Rossputin.com Rational Thinking About Our World

My friend Mike, aka MUD, also a former CBOE options trader sent a comment to yesterday's article about Bear, Stearns which I thought deserved its own posting...and a response from me, because I don't really agree.

First, here's MUD:

Ross,

I think that there is fraud here on two insidious levels and I think Bear is only one of the many perpetrators.

The first way in which there is fraud is in the use of poorly understood and esoteric derivatives products to mask risk. (I'm not against derivatives at all, only their misuse)As long as the profits are rolling in no one bothers to peek at the true source of those profits and determine the real risk characteristics and profile of the instruments positions. Or to see if the risk/return is even properly compensatory, something truly grasped by too few.

Much like the LTC debacle, much of what Bear and others have been doing has been veiled in false notions of 'cross hedging' which in many cases is no real hedge at all but merely a temporary relationship between various instruments that has the appearance of a hedge. Every time apples go up oranges go down.... No one ever asks what happens if all fruit prices go up or down simultaneously and so the risk monitors never take that possibility into account and proper margins, reserve funding and position size as relates to global portfolio exposure is never questioned or maintained.
It always seems to be just another contrived way of over-booking the longshot and then it's always a BIG surprise when it comes in and the house of cards collapses. (excuse the mixed metaphors)

The second and even more insidious fraud lies in who ultimately pays the price for these failed practices. No "genius" trader is ever required to return the years of profits and bonuses he has received for betting other people's money. He, in most cases, receives a far larger compensation than the people who unknowingly are backing his trades. They are in fact not being adequately compensated for the risk they are being exposed to. This sort of cynicism goes even further when there is an implicit thought that if the shit ever does hit the fan Bear and companies like it will be bailed out partially or in total by taxpayer dollars because the aftermath of collapse is too far reaching for the rest of the economy.

I'm sure you remember the variations of this theme which we used to joke about back in the heyday of index trading. We called it the Paraguay spread or some such thing. Basically the idea was you had a plane ticket to Paraguay (or Hong Kong in one famous case) in your pocket and you sold the hell out of "worthless" puts. If nothing happened you cash in, if all hell broke lose you simply board the plane....

I'm no fan of over-regulation but how many times are we going to see this play out, in how many ways before someone takes the step of not allowing contrived derivatives to be used as way of masking true risk and forcing firms to value their risk properly such that they are not 'free rolling' everyone else?

And now my response:

Mike,

I think you make some valid points about bad behavior in financial markets, but with the possible exception of "The O'Hare Spread" I don't think they are accurately called fraud.

Let me take your points one at a time:

The use, even if misunderstood, of derivatives is not inherently fraudulent by any stretch. Poor risk management is exceptionally dangerous to a business, as Bear learned (although derivatives were not, as I understand, a big part of their problem). If "no one bothers to peek at the true source of those profits and determine the real risk characteristics", the business likely won't last long.

You're right that firms sometimes make bets based on models which can fall apart, like LTCM. It's not crazy to make bets like that, but it probably is crazy to make a bet big enough that the firm fails if the model fails. But again, it's only fraud if the firm or the trader hides the risk from managers or shareholders.

Usually, though clearly not always, it's the firm who "pays the price for these failed practices." Bailouts are rare. In the Bear situation, no Bear clients lost their money, but the firm and stockholders lost everything. Sure, traders are, in the opinion of many, overpaid. But so what? Aren't baseball players overpaid? No? Well, then aren't compensation levels simply a function of market forces? Competition for talent (maybe they're not as talented as they think, but the same applies to many athletes) drives the prices. If firms could get away with deals where some part of traders' pay would be held in escrow to be given back if the trader has a bad year, I'm sure they would try to implement those deals. Until one firm says they won't. You get the idea. Payment (or overpayment) of traders is not fraud.

Keep in mind that fraud has a very specific legal definition. It is, after all, a crime, a level which not all bad behavior rises to.

The Black's Law Dictionary definition of fraud includes this:

Fraud: "An intentional perversion of the truth for the purpose of inducing another in reliance upon it to part with some valuable thing belonging to him or to surrender a legal right; a false representation of a matter of fact, whether by words or by conduct, by false or misleading allegations, or by concealment of that which should have been disclosed, which deceives and is intended to deceive another so that he shall act upon it to his legal injury."

And: "All multifarious means which human ingenuity can devise, and which are resorted to by one individual to get an advantage over another by false suggestions or suppression of the truth. It includes all surprises, tricks, cunning or dissembling, and any unfair way which another is cheated."

The O'Hare Spread is fraud in the sense that a trader has an at-least-implied promise to his clearing company not to risk more than he has in his account. The O'Hare Spread involved making big trades and not telling the clearing firm about them (presuming the firm would not permit the position if they knew about it.) If the trades clear and the firm's risk managers know about them and decide to allow the position, then the bet may be reckless but is not fraudulent.

I think the Bear, Stearns case is a bad example on which to make claims of fraud in financial markets. It was not fraud that took the firm down, but excessive leverage in their capital structure which did not allow them to meet a barrage of demands by clients for their capital to be returned. And Bear paid more-or-less the ultimate price, in a truly tragic way for thousands of employees other than (overpaid?) traders and executives.

And overall, fraud in financial markets, especially on a large scale, is rather rare because it is hard to get away with these days. The SocGen fiasco is the first real case of fraud in a few years, as far as I can remember. Even Amaranth wasn't fraud...and LTCM wasn't fraud either. Just bad bets.

The reason I object so much to calling such things "fraud" is that fraud is a criminal action, made with criminal intent, which should be punished by prison. In most cases including Bear, the market punishes bad decisions, and their is simply no legitimate argument to be made that those decisions rise to the level of criminality, even if you think them to have been excessively risky.