Mod note: Blast from the Past - "Best of Eddie" - This one was originally posted in March 2011.
The following is an exclusive guest post by Omer Rosen, author of the controversial Legerdemath, originally published in the Boston Review. Omer is a former Citigroup corporate derivatives guy, and this latest piece explains the monkey math that was used to pick clients' pockets by confusing them with yields instead of prices. The scheme's elegance is in its simplicity, as the corporate derivatives desk convinced clients to compare apples to oranges and by doing so think they were getting a square deal.
Omer has graciously agreed to respond personally to your questions and comments in the comments section for the first 24 hours this piece is posted. His blog is located at Legerdemath.com and you can (and should) follow his Twitter feed at @omerrosen. Without further ado...
Legerdemath II: Anatomy of a Banking Trick
In my previous article, “Legerdemath: Tricks of the Banking Trade,” I made brief mention of Treasury-rate locks:
Most brazenly, we taught clients phony math that involved settling Treasury-rate locks by referencing Treasury yields rather than prices.
A number of readers expressed a doubt that using a settlement method based on Treasury prices was appropriate. What follows is as good an explanation of Treasury-rate lock settlements as 2,000 words will allow. I have simplified some of the bond math and concepts and will end with an analogy that I hope will elucidate what the math did not. However, as this post hardly qualifies as an easy read, feel free to ask questions in the comments section. Confession: I fudged the word count a few sentences ago to increase the likelihood of you reading on.
Forget for a moment, everything you have heard or think you know about Treasury bonds. Taken in isolation, the purchase of a Treasury bond is nothing more than the purchase of a fixed set of future cash flows. If you find the term “cash flows” confusing, think instead of the following: buy a bond today, receive predetermined amounts of money on predetermined dates in the future.
In this column I will be referencing a 10-year Treasury bond paying a coupon of 5.00%, with a notional amount of $100. For convenience, I will christen this bond “Bondie.” Sans jargon, the fixed set of cash flows received when purchasing Bondie would be $2.50 every 6 months for 10 years and an additional $100 at the end of the 10th year.
There are two basic ways to describe the value of this fixed set of cash flows, either by price or by yield. Price answers a simple question: How much would it cost you to purchase this fixed set of cash flows? This price will change over time, in much the same way that the price of a stock changes over time. Yield expresses the return earned by purchasing these cash flows at a certain price.
If you had to pay $100 in order to receive the fixed set of cash flows I described above, then your yield would be 5.00%. If you had to pay more to purchase these same cash flows, say $105, then the return you would be earning (the yield) would be lower than 5.00% – it would be 4.3772%. Intuitively this should make sense – the more you have to pay for a given set of cash flows the lower your return will be. Or, more simply, when prices go up, yields come down. Conversely, if you had to pay only $95 for these same cash flows, the yield earned would be higher than 5.00% – it would be 5.6617%.
Algebraically speaking, price and yield are linked by an equation where all the other variables are known. Therefore, if you know the yield of a given bond you can calculate the price of that bond and vice versa. In plain terms, saying you are willing to pay $100 for Bondie is the same as saying you are willing to buy Bondie at a yield of 5.00% (i.e. at a price that will allow you to earn a return of 5.00%). It is similar to how one can describe the speed of a car either by the number of miles per hour it is traveling at or by the time it takes it to travel one mile – if you know one you can solve for the other, and if one goes up the other comes down.
To belabor the point, if a car is traveling around a 1-mile track at an average speed of 1 mph then it is easy to solve for the time needed to complete a single lap: 60 minutes. Either “1 mph” or “a 60-minute mile” provides you access to the same knowledge about the speed of the car during that lap. And, if the car’s speed were to increase, the time it would take to complete another lap would decrease (At 2 mph a mile would only take 30 minutes). The same inverse relationship holds true between prices and yields.
Now back to Treasury-rate locks. When a company puts on a Treasury-rate lock, it is doing nothing more than taking a short position in a Treasury bond. A short position is a bet that will pay off for the company if Treasury prices go down and go against them if prices go up. Why would they do this? That is a subject for another column and I ask that you accept as an article of faith that sometimes this bet, rather than being a gamble, reduces risk and uncertainty for a company.
The short position can be viewed as an agreement under which the client will sell the bank Treasury bonds at a certain price on a set date in the future. This price is determined based on current market conditions. For example, let us say, that based on what current market conditions dictate, the client agrees to sell Bondie to the bank at $95 one month hence. A month passes and Bondie is now trading at $100. The client will have to go into the market, buy Bondie at the current price of $100, and then sell it at a loss of $5 to the bank at the previously agreed upon price of $95. For expediency’s sake, the client just pays the bank the $5 it has lost and the bank takes care of all the buying and selling behind the scenes. The calculation of $5 in the above manner – subtraction – is an example of the price-settlement method of Treasury-rate locks.
