IFR DCM Milestones Roundtable: Part 2
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Cyrus Ardalan: The size and culture of companies made a huge difference. I remember certainly when I was at Paribas it was completely open plan seating, everybody sat out, we had no titles. We basically had a bonus culture where all bonuses were discussed by the executive committee one-by-one; we spent three days going through everybody and questioning who made what and how they made it etc. Everybody knew everybody else, there was a huge amount of mobility and we organised our business on a global basis.
You had a pretty good sense of what was going on; everybody was involved with everybody else and everybody knew everybody else. That type of culture on the whole worked towards trying to do the right thing, as opposed to doing the wrong thing. When things went bad it wasn’t through bad intention, it was just that we were often just trying to discover our way through things rather than trying to be malicious or manipulate anything.
Michael Dobbs-Higginson: Or duplicitous.
Cyrus Ardalan: Or duplicitous, absolutely.
Iain Baillie: It’s worth remembering that a number of participants at that point were partnerships. When I first went to Salomon Brothers in 1978, it was a partnership. In terms of risk management the partners had a pretty keen eye on who was buying what and who was doing what to whom. That was a clear distinction I think and when Big Bang arrived in the UK in 1987, a lot of partnerships went away and limited liability changed the risk culture of a number of organisations.
Gene Rotberg: On the issue of regulation, in 20 years I don’t think I ever got a call from a regulatory agency, like the SEC or their counterparts in Western Europe. Where the regulation occurred wasn’t so much regulation of the nature of the transaction; it was regulation designed to protect the silos in each country. Germany would say, “Deutsche Bank can do public issues, but the Sparkassen/Girozentralen won’t be able to get any of the paper so they can have their own separate syndicates. The Genossenschaftsbanken, the co-operative banks, couldn’t get the paper either, so they can have their own syndicate. The commercial banks could also have a separate syndicate just for commercial bank placement”.
In Japan the trust banks had a separate syndicate, as did the commercial banks, the investment banks (headed by Nomura, Daiwa, Yamaichi and Nikko) and the savings banks and you could place privately or publicly. The regulation was: when you come, you tell us which syndicate you want to use. There was very little cross-selling across different institutions within the country. What the Euromarket did, it broke that down because it permitted underwriters to place all over the world, irrespective of the silos that existed in each country.
IFR: The history of the Eurobond market has been accompanied by the history of its member organisations, be it the AIBD, the IPMA, ISMA, and then the creation of the ICMA. In its early days, of course, the Associated of International Bond Dealers was known as the Association of International Beer Drinkers. When it became ICMA, people referred to it as the International Caviar and Moët Association, which rather illustrates the evolution of the market in the eyes of many. But on a serious point, Rene, what impact has the existence of these organisations had on the development of the Eurobond market and for whose benefit?
RENE Karsenti: As this market was a cross-border market, it was not supervised by a single entity so it had to be organised as a self-regulatory market. I think these organisations were very successful in accompanying the tremendous development of the Eurobond market at that time, in establishing rules and regulations and in providing standardised training and certificates for bond dealers. That was essential. They provided rules for the clearing and settlement, the post-trade arrangements. This was indispensable for the development of this market, which now represents more than US$5trn of issuance per year.
It was made possible only because market participants were concerned about the integrity of the market and were willing to put aside their own commercial concerns for the good of the market. I think it was very important that these self-regulatory organisations were created.
Cyrus Ardalan: You’re absolutely right, Rene. Perhaps one of the big differences was that the organisations as they existed in the 1980s and 1990s were designed to be self-regulating, to set standards within the industry itself, and recognising that the interests of every single institution was better served, by agreeing on a robust set of standards that everybody would adhere to.
If I look at associations now, many of them have become more advocacy groups, because regulation has become such an important part of what’s happening. Whether you look at AFME or SIFMA etc they’re not rule-setting groups; they’re not there to try and set best standards and practices. Their objective is to say: “this is what’s being proposed, we either agree or don’t agree” whereas ICMA and IPMA were very different in nature. Even today, ICMA is not an advocacy group per se; it’s much more involved in looking at best practices and rules.
Robert Gray: I have a very vivid recollection of the formation of the IPMA, because it was in 1984 and it came out of the AIBD meeting in Nice. The idea for IPMA grew out of a feeling at that time that the primary market was not gaining sufficient attention within the AIBD frame. I think the formation of the IPMA could not have been more timely in terms of addressing some of the poor syndicate practices that were prevalent in the mid-80s. IPMA moved very quickly to address those, and I don’t think things like the Global bond could have been achieved without the more collaborative atmosphere that IPMA encouraged in the primary market.
