Chapter 66: Propositions

November 8, 1984, Chicago, Illinois

Thursday was a routine day, with the only real news being a quarter-point cut in the discount rate, yielding a Prime Rate of 11.75%. The market effectively yawned at that, as it had been priced in. A couple more cuts similar to that, or better, a couple of half-point cuts, would kick the market into gear, and we could earn some serious returns.

Late in the afternoon, Tony came in to discuss the plans for the new country and region reports. He provided exactly what I needed to speak to Noel, so I called Julie to see if Noel had time for me. Given that the markets were closed, and it was after 5:00pm in New York, he did, so I went right up. Julie directed me in, and Noel was just hanging up when I stood at his desk.

"I have a pair of proposals," I said.

"How much is this going to cost me?" he asked with a knowing smile.

"About a hundred grand, loaded operational costs."

"What do I get for my money?"

"Regularly updated country and regional reports — I mean in-depth stuff, that covers economic, political, and social trends. We'd directly cover the top fifteen global economies, and then have regional reports for others. The bulk of the money is for an analyst with a degree in political science, international relations, or history. The rest of the money, and it's a small part, would be for a Summer intern."

"Your desk or Research?"

"Research. It'll give us a pool of people to consider as they graduate from college."

"Don't you risk leaking proprietary information?"

"Yes, but unless we gave them what Bianca calls 'root' access on the server, they couldn't see the crown jewels — the source code to the computer programs. Everything else we do is similar to what other firms in the industry do. The fact that we use computers isn't a secret; the computer code is. The true risk is losing one of the data analysts to another firm."

"The non-competes and trade secret agreements prevent that."

"Do they? Really?"

Noel laughed, "OK, they threaten my unleashing havoc and letting slip the dogs of war."

"I prefer Conan the Barbarian's answer to the question of what is best in life!"

Noel smiled, "Our corporate motto should be 'To crush our enemies, see them driven before us, and to hear the lamentation of their women!'"

"I wonder how the SEC would view that?"

"Actually, they could bitch, but they couldn't stop me from putting that quote on the cover of every prospectus! Complete with Arnie in his Conan outfit!"

"I'm not sure that sends the right message to our clients, though, to our competitors..."

"Damn straight! What's her name?"

"Whose name?"

"The prospective intern."

I chuckled, "Isabella."

"Now, see, that is doing it right! Do you have proposals?"

"Yes," I said, handing him the proposals and Tony's analysis I'd brought with me."

"I'll likely approve. Give me overnight."

"Will do."

"Keep up the good work, Kane."

As was usually the case, he simply picked up the phone to indicate I was dismissed. I returned to my office to complete the day, then headed to Maja's house for dinner. She greeted me with a kiss and a hug, and I handed her an envelope.

"What's this?"

"Your commission slash finder's fee for Marlena Volkmer."

"This better be in addition to the fee I negotiated!" she declared.

I chuckled, "I can't very well tell the SEC or IRS about that payment!"

She laughed as she opened the envelope, "No, I suppose not ... WHAT?!"

"That's a standard finder's fee for $25,000,000. You know our commission structure."

"Sure, but Jesus..."

"Pascal's wager aside, he's a bad investment! I'm not!"

"No kidding! This is taxable income, right?"

"Yes. You'll actually receive a 1099 from Spurgeon in January. Your commission for Ralph Horton will be paid in January."

"Does this come out of your pocket?"

"It's considered joint operating expenses, so it's spread around to all Spurgeon funds. It doesn't cost me anything, per se, because it's built into the structure of the overall expense charges against my fund. If anything is left in that pool of money at the end of the year, it goes into Noel Spurgeon's pocket."

"It's great to be the king!" Maja declared.

"Absolutely true!"

"Dinner is almost ready, and then I am going to show you just how much I appreciate the check!"

November 9, 1984, Chicago, Illinois

On Friday, I met Andy Fastow for lunch at Gordon on North Clark. It was absolutely a place to be seen amongst lawyers, bankers, and senior executives. I was easily the youngest diner by probably five years, possibly more, though there was one guy who I took to be a lawyer who might only be twenty-six or twenty-seven.

"What is your fund's profile?" Andy asked after we were seated.

"I brought a prospectus for you," I said, taking it from my bag and handing it to him.

"Thanks."

The waiter came, and we placed our drink orders, and both accepted his recommendation of the special of the day.

"Let me get the potentially uncomfortable part of the conversation out of the way, Andy said. "Continental is toxic. No need to mince words. Now, I hope we can have a freewheeling conversation about structured finance and other derivative investments."

"I actually had a conversation with Murray Matheson about them, though it was in the context of a different financial product. What I said to him is that, when handled properly, structured finance or similar derivative investments can be useful for mitigating risk. For the originator, they allow you to shift risk to a counterparty in exchange for a portion of the income stream.

"There are significant challenges to price such derivative instruments because risk evaluation is exceptionally complicated, and might not even be possible. Those risks involve default risk, counterparty risk, pricing risk, market risk, and so on. Even if the valuation problem could be solved, those instruments would actually increase systemic risk, as they would add risk to the market that doesn't currently exist.

"Any notion that they would reduce overall systemic risk is misguided, because risk can only be transferred, not eliminated. Somebody has to take on that risk, and I can't, at least as far as I can determine, figure out a way to price such an instrument. If I can't price it, I can't evaluate the actual risk I'd be taking on, and that's a non-starter. I have no aversion to risk, but I have to be able to evaluate that risk."

"Your analyst thinking is showing through."

I nodded, "I am an exceptional analyst, and that's what allows me to make serious money by taking properly calculated risks. Consider this — if I can't figure out how to calculate risk and correctly price the securitized debt instruments, how can I determine my potential profit? OK, sure, I can look at the ROI and think everything is rosy, but that's 1929 thinking. It was collateralized debt that caused that collapse, and when the collateral value collapsed, the entire market collapsed, taking the banks and the economy with it."

"There are risk mitigation strategies," Andy said.

We were briefly interrupted by the waiter bringing our food, and the conversation resumed once we began eating.

"For any specific individual, that's true," I observed. "That said, systemic risk simply can't be mitigated. It has to be managed, and that's what the SEC, FDIC, CFTC, and all the other alphabet soup regulators are about. We learned the hard lessons in 1929 of what amounted to structured finance, and repeating that would be a VERY bad idea.

"Now, that is not to say securitized debt is inherently bad, nor that nobody should make use of it. In terms of a lending bank, it helps by reducing risk in exchange for a portion of the income stream and, by moving the loans off the books, makes more capital available to lend, which is good for the bank and the economy.

"The challenge there is ensuring your counterparty has the necessary assets to survive default on the underlying debt instruments. If not, it's 1929 all over again. That means you need to properly evaluate the risk of the underlying loan as well as that of your counterparty. If you can do that, then you're in good shape. Or, you follow Van Kampen by insuring the underlying asset in exchange for a small portion of the income stream."

"Let's assume all of that is true," Andy said. "How do we solve the problem?"

"That depends on your goals. The type of derivative we're discussing doesn't fit my fund's investment profile. They might fit the FX/Currency desk's profile, but coming from Continental is a non-starter, as you acknowledged before. If you were anywhere else, I could at least get you in a room with Matheson, though he'll ask you the same questions I did, because I asked him the same ones about a different product."

"Interest rate swaps?"

"I can't comment on that," I said.

He frowned, but he knew I couldn't reveal inside information, and at this point, I didn't know him well enough to even speak in general terms. The conversation shifted to our personal lives, and I learned more about his background. He had graduated from Tufts University the previous year with a BA in Economics and Chinese, and was currently pursuing an MBA at Northwestern.