However, when it comes to bonds, corporate clients do not think in terms of price; they think in terms of yield because yield is expressed in the language of interest rates, the same language companies are familiar with from business concepts such as rates of return and borrowing costs. In theory, this should add only a simple step to the settlement process. The company locks in a sale of Bondie at the same level as before, $95, but rather than quoting them that price the bank quotes them the corresponding yield of 5.6617%. We can refer to this yield as the locked-in yield.
A month passes and the Treasury rate lock is settled. Rather than telling the client that Bondie is now trading at $100, the bank tells them that the yield is now 5.00%, having fallen by 0.6617%. But 0.6617% is not a dollar value that can be paid out as a settlement. To calculate the settlement, both yields, 5.6617% and 5.00%, need to first be converted back to their respective corresponding prices, $95 and $100. Taking the difference between the two prices results in the same settlement value we calculated before: $5.
But the client is never shown how to settle based on prices. Instead they are introduced to a nonsensical and more complicated method called yield settlement. The sole purpose of this settlement method is to trick the client into allowing the bank extra profit.
Whereas price settlement asks the question, “By how much did Treasury prices change?” yield settlement asks, “By how much did Treasury yields change?” As mentioned in the previous paragraph, the yield decreased by 0.6617%. But how does one convert 0.6617% into a dollar value that can be paid out?
First, a unit conversion is necessary. For clarity and convenience, finance makes use of a unit called a basis point. Each basis point is equal to 0.01%. Using this new unit, the above decrease of 0.6617% can be expressed as 66.17 basis points. Of course, this solves nothing, only modifying our most recent question slightly: now we ask, how much is each of the 66.17 basis points worth in dollar terms?
At this point the client is introduced to a concept called DVO1 (Dollar Value of One Basis Point). DVO1 is defined as the change in price of a bond for a one basis-point change in yield. For example, if the yield on a bond changes from 5.00% to 5.01% or from 5.00% to 4.99%, by how much would the corresponding price of that bond change? This change in price is the DVO1. If yields shifted by 66.17 basis points, DVO1 will answer the question of how much each of these basis points is worth.
The starting point for this calculation is the yield at the time of settlement. In our example, the yield at the time of settlement is 5.00%. At this yield, the corresponding price of Bondie is $100. If the yield were to rise by one basis point to 5.01%, the corresponding price of the bond would fall to $99.922091, a decrease of 7.7909 cents. If instead the yield were to decrease by one basis point to 4.99%, the corresponding price would rise to $100.077983, an increase of 7.7983 cents. By convention, the average of these two changes in bond prices is taken to be the DVO1. So, at a yield of 5.00%, the DVO1 would be 7.7946 cents per one basis-point move ((7.7983 7.7909) ÷ 2). If the yield changes by one basis point, price is said to move by 7.7946 cents. Or, in more plain terms, each basis point has been assigned a value of 7.7946 cents.
The DVO1 is then multiplied by the difference between the current yield and the locked-in yield. In our example the difference between 5.00% and 5.6617% is 66.17 basis points. From the previous paragraph we know that each of these 66.17 basis points is worth 7.7946 cents. Multiplying 66.17 by 7.7946 we arrive at a settlement value of $5.1577. This is the yield-settlement method of Treasury-rate locks.
Apart from being confusing, the yield-settlement method has resulted in a settlement value that is greater than the $5 calculated using the price-settlement methodology. For a good-sized rate lock, say $500 million dollars worth of 10-year Treasuries, the client would pay the bank an extra $788,500 (500 million x (5.1577 – 5.00) ÷ 100) when settling using the yield-based methodology. This “extra” is profit for the bank.
I ask that you stop reading here for a moment. I have stated from the beginning that yield settlement is incorrect. However, when reading the explanation of yield settlement, did you find yourself agreeing with the logic? At what point, if any, did you spot the flaw? And can you guess what happens if prices had gone the other way? If prices had gone down instead of up, say to $90, the bank would have owed the client money. However, yield settlement would have allowed the bank to earn a profit by paying the client less than it actually owed them. No matter what happens to prices, yield settlement allows the bank to earn extra profit.
Now picture yourself as a client receiving a tutorial on Treasury-rate locks. You are being instructed by a banker on a matter that seems procedural, in a manner that seems advisory and helpful, without any warning that something might be amiss. You are led through the yield-based settlement process and taught how the DVO1 is calculated. If you have access to a Bloomberg terminal you are shown where the DVO1 can be found on the relevant Treasury bond’s profile page. Perhaps presentation materials are sent over detailing the mechanics of rate locks and different possible outcomes depending on various possible market movements. And all this is part of a larger interaction, a relationship even, during which the banker is nothing but genuinely friendly and informative. Furthermore, there is a good chance that someone from a different part of the bank, someone who has advised you before, was the one that introduced the two of you in the first place. Would you question your banker?
Clients, among them some of the largest corporations in the world, never did. Confident in the tools provided them and blinded by specious logic, the client never even thinks to question the underlying methodology. And, especially since the client is never made aware of price settlement, the methodology does sound logical: Check to see by how many basis points Treasury yields moved. Calculate the dollar value of each basis point. Multiply the two and arrive at a settlement value.