One of the strengths of the IPMA was its ability to make representations to issuers that no single firm could make on its own. The Gulf War was one example where the use of force majeure was a major issue; it was hard for one firm to confront an issue like that with leading issuers but the IPMA could take that initiative.
At the same time - and I was Chairman at the time we merged with ISMA to create ICMA - I was convinced that the time was right, for the reasons Cyrus indicated, to bring them back together again, which we did in 2005. I think it was the right decision at the right time, just as the formation of the IPMA in its 20 year existence I think added greatly to the sinews of the market.
IFR: We’ve talked a bit about syndicate practices. Iain, I was quite curious to know how the life of a trader has evolved over the years. People have this notion of traders of old being slightly out of control, with no any internal oversight and no real internal risk management.
Iain Baillie: I think the skill changed fundamentally from the 1970s to the 1990s and beyond because when most of the liquidity was provided by making prices to other traders, the real skill of a trader was to keep out of trouble, to see what was likely to be going up and down, rather than looking at fundamental value and looking at what clients wanted to do.
That was the driving force behind bringing in interdealer brokers, because the view was that it freed up the trader’s time so they could focus a) on value and b) on providing liquidity to clients, which was becoming the primary goal.
The skill-set changed, and I think it comes back to the point earlier; in the early days the traders were a pretty diverse group of people. It changed because the skill-set became morphed to understanding relative value and being able to understand the underlying credits you were dealing in. Over the course of that 20 years, it became much more sophisticated job.
IFR: When did leverage start making traders’ lives a bit more dangerous?
Iain Baillie: I guess the CDS market really took off in the very early 2000s. My memory of us having a specific CDS desk would have been about when we moved to Canary Wharf; it was the very early 2000s. Through that you got the development of leveraged products like CDOs and the various things that came after it, so I think that was when it was.
The earlier leverage, which was largely in government bonds, was much more controllable and clearly at a much lower level of risk. I think there are a number of old-school participants who think that the development of the CDS market was the beginning of the end.
IFR: As we knew it.
Iain Baillie: As we knew it.
Michael Dobbs-Higginson: And led to egregious greed.
IFR: When you say “led to” do you mean it wasn’t there before?
Michael Dobbs-Higginson: No, led to egregious, I repeat egregious, greed; there was always greed.
Robert Gray: I think there were intellectual abstractions; there were degrees of intellectual abstraction that were allowed to develop. CDO cubed is a classic example of taking an idea and pushing it beyond any reasonable dimension.
Michael Dobbs-Higginson: It wasn’t just greed on behalf of the investment bankers and the traders;
it was greed on behalf the credit companies, the rating agencies, the regulators, the stock exchanges, as they were all making so much money off this sector.
IFR: And investors.
Michael Dobbs-Higginson: Investors too, but investors were at the end of the queue in terms of who took first dibs at the trough. All these people led to the growth of egregious greed, and egregious greed could exist because of these very complex instruments, which disguised the reality.
Gene Rotberg: I think also what probably happened over time is that when the firms went from being private firms, which they were several decades ago, to becoming public, there was enormous pressure to get what they considered to be a sufficient return on capital from the public to justify their being. They went from straight agency business, which became a commodity, to underwriting, which had a lot of competition but also not very much profit, to proprietary trading.
As each level expanded, more and more participants from the investment banking community went into each of those fields. What ended up developing is there was so much competition worldwide and so much cross-border competition, with Japanese firms in New York and London; US firms in Europe etc that the idea of the leveraged transaction was one of the few things which were left which could produce substantial profit, albeit with great risk.
I think it was a normal, typical consequence - you can call it greed - of wanting to have a higher and higher rate of return, when so many other products were simply commodities or suffered from too much competition.
Moreover, as firms like Salomon Brothers came up with interesting algorithms for proprietary trading, they weren’t patentable; others copied them and others developed their own techniques. The use of computerisation made all of these transactions, all of these products rather unprofitable, or if not unprofitable, not very profitable. That led inevitably - and still does - to more and more risk through leveraged products, and leveraging took dozens of different forms.
What was also happening is that the most senior managers were and still are totally unaware of the complexity of the transactions. The trader ended up running the firm and taking great risk, because the heads of the firm were coming out of marketing or sales. Even if they were coming out of trading, there was no way they could keep up with the PhD mathematicians.
