With the Olympics almost upon us in London, it seems appropriate to have a Muppet team award. This goes out to the private bankers at Credit Suisse for their tri-athlon performance on behalf of their clients in matters structured products in the holy church of open architecture.
(Editor’s note: I was at CS when these events happened. I have no inside information and no more information than the man in the street. What I do have is a highly tuned bullshit detector and a highly developed sense of what is the right way to treat your clients )
Banks and their client advisors have a very special relationship with their clients. It is perhaps the single most intimate one after the one with their doctor, as an old manager of mine from IBM, the great Kevin Walling, once remarked after embarking on a second career as an independent financial advisor. It does not take a PhD. to understand the enormous responsibility any bank has to give the right and the best advice. In my Goldman Sachs years, one of the great mentors I have had, Eddie Watts, impressed on me the need to make sure that clients really understand what they are buying. “Otherwise, Olaf, “he told me, “if it is not totally clear, they pretty much have a free put” A put being the right to give something back, sort of like the returns policy at M&S. That observation from the university of life re-enforced a basic concept I learned at a real university: “the duty of care”. If there is a professional relationship where one party is relying on the expertise of the other, there is a very clear duty of care. (For more on this see Donoghue v Stevenson, this is an old case, but still the reference one). Now, even with all this said, there are repeated cases of mis-selling. One of the more egregious ones of recent times centred on the late Lehman Brothers and their structured note programme. And to add a twist to the tale, this week’s blogpost is not about the evils of Lehman; rather it is about the foolish bankers who did their work for them.
Structured products have been the opium of the private client for quite some time now. The basic idea is that the “structure” allows a client to be extremely selective about the degree of risk and the target of the investment that is being made. If as an investor you want a degree of capital protection, but want to have some of the upside from the performance of a trio of pharma stocks, the banks can tailor a structured product to do just that. Customisation is what that is called in other industries. Generally, there is a trade off; the more capital protection you want, the less of the upside in your chosen target investment you are going to receive. Not a straightforward product and certainly not for everyone or for everything. As was once said of advertising: “It is not necessarily either a good thing or a bad thing, it just depends on the use to which it is put.”
In the mid noughties, one of the big producers of these fine instruments was none other than Lehman Brothers. As is so often the case with special investment types, these things were created under the banner of an offshore vehicle, in this case Lehman Brothers Treasury in Amsterdam, which created a staggering $35 billion worth of these things under the stewardship of a highly talented Goldman Sachs alum, Jeremy Isaacs. (For more see Business Week). In his days at Goldman Sachs, Jeremy was one of my internal clients and a very occasional drinking partner. A pretty smart guy, surrounded by many of a similar ilk. $35 billion is a big number, even on Wall Street and in the last heady days of Lehman in 2008, there was a lot of pressure on to sell these things. If you break the thing down into its component parts, it is easy to see why any Investment Bank would love them and a Treasurer suffering from a lack of liquidity would push his IB troops to sell the things. Where these bonds offered some degree of capital protection, as most did, they were essentially made up of two active ingredients. A zero coupon bond and a bet. The bond part works like this; suppose you have $100 to invest. You are willing to take some risk, but absolutely want to get no less than $90 back in two years time. For the risk of losing $10 in capital, you want to participate on any increase in value in a basket to tech sticks, say Apple, Google and HP. The trader selling you this needs to have a certain way of getting that $90 back, so off he goes to see the Treasurer and says “How much do I have to give you now so that you will guarantee to give me back $90 in two years time?” The answer to that question will depend on both market rates and how much the Treasurer needs those funds. This is the equivalent of a a zero coupon bond. Let’s say the Treasurer says “For $85 now; I guarantee you will have $90 back in two years. That leaves the trader with the remaining $15 to cover the bet that the client wants on the three tech stocks and to make a profit. Once you understand these two components, it is not hard to imagine what happens when a Treasurer really needs the money. If the market rates would suggest he should pay $85, he can get aggressive and offer to give $90 back later for $82 now. The trader now has $18 to make that bet and some P&L. So he can offer a little bit of it to the prospective client, or at least the private bank looking after then, and still book some good P&L. Structured are a derivative.