However, this methodology is an approximation that always works out in the bank’s favor. Why? Because each of the 66.17 basis points has erroneously been assigned the same value of 7.7946 cents. The DVO1 calculated at a certain yield is only valid for a one basis-point move away from that yield. Therefore, while the first basis-point shift away from 5.00% is indeed worth 7.7946 cents, successive ones are not.
Put another way, DVO1 at 5.00% is different than DVO1 at 5.01% is different than DVO1 at 5.02% is different than DVO1 at every other yield. And so the value of the basis-point change from 5.00% to 5.01% is different than the value of the basis-point change from 5.01% to 5.02% is different than the value of all successive basis-point changes. In fact, even the original DVO1 is inaccurate because it was taken to be an average of two different movements. Multiplying the 66.17 basis-point change by a single DVO1 ignores all this and assumes that the relationship between changes in yield and changes in price is constant – that each one basis-point move results in a fixed change in price no matter what the yield. Yield settlement takes the graphical representation of the relationship between prices and yields – a curve – and flattens it into a straight line.
Admittedly, all this can be a bit confusing. After all, if price and yield are both valid ways of expressing the value of a bond, shouldn’t you also be able to measure the change in value of a bond by looking at either the change in its price or the change in its yield? The math says no. Resorting to hyperbole, teaching the client yield-based settlement is akin to selling them on time travel.
Return for a moment to the example of a car driving along a 1-mile track (a conceptual, though not mathematical, equivalent to rate lock settlements). In this analogy, “mph” will play the role of “yield” and “travel time” will play the role of “price.” Assume the car is traveling at a speed of 1 mph. If the car speeds up to 2 mph, the time required to travel a mile decreases from 60 minutes to only 30 minutes – a 30-minute decrease in travel time. This 30-minute decrease plays the role of “DVO1″.
Now assume that the car is traveling at a speed of 120 mph. If again the car’s speed increases by 1 mph, here to 121 miles per hour, does the time needed to travel a mile again decrease by 30 minutes? Since a mile only takes 30 seconds to complete at a speed of 120 miles per hour, short of a DeLorean and some lightning, reducing the completion time by 30 minutes would be impossible. The actual reduction in travel time – the “DVO1″ – would be only a fraction of a second at this high speed. “DVO1″ is not a constant in this analogy either.
To extend the analogy, calculating a rate lock settlement would be akin to calculating the difference in travel times for each of two laps. If lap 1 were completed at a speed of 120 mph and lap 2 at a speed of 1 mph, how would you calculate the difference in travel time between the first and the second lap? Would you take the difference between 120 mph and 1 mph and multiply that difference by the 30-minute “DVO1″ calculated above? Doing so would imply an impossibly high difference between the two lap times: 3,570 minutes ((120 – 1) x 30). This calculation is the parallel of the yield-settlement method.
For makes and models without a flux capacitor, you would simply look at the difference between the times the car took to complete each lap. If a stopwatch is not handy, the following quick math provides the answer: a 120-mph lap takes 30 seconds to complete and a 1-mph lap takes 60 minutes to complete. The difference in travel time between the two laps is therefore 59.5 minutes. This calculation is the parallel of the price-settlement method. As you can see, the 3,570 minutes calculated using the other method is far off the mark.
In price/yield relationships the same problem exists – that problem being the realities of math. Yet banks I encountered almost always instructed clients to use the yield-based settlement method. And so a product that is meant to return the difference between two Treasury prices, a matter of elementary subtraction, is perverted for profit.
If yields change by very little, this profit does not amount to much. Fortunately, depending on one’s point of view, banks have other tricks for profiting from rate locks and do not rely solely on yield-based settlement. In fact, miseducating clients with yield-based settlement is almost an afterthought, just a bonus that pays off with large movements in yield. Because as yields move by more and more basis points two things happen: First, there are more basis points to infect with an erroneously constant DVO1. Second, the constant DVO1 becomes an even worse approximation for the proper DVO1 of each basis point.
In behavior that might be considered yet more sinister, sometimes banks had to implicitly agree with one another to use yield settlement. This transpired if a client decided to divvy up a single rate-lock transaction, with each bank getting a piece of the deal and each bank knowing that settlement of the rate lock would have to be a coordinated affair.
All this mathiness is hidden in plain sight. Some examples of yield settlement can be found online. Or you can just ask a company that put on a rate lock to dig up some trade confirmations and see what settlement methodology was used. There are hundreds, if not thousands, such documents in corporate offices around the country, each one part of an unwarranted transfer of millions of dollars from clients to banks.
Wow, that's an exceptionally thick read. Very candid and informative, thank you so much for sharing. So how extensive may this deception have been at that point in time? Are there banks still conducting this today?
I know from a friend that it was still going on in 2008. I can't verify that it was going on after that but I don't see why it would have suddenly stopped industry-wide. If you search online for Treasury rate lock settlement, while you won't find much, what you will find is always discussed in terms of yield - price is never mentioned. In any case, the goal of this article (and its predecessor) was to describe a type of behavior and a type of thought process - the individual example is less important than the theme that example points towards.
