the pattern we've seen over and
Speaker 5: over again. And the reality is that every single innovation
Speaker 5: in history has a good side and a bad side,
Speaker 5: and the older generation can often see the bad side,
Speaker 5: the younger generation can see the good side. Without the
Speaker 5: enthusiasm of the younger generation, nothing will change, but they
Speaker 5: still need the older generation. Oldie is like me now
Speaker 5: to basically point out the previous risks.
Speaker 2: So since we're on the topic of financial products and
Speaker 2: very big changes in the financial system and the way
Speaker 2: people are thinking of trade and things like that, there
Speaker 2: was something that caught my eye and certainly caught your
Speaker 2: eye recently, and that is something called Section eight nine
Speaker 2: nine that basically opens the door to the US taxing
Speaker 2: foreign holders of treasuries, which would be an enormous, enormous
Speaker 2: change to how they've previously been treated. How big a
Speaker 2: deal is that.
Speaker 3: Well.
Speaker 5: One of the other hallmarks of the neoliberal economic mindset
Speaker 5: that we all grew up with and assumed was normal
Speaker 5: and inevitable and unchanging is this idea that capital should
Speaker 5: move freely, and that was seen in the prescriptions of
Speaker 5: the IMF. It was seen in the way that Wall
Speaker 5: Street worked and operated and in pronouncements of politicians, and
Speaker 5: so Section eight ninety nine reverse to the idea that
Speaker 5: there might be taxes, new taxes imposed on non American
Speaker 5: holders of American assets. Now, some people might say, well,
Speaker 5: that's kind of fair enough, because guess what Americans pay
Speaker 5: taxes on capital gains, Why should non Americans be any different.
Speaker 5: But the reality is there's been quite a few tax
Speaker 5: breaks in the past for non Americans to encourage them
Speaker 5: to bring their money to America, and there's been such
Speaker 5: a desire to unleash that flood of money foreign capital
Speaker 5: that back in nineteen eighty four, the American government actually
Speaker 5: removed a pre existing tax on Chinese investors say that
Speaker 5: bought treasuries securities, and so one of the reasons why
Speaker 5: you've seen in China parlia in such big time into
Speaker 5: the American treasures market is because of those kind of incentives.
Speaker 5: Now we've all got used to this idea, is that
Speaker 5: there should be encouragements so foreigners to come and invest
Speaker 5: in countries we give a granted as normal. The reality is, though,
Speaker 5: that Trump administration has a very different perspective on this,
Speaker 5: and so not only are they thinking reversing the nineteen
Speaker 5: eighty four ruling, which means that in fact, Chinese and
Speaker 5: others would face the taxes if they bought treasuries. But
Speaker 5: they're also thinking of using this so called Section eight
Speaker 5: ninet nine to impose taxes on non American holders of
Speaker 5: American assets. And they're doing that partly because they want
Speaker 5: to get lots of revenue. There's a think tank allied
Speaker 5: with Jdvans that suggests you could get two trillion dollars
Speaker 5: worth of revenue from this. But there's also a desire
Speaker 5: to slow the amount of money flooding into America, to
Speaker 5: weaken the dollar, and to ensure that American industry can
Speaker 5: become more competitive. So it's quite a different mindset again
Speaker 5: that I think most people are not prepared for.
Speaker 2: Yeah, a very big change, Jillian. We're going to have
Speaker 2: to leave it there. Honestly, we could talk to you
Speaker 2: for hours about many, many different things. But that was
Speaker 2: so much fun to catch up on derivatives and talk
Speaker 2: about maybe where risks are lurking in the financial system. Now,
Speaker 2: really appreciate you coming on our thoughts for the first time.
Speaker 2: We have to have you back.
Speaker 5: Well, thank you. I really enjoyed chatting to you. And
Speaker 5: the last thought I'll leave you with is that the
Speaker 5: period of time that we all grew up with when
Speaker 5: free market ideals were taken for granted, is actually a
Speaker 5: historical aberration, and if you look across the societies and
Speaker 5: most points of history, it's not the case that the
Speaker 5: world we're moving into now it's weird. We were the
Speaker 5: weird ones for the last forty years.
Speaker 3: I love that.
Speaker 2: Okay, Jillian, thank you so much, thank you.
