The Wealth Manager
Following on from Credit Ratings, here’s a true story about how reassuring mathematical analysis can be. Until it turns out to be baloney. This story is also a warning about experts. Unfortunately, although there’s a lesson here we aren’t sure what it is. Sometimes you get screwed no matter how smart you are. Maybe that’s the lesson.
For Paul, 2007 had been a good year financially. His businesses, based around financial mathematics, publishing and training, were starting to take off. Being self employed his earnings were paid without any tax having been withheld. This meant he had to keep a regular check on how much he owed the UK’s Inland Revenue and, not wanting to end up behind bars like some tax-dodging TV evangelist, put it aside for later payment.
Paul is financially very conservative, he wanted to put this money somewhere incredibly safe, but he’s also a bit of a worrier. He knew that the complex financial instruments he worked with were poorly understood, and that their risk management was even worse. He knew that people in banks were confused about fundamental financial principles, and worse, that they didn’t know that they were confused. He knew that it’s important that the incentives of employees (the bankers) and the benefits of the owners and creditors (the man on the street) be lined up, and that in practice they rarely were. And long before it became fashionable he would tell anyone who would listen that the cleverest of the bankers didn’t know what they were doing.
Paul decided to speak to his Wealth Manager at his bank, B______s, to see if there was anywhere safe that he could leave it for a few months before paying the taxman. This was now the second half of 2008. The investment firm Bear Stearns had bitten the dust earlier in the year. So prudence had been the word of the days for several months now.
Paul mentioned these concerns to his Wealth Manager. And the Wealth Manager made some recommendations. One thing that Paul knew about was the Financial Services Compensation Scheme (FSCS), the UK’s version of the US’s Federal Deposit Insurance Corporation, which would at that time cover up to £50,000 in the event of a collapse. Well, the money that Paul owed Alistair Darling, the then Chancellor of the Exchequer, was quite a bit more than this. However, he also knew that there was a version of the financial guarantee that applied to insurance companies where the cover was 90% of any money lost, with no limit. Paul had done his research. So when the Wealth Manager mentioned that he had a couple of insurance-company products to offer, Paul naturally was keen.
There were two products on offer. They both had interest rates of about 4% annualized. One had a slightly higher return than the other. But the return wasn’t the point. The point of this exercise, remember, was to protect the money that he was holding onto on behalf of the Inland Revenue. The Wealth Manager gave the sales pitch for these two products. They seemed very simple, very “vanilla” in the financial jargon, basic short-term bonds. Credit ratings were mentioned and Paul does recall his sense that one of these investments was very, very, very safe, while the other was a mere very, very. The latter had the slightly higher rate of return. The greater the risk, the greater the expected return. That’s classics portfolio theory.
The conservative Paul opted for the lower return, thrice-very-safe investment. The government’s tax money, or at least 90% of it, was now secure.
This was a Thursday in September 2008.
That weekend brought the news of the collapse of Lehman Brothers and the near bankruptcy of AIG due to trading in complex credit derivatives, the very same instruments and models that Paul had said in 2006 “fill me with some nervousness and concern for the future of the global financial markets.”
Did we mention that it was an AIG insurance bond that Paul had bought?
Paul spoke to his Wealth Manager who reassured him that “there was nothing to worry about,” and that they “were speaking to AIG at the highest possible level.” This gave Paul a warm glow, he felt special. It was nice having a Wealth Manager. “Whatever happens to AIG, the money will be returned in 24 hours,” they said.
The next day the money had not reappeared, and B______s were now saying “48 hours” for the return. There was still nothing to worry about because insurance products come with a cooling-off period of 14 days.
Over the next few days the language of the Wealth Manager changed subtly, mention of cooling-off periods disappeared and timescales became more fluid. And suddenly there was talk of early-redemption penalties. This certainly didn’t fit in with the promise of a full refund in the first 14 days. Meanwhile AIG wasn’t getting any better.
Paul decided to take what little control he could, and started to make his own enquiries. He called AIG. To his surprise, considering their situation, the call was answered promptly, and he was put through to someone dealing with these bonds. Paul’s question was simple: “Was there or was there not a cooling-off period?” The AIG person did not know. She read out the bond’s particulars, the same paperwork that Paul had in front of him during the call. No mention was made in the paperwork of cooling-off periods or early redemption.