Good read. The shit the banks pull never ceases to amaze me. I'm sure their defense would be that "these are big boy clients that should know what they are investing in," when they're really just stealing.
Does this shit still go on?
I wonder how many people are going through statements / files and redoing their bond math today...
I wish I could say the answer is more than zero...but somehow I doubt it. Sigh.
I wonder if options do something similar, like a "delta settlement". lol. Good and informative read, appreciate the effort.
Who in the business usually does the calculations for the yield settlement? Are these the 700 GMAT whiz-kids or just client account stewards?
What were the boss responses to anyone who tried to use a method that didn't rip people off?
What did co-workers usually think about practices like these? Were people openly accepting that fraud was used, was it rationalized, was it loved or hated? Did anyone quit or get fired because of it?
Thanks. It's a shame that the only respectable position in the business world is to do the wrong thing for years and years (as long as it's profitable and prestigious) and then confess, rather than doing the right thing immediately when the first instance of fraud is noticed. What employer would hire the man who quit the first day on principle, or supposedly passed up offers from companies purely because he knows they do wrong?
The same people that transact the product do the calculations. In this context, what I think you are referring to by account stewards, would be the people who send out the payment or book the trade in the system or send out trade confirmations - but all of that is a flow-through based on instructions
I never heard much questioning about how things were done, though I obviously cannot speak to people's internal monologues. Sometimes there were some jokes but otherwise it was kind of just pretty normal, day-to-day type stuff. I can remember one time a coworker telling me he felt dirty (though he never refused to do anything), and one time someone from another group told me that he couldn't believe the type of stuff we did "up there" (we were on a higher floor).
I don't know anyone who left explicitly because of their discomfort with all this, but you never really know all the factors behind someone's departure. As for getting fired, I can't imagine why someone would have been fired for doing what they were taught and encouraged to do...I guess I can sum up this type of behavior by saying that, like many things in life, it just is and shouldn't be.
i'm sure there are some clients that understand this. if you're good at math you can detect it pretty easily without all of the car track analogies. or you could just stumble upon it by running a few scenarios in excel. how does the bank explain this practice to the clients that notice and ask about it?
i don't think this is that sinister. people should do their own work. caveat emptor and all that.
I never heard of a client that noticed and asked about it. Also, it is much easier to detect when I state ahead of time that it is wrong...otherwise most people don't even having a passing thought about whether or not it is correct or incorrect - in other words, they don't think about whether or not they should accept it or not, they just accept it.
As for it being right or wrong, or when people should do their own work and when it is okay to trick them, that is a long and endless debate. However, looking back on my time at work and the nature of the interaction with the client, I do not feel it was appropriate in that context.
I agree that it isn't the most sinister practice, but it is still fraud, even if it's something people should check. Professionals are legally bound to do things the correct way because they know better, so this is illegal as well but easily defendable by saying "I had no idea, everyone else was doing it, and my boss told me to do it this way."
I am sorry but a company that allows a person who doesn't pick up on this enter into contracts is not being fair to its shareholders. This is pretty darn obvious, and as bankbank mentioned, if you fall for this its your own damn fault.
The fool is always at fault for his own victimization but do you really think that removes the guilt of his victimizer?
Not always, no. But in this situation, a company enters a contract with a bank that undoubtedly mentions the settlement method to be used. It is the company's responsibility to know what they are signing.
I suppose you could make the argument that this is just an additional fee that is charged, and by efficient markets, it is deducted from other fees charged on the transaction. So if you were to do away with this "implied fee" then the stated fee would increase. If this were not the case there would be an opportunity for someone else to come in at a lower price.
Caveat emptor does not apply when there is an an insitutional lack of transparency as regards yield settlement caluclation as a deliberate means to mislead clients for profit. Caveat emptor is like believing in "prefect markets", where all information is attainable and practices transparent, such a system does not exist in reality.
Anyways the backlash is coming against this kind of misinformation and its for the best if you want to work somewhere with a half decent reputation. Continuing business practices like this garuntees you the loss of reputation and your client's trust which should be paramount. As a potential client reading the below suit against DB, I would affirm never to do business with them again (even though all the BB's do the same)
http://online.wsj.com/article/SB100014240527487044613045762160322353616…
This is with out a doubt a big problem in the industry, but does it not stem from a general social standard in the country if not the world. That the needs of me (i.e. a company, individual, or small group) out weigh the needs of any other group or individual. While I see this as wrong, I also see it as a natural progression of a self obsessed society. Who are we to tell off others when as a society of individuals as a whole can not regulate their own narcissism. This is really no different, it is just a bunch of bankers who think they are the smartest guys on the plannet fed by the seemingly blind faith that people put in them. I think the problems that lie at the base of actions like this are much deeper than just pure greed.
I should add that this is quite similar to a lottery - it is legal to charge people for being stupid.