Michael Dobbs-Higginson: Gene, I totally agree with you on that. I’ve actually seen it and so have you, viz the Merrill Lynch trader case when you joined us …
[Note: After Rotberg left the World Bank after 20 years, he became executive vice-president of Merrill Lynch for two years in charge of risk management to solve a particular problem the firm had on derivatives.]
Robert Gray: There was no lack of complexity in the 1980s, though; I think it was just the scale was nothing like as dramatic. We had our collared floaters, our mini-maxes, our warrants of all complexions, our zeros, partly-paid zeros, you name it. It was an extraordinary period in terms of complexity. Some of the floating-rate note structures we devised were mind-boggling, but none of those individual initiatives had the scale to do the systemic damage we saw later.
Gene Rotberg: Yes, I agree; they were complex but they could be replicated pretty easily by other firms.
Michael Dobbs-Higginson: And understood by management.
Gene Rotberg: The bottom line, although it was beautiful and complex, it could not produce that much profit for the firm inventing it. As a result, the only way to get the profit, and I expect it still is today, is the more leverage the better. That is a very, very dangerous proposition, particularly when the leverage is accomplished through taxpayer-funded capital.
IFR: Would your sense be that innovation in the capital market has had its day?
Cyrus Ardalan: There are several reasons why innovation occurred at the pace it did in the early 1980s and a lot of that was driven by technology. We went through a quantum shift in the way we were able to analyse and follow markets between the 1970s and the 1980s when computers came in. If you look at option pricing models, they existed in the 1970s but frankly what were you going to do with them?
They were a nice theoretical construct, but there wasn’t much you could do; it was technology that allowed you to commercialise and utilise them.
Similarly, you can’t really do arbitrage, you can’t trade asset classes against each other unless you have data; OK you can do it on a limited scale but you can’t really start doing fancy types of trading. Again, the availability of real-time data and the ability to collect and analyse huge volumes of data only began to become a reality in the mid to late 1980s.
A lot of the innovation was driven by that. I think that will inevitably mean the type of innovation that we’re seeing now will be more muted, and it has been more muted as a result of that, but we will continue to see innovation. When I left the World Bank I was hired by Chemical Bank to create a product development unit. The concept was that you actually created a little group of people that would come up with new ideas, which in retrospect doesn’t make any sense, it was completely absurd.
Michael Dobbs-Higginson: We did the same thing at CSFB but it didn’t work.
Cyrus Ardalan: It didn’t work at all, because [product development] had to be part of everything else. It wasn’t like a manufacturing business, where you have R&D and can generate something…
Michael Dobbs-Higginson: Or create a chip.
Cyrus Ardalan: Exactly. That was the mindset, that things were happening so quickly and so dynamically. A lot of it was driven by technology and also a point that you made, Iain, the type of people that went into the industry changed. Salomon was the leader; it began to put MBAs and PhDs on these desks in a way that never existed before, because now the technology lent itself to using people like that. It was a combination of different things which led to this really quantum shift in the way things went.
Michael Dobbs-Higginson: Very good point.
Iain Baillie: My guess is it was the late 1970s before the average Eurobond desk discovered that they could hedge out interest-rate risk by selling US Treasuries. Until then the major price determinant was interest rates, not credit. It was from the late 1970s, early 1980s when most Eurobond books started to be fully hedged. That was a very simple limiter of risk.
Robert Gray: If you look across the span that we’re discussing, the 40 years, there have been two major innovations: securitisation and derivatives, broadly defined. Those are the two generic areas of innovation that we’ve had to work with; I can’t think of any others of similar significance.
IFR: Certainly not of that magnitude. Michael, earlier on you said derivatives heralded the arrival of egregious abuse. They’ve also been referred to famously by Warren Buffett as weapons of mass destruction. But you couldn’t really conceive of a market like today existing without derivatives. I’m curious to know your views.
Michael Dobbs-Higginson: I think you have to marry two points; one is the extreme complexity and the other is your point, Robert, and that is the ability of management to understand. You’re getting new generations of management now who’ve learned derivatives at the breast so it’s part of their DNA or at least very present in the daily activities. If you can marry those two together, then you have a better chance of managing the risk. Our problem was management hadn’t got a clue what these young tigers were doing. Hence, all sorts of horrific things happened, which ultimately led the financial markets’ global meltdown.
Iain Baillie: I also think there was a lack of understanding of the true correlation between some of the instruments people were using. I remember very early on being told “the only true hedge is to sell it and everything else is slightly less correlated than that”. A number of them were much less correlated and still are much less correlated than people thought they were.