Paul called the Financial Services Authority, the then regulating body. He was going to ask about specifics of his bond and was expecting a response such as “Go to the FSA website, type in the company name, look for your bond in the dropdown menu, and the details will appear in a pop-up window.” It was the 21st century after all. Unfortunately the FSA’s representative said something somewhat different, in a very tired voice, something rather like “Do you know how many companies there are? Quite frankly, we don’t know who we regulate.” This was not looking promising.
Paul then went to the FSCS’s website. In the event of AIG collapsing they would be the ones to pick up the tab. Although they seemed very proud of their record in recompensing clients of failed institutions it was clear that they had never had to deal with anyone quite the size of AIG, a top-20 global company which sponsored Manchester United football team and, it seemed, much of the rest of the economy. (Forbes ranked them the 18th largest company in the world in 2008. “I bought one of your insurance bonds and all I got was this lousy Man United t-shirt.”) The case studies on the FSCS’s website were all firms that you’d never have heard of. Oh dear. It was now clear to Paul that he couldn’t depend on the insurance bond’s insurance.
Fortunately, this story has a reasonably happy ending – after a number of weeks nearly all the money was returned. Paul was in fact probably one of the more fortunate purchasers of this product. The BBC television journalist Jeremy Clarkson, who found himself in a similar situation (but with only the “very, very” safe AIG bond instead), said “I made strenuous efforts to get my money out of AIG as soon as the scale of its problems became apparent. But it wasn’t possible. Inwardly I was screaming. It’s my money. I gave it to you. You’ve squandered it on a Mexican’s house in San Diego and a stupid football team and that’s your problem. Not mine.” (Clarkson and Mexico have some history, but his observation had some truth to it, many mortgage brokers targeted specific racial groups for their sub-prime, teaser-rate, AIG-insured mortgages.)
But this was not a problem just for isolated investors. AIG was a major node in the financial system, and as its tangled web fell apart many companies, indeed entire countries, were severely affected by the ensuing economic mayhem. People lost their jobs, their homes, their life savings, even their lives (financial crises are strongly correlated with health crises and suicides).
Now, as tales from the credit crunch go this is not exactly movie material – it’s more the Big Short in reverse, not an attempt to make a killing from a crisis, but an attempt to save money to pay tax – but it does prove a point: We are only human, gullible, fallible, and despite our best efforts as prone as anyone to getting things wrong.
This brush with a failing, flailing insurance giant also taught Paul things he didn’t know, and reinforced a few that he did.
• Banks don’t know what they are talking about. They speak in jargon, much of which they don’t understand. But since there is no down side for them it doesn’t matter. To some extent you just have to hope for the best. Experts? Phooey!
• Regulators are clueless.
• Guarantees mean nothing. The FSCS paid out an average of £200million a year between 2001 and 2006. Between 2006 and 2011 that rose to an average of £5billion per annum, and they had to take out a loan from the Bank of England. But AIG was bailed out to the tune of $85billion. The numbers just don’t add up.
• Bailouts can be necessary, but only because some companies are so humungous in size. In some Darwinian sense entities should be allowed to collapse. But AIG was too big, its influence was everywhere. How many people had insurance through AIG? Just take car insurance, for example. How many cars would have been left uninsured, what repercussions would that have had? It’s impossible to tell.
• Being a mathematician doesn’t make you immune to the financial system’s occasional paroxysms – which is bad news because the system is effectively run by quants.
You could say that Paul should have been more careful. But that was precisely his goal. At some stage he had to take a chance on the advice he was given. And we know that that is risky. The alternative is to research and research and research, leaving no stone unturned … but the end result would be what? To not invest in anything? To not put your money in the bank even? Put it in government bonds? Invest it all in gold, or in property? Put it under the mattress? There’s no middle ground where absolute safety and trust overlap. But perhaps this new world in which there is no financial security – where a banknote, a cheque, a bond, a share certificate, can suddenly become irrelevant – is more natural. Perhaps the few decades in which banks were apparently safe was the anomaly, that a return to the precarious state that has been the norm throughout history, and still is in many countries, was inevitable.