If banks are not at fault, why is it that if I were a banker (and I had done this) I would not like my clients to read this post...
I guess I'm shocked clients don't figure this out. I'm sure most treasury departments have an idea of what duration and convexity are, the math on this isn't all that different.
Just some thoughts off the top of my head:
a) It is easy to figure this out when you are told that you don't know it...but if you don't know that you don't know it...different altogether...just never occurs to them to think about this...they are probably just happy they even understand the concepts they are learning. Also, they have an entire job to do that is unrelated to Treasury-rate lock settlement mechanics...if they don't instantly see a problem they aren't going to take it home with them and study it for no reason.
b) confrontation isn't easy for most people, especially if they are afraid of looking dumb for not understanding something or of incorrectly insinuating that they are being lied to.
c) It is one thing to know what convexity and duration are, but quite another to apply the logic of them to new and unfamiliar situations.
d) Bank is in the position of teacher on this one...as long as you talk confidently you aren't likely to be questioned. Plus, with the way it is phrased, even if a client might recognize that the DVO1 changes with yield they still might conclude that they are somehow being given an average DVO1 for their deal.
e) Maybe a client notices and, rather than confronting the bank, just never calls them for business again.
f) One guy at a different bank told me that he always used to speak of it as an approximation and that that way he was never technically lying (he never mentioned how large the approximation might become or that it always worked out in the banks favor). I've never personally seen someone use this tactic...most people want exact numbers in my experience.
g) Forget, clients...I am quite confident most investment bankers (i.e. people away from the fixed income trading floor world) and even some capital markets people would easily fall for this.
I always get a laugh at the caveat emptor defense in this sort of case. Could you imagine what would happen if a client complained about this practice and the bank said "well, caveat emptor, you should've done your homework to make sure we aren't cheating you out of money!" Yeah, good luck with that shit.
It is assumed that the bank is acting in the best interest of its client. This is generally true when buying a legitimate service. Unless something is egregious, you should feel comfortable that you are not being lied to or misled. It's one thing when you're dealing with a shady chop shop advertising on Craigslist, it's another when the service is being provided by fucking Citigroup.
Furthermore, where the fuck is the integrity? Some of you people are disgusting.
On a side note, if this were a story about the federal government doing something similar with tax returns and somehow fraudulently keeping more of our tax dollars, people would be going ABSOLUTELY APE SHIT, and there's zero chance anyone would say "caveat emptor!" like some shit eating, bank shilling, fucking retard.
that's what i originally asked in my post before i said "caveat emptor..." i imagine some clients would somehow notice this and mention it and i was wondering what happened in that instance. does the bank just position it as a transaction fee for doing the trade, or are they forced to switch to a different methodology for settlement, or what?
i wasn't trying to comment on right or wrong. when i do my business, i make sure i understand what i'm agreeing to, and it's my opinion that other people should do likewise.
for example, when we're drafting shareholder agreements and a seemingly straightforward ownership adjustment or dilution mechanism is proposed and drafted, we still run the math and run scenarios to make sure it actually plays out the way we thought it would. granted, this is a more important part of our business so we afford it more attention/time/money than i assume these corporate finance guys do for the rate locks, but that doesn't excuse them from understanding what they are signing up for.
Right, I understand what you are saying, but the fact is that you shouldn't have to check for something misleading and fraudulent when paying for a service like this. I don't think your purchase agreement is analogous to the topic at all. If one had to double check and think twice about the validity of every service they paid for, the world wouldn't function. You shouldn't have to be extra cautious about this sort of thing.
Plus, I presume the client has other shit to do (namely, running their own business) instead of worrying about whether or not their banker is defrauding them.
"Assuming makes an 'ass' out of 'you' and 'me.'" Why is it assumed that a bank is acting in the best interest of its clients? I don't assume that. I think it would be nice to live in a world in which that were true, but I think it's pretty naive to assume we live in that world. It might be good, profitable business for a bank to act in that way and i think it usually is, but that doesn't mean it's the only profitable way for a bank to behave or that it's the most profitable way for a bank to behave.
Yes I think the world could be better for everyone if everyone were more trustworthy and less self-interested, but I don't think that's the world we live in.
As for the side note on the taxes. I do think the government should be held to a higher standard. It's not a corporation. "by the people, for the people" and all that. corporation is supposed to be by the shareholders, for the shareholders. and also, if the formula for calculating your taxes were laid out in the tax documents you were provided and then according to the formula you ended up paying more tax than you assumed or thought you should have paid, i still think that's your fault for not doing the math.
If assuming the bank isn't defrauding me makes me an ass, then I'm at a loss for words. I agree that the banks are businesses and their goal is to make money, but again, knowing that, you should still be able to assume that they are not defrauding you. This is not crazy.
Again, where is the integrity?
Along with King's post, remember that banking is a service based on relationship, reputation, and trust. Lose that subjective position and you lose business. Simple as that. Putting a shit-eating grin on your face and saying "caveat emptor" is easy to do across the Internet. Even considering that in a real-world situation like this gets you fired and pariahed.
