Ex-Lehman Brothers Investment Banker Illustrates How Wall Street House of Cards Works

17 Sep 2009

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In this timely interview, one year after the closure of Lehman Brothers, which coincides with the anniversary of the global financial crisis, The Real News Network talks to Sony Kapoor, Managing Director of Re-define.org.

Kapoor is an ex-Lehman Brothers investment banker who now applies his skills for social benefit. He sheds light on the intriguing world of financial markets, exposing the house of cards we familiarly refer to as the international financial system.

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PAUL JAY: Welcome to the Real News Network coming to you again today from San Francisco. We're at the Momentum Conference of Tides Foundation and joining us now is Sony Kapoor from Re-defin.org -- and please define Redefine.org for us.

SONY KAPOOR: It’s an international think-tank working on applying finance to get better outcomes on development, environment and fairness in society. 

PAUL JAY: So I'm going to put this a little more dramatically. You have gone to Dante's Inferno. You have investigated the netherworld of international finance capital. You emerged somehow without being consumed by the fires. You’ve moved from the corporate profiteering world to the nonprofit advocacy world. Am I right so far? So tell us a bit about your story.

SONY KAPOOR: A slightly less dramatic version would be more accurate. But I have been burnt brown as you see.  

The quick version is I started out my career in investment banking and worked for what used to be called Lehman Brothers, amongst other things and did leverage finance and private equity. Then did derivatives trading for a firm, which was one of the biggest trading partners for Enron, amongst other things.

So (I) got to see quite a bit of the drama of the financial system from the inside. But then quit in about 2002/3 to apply the financial skills I had to trying to achieve better outcomes for society.

PAUL JAY: Your friends must have been telling you how crazy you were. You could have been fabulously wealthy, one would assume, if you were good at what you were doing -- and I assume you were. So what brought you to this decision?

SONY KAPOOR: I wasn't sure what the work I was doing was adding up to. And you know, when you work as hard as you often do in banking, you spend long hours and you have a lot of money, but you don't actually have the time to do anything with the money. But more than that, when you go to bed, you are not very sure what you did during the day.

At some point, you know, the realization dawns that “Hey, I think I should be doing something different. This is not for me.”

That combined with the fact that in my, for example, very first two weeks at Lehman brothers, I was offered by one of the accounting firms to open my salary account in the Cayman Islands, a tax haven. I saw Chinese walls being broken and I, for the first time, understood what Richard Gere said -- what he did in "Pretty Woman," which was buy companies, break them up and sell them.

PAUL JAY: Or Danny Devito's movie "With Other People's Money."

SONY KAPOOR: Absolutely. It was (a) fast learning curve. So there was a lot of systemic stuff that I saw from the inside, which grated with what I believed in -- both emotionally but also intellectually, you know. It wasn't just a moral question.

Intellectually it didn't seem to be a sound model. It was a house of cards.

PAUL JAY: So talk about what you learnt about the construction of this house of cards and how this helped contribute to this current crisis we're in.

SONY KAPOOR: The financial system - because, you know, you can't eat or drink finance; you can't sit on it - it's easy for it to get very dissociated from reality and I think that's what happened. The financial system became more and more self referential and inward looking where more and more money was pumped in.

For a long point of time, the most profitable investments were actually to...instead of putting money in a real factory or building something up, greenfield investment. It was just to put money in speculation, in bonds, in the financial industry itself. So it fed on itself and it became this giant monster.

PAUL JAY: In another form of work it would be called "swine flu." If pigs start eating pigs, we get it. Or mad cow disease, when cows start eating cows.

SONY KAPOOR: It’s a very incestuous world and it’s so easy to lose connection with everything else outside (because) you only interact with your brethren. 

PAUL JAY: So tell us what you found?

SONY KAPOOR: It was "just in time" finance. Just Like, you know, you have "just in time" production lines where in the name of efficiency things move faster and faster. It was very big and it became bigger and bigger.

The financial markets have grown by, you know, an exponential amount for the past several years. It became more and more complex...in terms of the nature of the institution. Citicorp has 2,400 subsidiaries. You had complex products like CDO's, etcetera.

So what you had was a system that was faster than ever before. More tightly connected - "just in time" - than ever before and less transparent and larger than ever before.

And this was akin to driving a fuel-laden truck on a highway with a drunken driver and with a massive fog having descended with poor visibility. And this was a system that was just waiting to crash. 

And yes, we associate the particular crash we are in now a lot with the sub prime assets or CDO's etcetera, but the fact of the matter is the financial system has crashed before - before these things existed - and would have crashed, in any case, by a different trigger -- and will crash again.

So, there are more fundamental forces at play as to why finance does this.

PAUL JAY: Well, let's try to break down some of these fundamental forces. So certainly one of them must be that the world is awash in capital.

There's been such a transfer of wealth to the top 2-3 percentile and as you said, you can't just sit on this money; you've got to do something with it, so talk a bit about this.

SONY KAPOOR: Well, that's actually been a very problematic thing (because) this is the end result of...what you see is a manifestation of increasing inequality.

And what you have, for example, in the US is depressed average wages. For most people, the real wages haven't gone up or actually have gone down.