With that basic understanding, let us move to the corridors of power at Credit Suisse’s private banking unit. Inside the Credit Suisse Group there has since records began, been a love-hate relationship between the Swiss who run the private bank and the Anglo-Saxons who traditionally run the Investment Bank and Asset Management. To be fair, the same love-hate scenario plays out at UBS too. In a full service banking group, you would think the private bank would just buy these things from their own Investment Bank. Mais non! Every private banker the world over will always demand a free choice of where they execute their business, irrespective of how big their Investment Bank is. Their war cry is “Open architecture and best execution”. In general, the brotherhood of private bankers are as fervent in their defense of what they consider their inalienable right as a Texas Redneck is about his right to carry a gun everywhere.
So now picture the scene when the sales guy from Lehman knocks on the door eagerly selling these structured notes with phenomenal returns thanks to those incentives offered by the Lehman Treasurer. Now gee whiz, golly gosh, those fine structured bonds from the house of Lehman look so much more attractive than the equivalent product being peddled by the Investment Bank at Credit Suisse. At this point, the testosterone kicks in and the Private Bankers get on their soap box about those greedy bastards over in the Investment Bank. “You are ripping us off ja. Zese nice people vrom Lehman are giving our clients ze much better rates ja.” And so it came to pass that the CS bankers bought lots of lovely structured products from Mr Isaacs and his merry men. So taken were they by the optical attractions of these products (it must have been the products and not Jeremy Isaacs), that they loaded up on these things to the tune of $700 million, some 5% of what the big machine in Amsterdam created.
When Lehman went under, that, according to the press reports, was the nominal value of the bonds that were now worthless. But, this was not a loss to Credit Suisse, it was a loss to their clients. Now when there is a loss like that, it is inevitable that some questions are going to get asked and any investor worth their salt will see if they can make the bank take the loss for somehow failing in their duty of care. It may come as no surprise, that there as one awful stink. Let’s look at the facts of the evil trinity of sins we see before us.
Firstly, the sin of sheer volume. $700 million in what is essentially cheap funding for a competitor. The sheer size of that position should in and of itself have been a major cause for concern. If your own Investment Bank is always losing then some control process internally ought to be forcing some high-level discussions across the divisions.
Second, the sin of Widows & Orphans. This is an old Wall Street expression that perfectly captures the theme of “suitability”. If you are a banker or even a client, you know that you should sell or be sold products that are suitable. Well it turns out that the good private bankers of Credit Suisse lost sight of this oldest of dictums. In their haste to place these Lehman products with their clients, and of course take their piece of the pie out and stick two fingers up at their own Investment Bankers, they sold these to anybody and everybody. In many cases, in place of the traditional fiduciary deposits that are the staple diet of private banking as far as cash investments go. In the haste of the sale, the small matter of issuer risk went largely unmentioned. This is the risk that Lehman is not their when the bonds mature. Some of the client correspondence made the press. It made for shocking reading.
Thirdly, the sin of eggs and baskets. We all know that we should not bet all our money on one thing, whatever that is. Inside banks there are rules for all those mutual funds about what percentage of a funds assets can be in one investment or in related investments. Very sensible those rules; for example, retail funds often have a cap of 10 percent in one name. A prudent bank would, one might hope, have some controls over how its clients’ risks are spread too. Mais non! Not a chance. In some cases, in excess of 50% of the assets in some client portfolios found their way into these structured products. At this point a Buffett chorus of derivatives being weapons of mass destruction would be in order. Amen to that.
In Switzerland, there was uproar of the most public kind when the dust started to settle. Even a novice could see that much wrong had been done. In the US, the affected investors would be rounded up by a tort lawyer and the offending bank would be the subject of a class action law suit faster than you could say “I was wronged your honour”. In Switzerland, there is no such thing and you can imagine that the senior folk at Credit Suisse, and for that matter at UBS were thanking their lucky stars for such a helpful legal regime.
Lessons Learned: The first is a classic observation, but one on which the sun does not set. If it is too good to be true, it is too good to be true. Even the most anti Investment Banker minded Private banker ought to have wondered why one another investment bank was consistently outbidding his in-house colleagues. $700 million is way more than normal, which is a common sense control we have touched on in prior posts. Secondly, controls. All these trades should have been subject to a suitability check and thirdly, irrespective of the investment or the stock involved, there should be controls around concentration risk in client portfolios. So either these controls were there and they were ignored or they were not there. In either case, the conclusion is the same. Heads should have rolling down the hill.
The case was a sad indictment of the lack of good controls generally and a clear lesson in point as to why open architecture is as dangerous as it is a privilege.