@ Eddie,
Great job, bro. Unfortunately, I think that the average monkey's head is so far up his ass digging for buried treasure that the realities of the industry are not something he wants to face.
@ The King,
Why not consider writing a post about how actually working in the industry and running the track has shaped your opinions and views? Your caveat emptor comments here are a good example. Many of the younger guys would benefit and it might add to debate substance in the future.
@Midas, Agreed. I try and contribute as much as I can, but it'd probably be beneficial to outline what shaped my views at some point.
@TheKing Am I correct in interpreting your comments as the existence of an expectation in the business that, as the client, you should be informed of all sources of revenue to the bank arising from your transaction? Seems a bit excessive... similar to, when buying shares, asking the bank "well how much did YOU buy them for? how much are YOU making from this?". One might argue this line of questioning is irrelevant, and the point is that you are getting the product at a market rate - the same rate you would get elsewhere, and the same rate I could sell to someone else for. What am I missing?
Wait, what? I'm not sure how me saying "you should not have to worry about the bank doing fraudulent shit to screw you over" = what you are saying here. Again, I am arguing against fraud and saying that it's fucked up that clients should have to constantly worry about whether or not they are being defrauded.
A few thoughts, again, off the top of my head:
1) While I'm not for trickery of any sort, I do think it makes a difference (and is worse) when certain math is explicitly represented and taught as being correct when it is not.
2) With a hedging product, price is part of the product. It's not like an ice cream which you can enjoy the taste of even when you overpay for it (ignoring emotional cheapskate type thoughts). If a hedge is mispriced or not properly structured it is, to a certain degree, a less effective hedge or it throws off analysis you might be doing (eg if you're deciding on whether or not you should swap debt from fixed to floating).
3) I honestly don't remember much about the Series 7 and series 63 licensing exams, but we were required to take them (even though most of the financial subject matter was irrelevant to our line of business) because we talked to clients (or so I was told). I seem to remember that there was a good amount in at least one of those exams about ethics and the like and I don't think any of these games would have passed muster by those standards but who knows.
4) A lot of this comes down to what your relationship is with the other party and can't easily be discussed in theoretical debates. Some readers have said that these companies weren't our clients but our counterparties. Well we referred to them and treated them as clients. But what does that actually mean anyway? Forget labels, what was our actual interaction with these companies on a day-to-day basis? I don't think anyone should be scamming anyone, but, especially when I think about how these interactions between us actually transpired and what kind of relationship those interactions implied us having with these companies, I definitely do not think the behavior was appropriate.
Thanks for the post, great read!
Makes sense. I was obviously looking for the catch while reading your article and I'm not sure I would have cried foul the moment I saw DVO1 under different circumstances.
Yeah in my original drafts of this article I structured it in a manner that would not give a warning and without explaining price settlement first (ie I structured it with the purpose of tricking the reader, as if they were a client, and only explaining what was wrong later).
I realized that structure would be a problem when friends asked me to explain what "cash flows" meant. Having price settlement first and having all the warnings and explanations and analogies hopefully makes it an easier (relatively speaking) read on the off-chance that non-finance people pick it up...so if I don't get to enjoy the cruel satisfaction of tricking the maximum amount of people, I will just have to learn to live with that :)
Major props for this Omer (and Eddie). The general public distrusts Wall Street largely because of compensation when they really should be focusing on how banks squeeze the buyside (people's retirements) and corporates (at which most people are employed).
It would be nice if it's over soon and people on our end STOP FUCKING UP, but we're tough, we can take it
Holy fuck I didn't realize bar's are making 70+% on alcohol.....hmmmm
The clients didn't understand this? Like this is simple convexity, not complicated at all...
Maybe these fees are priced in? As in, if they did it by price settlement instead of yield-settlement, the fees charged would be higher? My guess is that maybe everything was previously done by price settlement, and then some smart banker came in and thought, "well, I'll offer yield settlement, and pocket the difference that creates, but this will allow me to charge lower stated fees and steal market share from my competitors". Maybe the clients are not losing as much as we think? Just food for thought...
LMAO.
Yeah, cause shit works out in the client's favor all the time.
I personally have not seen or head of a client getting credit for convexity when settling via yield settlement. Nor have I ever heard of someone explaining to a client that yield settlement is wrong but that they are getting some credit for it. I was specifically taught yield settlement, quite early on in my time at the bank, as a way to make extra profit...not as a way to give a lower rate.
The value of the convexity was not calculated ahead of time - as would have been necessary to give the client credit for it via a lower rate. It was calculated once the rate lock was settled and it was quite a simple calculation: subtract the true settlement amount found using price settlement from the incorrect settlement amount found using yield settlement. And this value was booked as profit. It was a separate calculation from whatever other profit had already been made on the rate lock through whatever other methods were used.
Also, if I remember this next part correctly, as giving the client credit for convexity via a lower rate would mean having to assign a value ahead of time to the convexity, the traders would have then had to hedge the convexity over the life of the rate lock. This simply wasn't ever done in the context of treasury rate locks, no more matter how competitive the deal, as far as I can remember.