Speaker 3: Thanks by.
Speaker 2: Joe, we were the weird ones.
Speaker 3: Yeah, I think about this all the time. Actually.
Speaker 4: The thing so many, so many things in that conversation
Speaker 4: I think about all the time actually, but one thing
Speaker 4: I think about, like we are the weird ones, which
Speaker 4: is probably true, but the idea that we would have
Speaker 4: any conception of what normal is or like you know,
Speaker 4: things are getting weird, Like it's so weird in its
Speaker 4: premise because like in some sense, I think that the
Speaker 4: modern economy or the modern world has roughly existed since
Speaker 4: the end of World War two, and so basically eighty
Speaker 4: years are a little more and so like literally like
Speaker 4: the entire like one person's lifetime, Like that's nothing. Yeah,
Speaker 4: that's literally nothing that we're barely getting. It's day one
Speaker 4: around here in terms of what the modern So when
Speaker 4: you think about all these changes AI et cetera, like,
Speaker 4: we have no normal index against really because we're just
Speaker 4: getting started.
Speaker 2: Yeah, timelines are very very long. The other thing I
Speaker 2: was thinking is just on the sort of geonomics revival
Speaker 2: of industrial policy point. I wonder if we will get
Speaker 2: financial products that are like tailored at targeting those particular risks. So,
Speaker 2: for instance, could you come up with like a tariff
Speaker 2: hedge of some sort just in case Trump is going
Speaker 2: to announce something one day and then maybe take it
Speaker 2: back the next day. I wonder if that's a risk
Speaker 2: that companies could offload in some way.
Speaker 4: It would be really interesting to think about like very
Speaker 4: specific measurable risks. Yeah, you could build on them in
Speaker 4: this new society. But I'm glad you asked that question.
Speaker 4: Also about the sort of geonomics and what that means
Speaker 4: for financial institutions, because you know, I really started thinking
Speaker 4: about this after a recent episode with Scott Bock, and
Speaker 4: I've thought about this in the derivative sense. So much
Speaker 4: of the growth of finance is very specifically about solving,
Speaker 4: not justres of problems of complexity, but problems of a
Speaker 4: cross border complexity. And you know, even the fact that
Speaker 4: Jillian talks about this in her book, the fact London
Speaker 4: emerging as a source of this in part due to
Speaker 4: US regulations and pre Glass Deegal repeal, stuff like that.
Speaker 4: Lots of interesting themes right there, right, And.
Speaker 2: If you have something like section eight nine to nine
Speaker 2: that is calculated to just incentivize investors from holding US treasuries,
Speaker 2: then that would decrease demand for a bunch of financial
Speaker 2: products such as treasury futures and things like that.
Speaker 4: I still want to push forward on my project to
Speaker 4: vindicate the existence of high finance, and I suspect that
Speaker 4: there's a reason that. And you know, like as Julian said,
Speaker 4: like you know, there's still derivatives, but the next crisis
Speaker 4: is probably not going to be in the derivatives that
Speaker 4: were sort of vilified or people were anxious about fifteen
Speaker 4: years ago.
Speaker 3: Right, It's gonna be something.
Speaker 2: It always changed.
Speaker 4: But you know, people still get paid a lot of
Speaker 4: money to create and trade these instruments. And I still
Speaker 4: have this intuition is because they're providing a valuable service,
Speaker 4: and so I want to you know, do more episodes
Speaker 4: on vindicating the status of finance and society.
Speaker 2: We got to get Dalio back on to do a
Speaker 2: deep dive into hedging the chicken McNugget totally.
Speaker 3: That's all kinds of these things that we will discover.
Speaker 2: All right, shall we leave it there for now?
Speaker 3: Let's leave it there.
Speaker 2: This has been another episode of the aud Loots podcast.
Speaker 2: I'm Tracy Aalloway. You can follow me at Tracy Alloway.
Speaker 4: And I'm Joe Wysenthal. You can follow me at the Stalwart.
Speaker 4: Follow Jillian Tet. She's at Jillian Tet. Follow our producers Carman,
Speaker 4: Rodriguez at Kerman Erman dash Ol Bennett at Dashbot, and
Speaker 4: Kilbrooks at Kelbrooks. More odd Lots content go to Bloomberg
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