Cyrus Ardalan: That’s a very good point and I think that takes one to another observation nowadays, the pros and cons of transparency and the impact that has on market psychology. The more transparent markets are, the more market psychology begins to play a more important role.
The more the market psychology begins to play an important role, you have a transparent world where everything is marked to market and prices begin to move all over the place. Then you can create these self-fulfilling scenarios where you get into vicious circles where people begin to believe in a certain paradigm. That immediately pushes the market in a certain direction.
If you look at the point Gene made about the early ’80s, and the way in which petrodollars in the 1970s were recycled to emerging markets, that led to a massive crisis in the early 1980s with Mexico and the rest, but that didn’t bring the world down; it didn’t bring the world down because there was no transparency in secondary market prices and no trading.
During the crisis of 2008, you could look every second at what was happening to your stock price, to every other price. That feeds into the whole question of market psychology. That has also been a big change and that creates this high degree of correlation, certainly within asset classes and potentially across asset classes, which is very dangerous.
Gene Rotberg: It’s an interesting phenomenon that the greater and the more sophisticated the technology, and a higher quality of information, the greater the amount of volatility, because everyone is getting the information at the same time in milliseconds. Everyone sees enormous amount of liquidity on one side, everyone becomes a buyer, everyone becomes a seller. As distinguished from 30 or 40 years ago, where the information was so poor; people would be buyers or people would be sellers, because they weren’t getting all the information. The fact that information is so widespread increases volatility. If there is an untoward development down it will go very fast.
Cyrus Ardalan: Particularly when people’s performance is driven by short-term considerations. You can argue that if people are driven by fundamentals then this should be self-correcting. That doesn’t happen when people are driven by short-term considerations, because they’ll say: “I think fundamentally this doesn’t make any sense, but it doesn’t matter, because I think the market is going to go this way for the time being”. You get on that bandwagon, because you don’t want to be caught out. I think that really again increases the correlation.
Rene Karsenti: I think Cyrus described very well the reasons for the innovation of the 1980s. One of the motivations of this tremendous innovation, particularly the swap market in the 1980s, was because markets were fragmented, protected, and regulatorily segmented. So if a borrower like the World Bank needed access in one currency and its market was somewhat saturated, it had to swap its access to a market with another issuer, which had better access to that particular market.
In the case of the first swap, IBM had access to the Swiss market at better costs than the World Bank. Because these markets were not global and were segmented, there was an opportunity to create an instrument to exchange these liabilities. Gene can comment much more on the motivations for these transactions, but that was really the rationale. We live in a world with much more opportunity to achieve more efficient costs for issuers, thanks to globalisation and access to information.
Gene Rotberg: The World Bank - and I’m sure others, too - were saturating the German and Swiss markets. We were doing public issues and private placements, and going to the savings banks, the co-operative banks and the insurance companies. The German Government basically said: “you’re saturating the market”. We had the same thing in Switzerland: we were doing perpetuals, zeros, long-term and short-issues term in the domestic bond market.
It turned out that IBM had a lot of Deutschmarks on its balance sheet and had a huge profit in them but it couldn’t capture it because its bonds were not callable. So we got together with IBM and essentially said: “we want more Deutschmarks. We’ll take them off your hands and pay all of your obligations. We’re a better dollar issuer than you are, so we will issue dollars and you pay our dollar obligations”. It took two to three months to do the first swap ever done in a public market, and the transaction was executed.
What people don’t know is that the board of directors of the World Bank was so concerned about having counterparty risk with IBM that it insisted that Aetna Life Insurance Company guarantee the counterparty risk. That led the World Bank to believe: “we don’t have to do a bond issue; let’s just try to clean up our balance sheet by swapping out some of our liabilities”.
Then others said: “this is the world of liability management. We can begin to restructure our balance sheets”. Then the next step was: “why worry about a balance sheet? It doesn’t matter if you have a balance sheet; let’s just speculate using the swap on our position in Deutschmark, yen, Swiss francs, or dollars”. Swaps became a product used not by issuers but a product used by investment bankers. There remained of course, one other risk: how do you take care of the credit risk? People began to speculate on the spreads over Treasuries, and that led of course to the credit swap market.
At the very beginning, no-one thought that derivatives would be used as a proprietary trading vehicle, let alone a vehicle to bet on credit spreads regardless of whether you have an interest in the issuer at all. They were originally just a way of doing a little bit of liability management by issuers, but then they just grew exponentially as soon as the technique was developed.