Omer insightful topic. Thanks. Would be nice if you touched a little of FX especially forward contracts. Are you familiar with NARC? Much appreciated.
While my group did handle cross-currency interest rate swaps, I don't recall really dealing with straight fx forwards - those would have been handled by the fx derivatives group. And so, while I am familiar with NARC, I've never executed one. What exactly are you interested in with respect to fx? Feel free to message me using the wso messaging system (or at [email protected]) if you want to discuss this in more specific terms.
This is quite a refreshing post. Thank you Eddie for posting this and Omar for taking the time to share this with the WSO community.
I'd like to echo these sentiments. Cheers for taking the time to write this and if you have any more stories along a similar vein they'll be greatly appreciated.
So this is basically saying that a bond usually experiences duration drift since its price-yield curve has convexity and isn't simply linear, so you can't assume DV01 stays constant as yields change. Surprised people can get away with implying otherwise, but this is basic fixed income to anyone that is familiar.
Just saw this thread. It's quite interesting to know what actually goes on in practice. So thank you for the post!
But looks like someone forgot their Fabozzi 101. Isn't this simple under/overestimation from using DV01to calculate prices based on relatively large change in yields and not adjusting for convexity, which in this case kills the investor in up and down movements?
Hmmm, I am not sure if you are posing a question here or just summarizing the math...if it's a question can you clarify?
First of all, people saying that they would have caught this dont understand the business...some corporate guy doing a rate lock is not going to catch this and even if he does the trader at the bank will berate him until he thinks he is wrong and apologizes. I trade at a place that is known as being very sophisticated and I get into fights all the time over the unwind values of OTC derivatives...these guys are shameless and will defend themselves even when its obvious that the value they showed you was flat out wrong.
The bottom line is that banks make alot of money defrauding their customers and the dumber the customer the more fraud they commit. This small cut is nothing compared some of the stuff I have seen and heard. It is a crooked business and standard practice is fraud at every step even up to little stuff like this.
As a buyside trader my only defense is to trade exchange traded products and cash bonds whenever possible and to hope the OTC stuff eventually ends up on an exchange with standard settlement methods (which the banks are fighting of course).
I think its amazing the number of people who are trying to rationalize this behavior. The underlying problem is that BB's have too many unrelated businesses and the result is too many conflicts of interest. When the bank is advising a company on M&A or investing its pension fund the company is a client and the bank has all the legal obligations that come along with that relationship. But when the M&A banker walks the client down to a different floor to meet with a different banker to do a treasury rate lock then suddenly the relationship changes. Its simply not the same as screwing a hedge fund or another bank on terms, since there the relationship is clearly adversarial. There is no other industry involving client relationships that behaves this way. Most are meticulous in avoiding even perceived conflicts of interest. Fortunately the answer seems simple to me. BBs are filled with smart capable people, many of whom want to do business in a more honest and ethical way. We need all the business units that compose a BB but we don't need them to be together under one roof. I think BBs should be broken up into separate businesses. And its not all bad, the bankers could pay themselves huge bonuses for breaking up their own banks.
Okay, I'll concede international arms dealing is a less ethical business than banking. Although to be picky, I'd say its a customer relationship and not a client relationship. Really though I was thinking more in terms of law, advertising, or consulting.
I love that debates can take place about what industries are the most/least ethical. Anyone care to sort all the major industries from least to most ethical? What would the ranking system be?
Ethisphere has rankings by company...maybe one day they'll gain prestige and companies will sacrifice profits to move up the rankings...maybe one day we can look forward to Oscar-style unethical campaigns to win Ethisphere awards...or not...
http://ethisphere.com/wme2011/
Just a quick thought here, more for the sake of discussion than anything else.
Assumptions: a. Banking is a relationship business - when a company needs a product for hedging or other purposes, it turns to the bankers they have dealt with in the past for a variety of reasons, including not wanting to be defrauded, ease of transaction, etc. b. Company (client) is not aware of these built-in fees - this seems to be the consensus. c. The profit from these fees is microscopic - less than say 1% of overall profit of the bank arising from a specific transaction. This might be questionable, especially in times of yield curve volatility, and I have no idea how much the "disclosed" fees amount to in a transaction like this. Lets call this number 0.5% of overall revenue from transaction, and X as an absolute amount (annual income from specific client due to this "trick" only - may include multiple transactions). d. This practice is perfectly legal, though questionable ethical. This seems to be the consensus, since it is probably in the contract somewhere. e. This practice is/was relatively common. This is only based on this article, but it sounds credible.
It would seem that if each of the above was true, then such a practice would not exist, since the risk-reward ratio does not really appear favorable for the bank. The bank would risk losing a valuable relationship that would result in a loss of a future stream of revenue that might be. Based on (c), the PV of this stream of revenue might be 1,000X-10,000X. The large range is due to the loss of other types of transaction that the bank assists the company with, while the 1,000X might be the PV of future transactions of this type only. Lets average that range to 5,000X.