But the fact of the matter is that in a country where two thirds of the economy is driven by consumer demand, you need to have that demand. And if people don't earn enough money, they are not going to have that demand.

So a serious problem is as more and more wealth gets concentrated at the top - and we all know - you know, the lower income you have, the higher percentage of that income you actually spend because you have to fulfil your needs.

As more and more income is concentrated upwards. It means that a smaller proportion is recycled into the economy, as consumption and more and more of it is put in assets because these people save. The richer you are, the greater the percentage of your income you save. 

And if there are only a limited number of assets available to invest in, the savings flowing into the assets inflates the prices of these assets at the same time as aggregate demand in the economy is getting depressed. 

PAUL JAY: Okay, break that down into simple language, with housing perhaps as an example.

SONY KAPOOR: Well, the simple language is, people simply are not earning enough wages to spend enough money and the only way people were sustaining themselves and their lifestyles was by borrowing against the assets, houses, where the prices were rising because of a lot of investment coming in from the top income groups.

So it was not a sustainable system and it's a bad substitute for having a fair wage distribution system where everybody has enough purchasing power...and it’s a long term aggregate, you know, sustainable rate of growth. 

PAUL JAY: So you have this massive transfer of wealth over the last 30-40 years. As you said, wages are relatively static or going down, but productivity is going up.

So productivity equals wealth and more capital going into the 2-3 percentile mostly and then they've got to do something with it (because) they don't want to sit on it. They want it to grow. So where does that lead them?

SONY KAPOOR: Well, that leads them to put money wherever they think they can maximize returns and that leads to a large amount of money chasing a limited number of places to invest money in, which is okay. 

Now if you just think of a stock market and you know the aggregate value is US$100bn or something. US$1bn of new investment comes in; the prices of stocks go up, but they go up by US$10bn. So suddenly the value of the stock market is US$110 billion, but US$9 billion of that wealth has been generated by magic out of thin air.

And that leads to this feeling of well-being and people spend more. But, the fact of the matter is the minute people start selling those stocks or try to take that US$1 billion they put in out, the prices fall. 

PAUL JAY: Break down the magic. What is the mechanism of what you're calling magic?...Even in this bailout that we hear, it's very hard to get one's head around, where is the money actually going in the bailout? What is the mechanism of what you're calling magic?

SONY KAPOOR: There is a difference between the flow of money or, you know, "income" in our parlance and the stock of money. You know, the stock of assets. 

So just think of it in terms of houses. 

So, let's say you have a certain income and with that income you can afford a particular mortgage -- lets say US$100,000. Now you buy a house with that and suddenly you find the price of the house is up US$200,000. You feel richer, but everybody else who bough the house at US$100,000 is equally feeling richer at the same time. But, the people who want to buy houses now with that same income can't afford those houses anymore. 

So this is the dichotomy. There is a difference between the sustainable relation between how much income you earn and...

PAUL JAY: One of the reasons why the houses went from US$100,000 to US$200,000 is because there was so much credit around.

SONY KAPOOR: Absolutely.

PAUL JAY:  I know myself. I was getting phone calls every three days. Would I like to increase the limit on my card? Would I like a new card? We were being sold credit endlessly. 

SONY KAPOOR: I think there's a little bit of issue there (because) what you had at the global level, but also within the US - there was this bifurcation of the economy.

People, for example, who had good credit histories, etcetera got 20 credit cards through the door. These were people who did not need credit, but you got 20 cards, you know, zero percent, you'd spend. 

And there was a whole section of people, millions of them who were completely left out of access to finance and access to credit who were getting payday loans at 600%.

So what you had was the people who actually needed the credit who could have made do with it, who might have invested in some micro enterprise or put the money to good use, they did not get the money...they were shut out of that.

Too much money was concentrated where it was (in the same place) already.

And the second problem with this was, unlike in the past where banks knew their customers and a good bank lent to people that nobody else lent to, but did not lend to people that everybody else was lending to.

But, here every bank had access to the same credit ratings; the same credit histories. Every bank was chasing only the people with good credit histories and every bank was leaving out everybody else.

So the system lost diversity. The system lost resilience and it became extremely brittle (because) every bank ended up with exposure to more or less the same customers, the same asset groups -- and what happens with that is any time there is a disturbance in one section of the market, like the sub prime assets, for example, it means it generates losses, which generates pressure to sell other assets, which infects other markets. So the whole system goes up together, but goes down together too. 

Diversity in finance brings resilience and stability. And the uniformity we have seen in finance development (means) that everybody is doing the same thing at the same time, which like soldiers crossing in step on a bridge would mean the bridge collapses -- as it has now.

PAUL JAY: In the next segment of our interview, let's talk about the stampede factor and lets also talk about complications, because as I've learnt from you, the more complicated it gets, the more money you can make. Please join us for the next segment of our interview with Sony Kapoor.

For part two of this interview, "Wall Street Musical Chairs Continues," please click here.

For part three of this interview, "More Volatility Equals More Profit," please click here.

For part four of this interview, "Derivatives and Tax Havens," please click here.

For part five of this interview, please click here.

Editor's Note: Part one of this interview was transcribed by SACSIS. For the most part, it is verbatim.

You can find this page online at http://sacsis.org.za/site/article/170.19.

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