However, the X is also a repeating charge, so lets say the PV of future income from these "hidden" fees is 5X.
So in order for this "scheme" to make sense on behalf of the bank, the probability of a client discovering this, AND being sufficiently upset to discontinue future business with the bank must be
Wow. a) You have too much time on your hands. b) How can you so arbitrarily assign concrete values to those probabilities? c) You're Milton Friedman, not Edward Freeman. d) This type of "well, why not?" mentality is what plagues society today. Call me an anachronism, an old head on young shoulders, but whatever happened to the morality our country used to ascribe to, at least nominally?
What the above long-winded post misses is that the trader and the desk are not acting on behalf of the bank they are acting on behalf of themselves. Its not like they clear this practice with the CEO, they just do it because they get paid a percentage of the proceeds. They could give two shits about some web posting that happens five years later when the money has already cleared their bank account. This is the same reason why nobody "blew the whistle" on the questionable securitizations going on in the housing bubble...they take the gains but not the losses.
Is this really the case? If it is, then isn't this a management problem within the banks? The traders are doing something that has a negative expected value to the bank, and are hence practically stealing from it... seems like something compliance would catch, or somebody out there. Interesting twist to things if the bank itself is not aware of this activity.
In theory, the shareholders should be angry about this but they are represented by the board of directors who are usually in the pocket of the CEO so they would never challenge the way the bank does business. Everyone else including management is just trying to get rich as soon possible and does not care about the expected value of this activity in the long run. In the long run they will be long gone with very large bank accounts. This goes for everything from scalping clients for a few thousand bucks on swap unwinds to churning out horrible securitizations in 2008. The fact of the matter is that almost everyone who was a major player in the financial crisis at every single bank involved got very rich...even the people who were still there holding the bag when everything collapsed. So why would anything change and why would anyone care to say anything about things like this?
Nice discussion. I 've got nothing to add, but I want to keep up with this thread.
I'm shocked and appalled that none of the clients caught this. It's actually extremely obvious that it's wrong if you know even basic bond math.
commenting so i can track
Random Thought:
I find it interesting how many posts/responses I've seen for both Legerdemath articles whose subtext is sort of like: what you did isn't wrong/bad/unethical/whatever adjective you like. And meanwhile, I'm saying to myself, wait what? wait a minute...I'm the one that did these things…for over three years…working 60-100 hrs a week…I'm pretty sure I can look back at what I did, knowing all the context surrounding my actions, and give a pretty good assessment of whether or not they were kosher.
Now I can theoretically understand another corporate derivatives guy/gal saying it wasn't on the up and up but that it is not wrong (although, from experience in having these arguments, I think they'd retreat from that position if pushed), and I can understand someone from the outside agreeing that it is wrong, but I do get a confused and disoriented feeling when someone from outside my group basically says "no, no you don't understand…it's okay"…I'm not saying I have a monopoly on deciding what is wrong and what is right, just that it creates an odd feeling to hear these things about my own past...I sort of expected more of the "you're an evil banker" type responses than the "there's nothing wrong with it" type responses if that makes sense.
Anybody who thinks that what you did is not wrong is not thinking straight.
But there are no consequences or legal ramifications to what you did. So its easy for anyone to make the case that maybe its illegal...maybe not....its debatable....but its certainly not illegal and there are no consequences...so there is no reason for it to stop especially if it makes your bonus check bigger.
Great read, thanks very much OP
? i don't understand why people are so distraught about this. the rules are pretty well understood in the marketplace on how the big boys play. how many times do dealer desks get run over by corporate guys or hedge fund or even other dealer desks?
some corporate guy doesn't understand the convexity in his rate-lock? that's no different than the same firm hiring an unqualified engineer to oversee some machinery. caveat emptor is portrayed as pretty heartless etc. but some markets (rates and fx especially) customers actually have the advantage over dealers. most well-informed people generally consider most vanilla bid-offer to be negative alpha at this point. again, don't go crying for ficc trading desks, but realize the days of spivving some poor corporate guy on libor vs ois discounting on an unwind are over.
spend 5 min. on a trading floor and watch the next time a rv fund comes in for 400 o5s/5s or a pension fund comes in for 200 bonds on the screws or a hedge fund comes in for a 2-way on kiwi or a mortgage servicer comes in on some long-dated vega or a bank portfolio comes in for 5bn fn 4 roll. the pendulum has shifted a long-time ago.
Thanks for front paging this again - I read the original post when it first came out but not the comments. Very interesting debate. For all the explanations of the details, and either the fact that it's not illegal or that it should have been noticed by the marks, etc., I'm still focused on the fact that banks are intentionally screwing customers, and that such a practice still has enough defense. (A poor use of libertarian principles, IMHO). Not surprising, but I dunno, annoying, regardless of whether "that's just how it works."
But I won't care about any of this crap until Corzine et al have a shot of going to prison, otherwise why pretend the system isn't rigged?
lol wow, clients not understanding basic calculus ftw
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