How the big boys make money

We can learn a lot from investment bankers, who are the biggest and baddest deal makers in the world.

Wed, Apr 28, 2010
The New Paper

By Larry Haverkamp

WANT to know how the rich get richer?

We can learn a lot from investment bankers, who are the biggest and baddest deal makers in the world.

The granddaddy of them all is Goldman Sachs, with earnings of US$1 billion (S$1.37b) per month. Two weeks ago, the US Securities and Exchange Commissions (SEC) charged it with fraud. As expected, the company denied all charges.

The SEC's complaint provides a rare glimpse into the world of high finance. The case involves 'synthetic credit default swaps' but to simplify, I'll use the metaphor of fire insurance.

Here are the charges explained in 7 steps:

Step 1
Mr Paul wants to buy fire insurance for 10,000 homes. To increase his chance of making a claim, he prefers homes surrounded by dry wood and gusting winds.

As we would say in Singapore: 'Sure burn.'


Step 2
He needs someone to sell him the insurance. And to keep premiums low, he needs them to believe the risks are low. He would like to pay only $100 for each $100,000 of homes insured.


Step 3
Mr Paul asks an investment banker - Mr Gold - to put the deal together and find the insurers who - naturally - prefer a package of homes with low fire risk.

Mr Gold doesn't tell anyone that Mr Paul is working behind the scenes to select a portfolio of homes that are likely to burn.


Step 4
Mr Gold hires a sub-contractor - Mr Sam - to 'officially' select the 10,000 insured homes. Mr Gold permits Mr Paul to quietly assist Mr Sam in the selection process.

Mr Gold hires another sub-contractor - Mr Moody - to rate the portfolio's 10,000 homes. Mr Moody is on Mr Gold's payroll for this and many other jobs.

He is very helpful and after inspecting the portfolio of 10,000 high-risk homes, he declares them safe and confers his super-safe AAA rating.

He later says it's because he was kept in the dark about Mr Paul's involvement.


Step 5
What investors see is a standard deal to insure homes selected by Mr Sam and rated AAA by Mr Moody.

With these solid endorsements, Mr Gold sells US$2 billion to investors, none of whom are told that the counter-party to the deal is Mr Paul, or that he designed this product to fail.


Step 6
One important detail: This isn't really insurance. That would require an insurable interest which Mr Paul doesn't have.

To get it, he would have to buy all 10,000 homes in the package.

It's expensive and more importantly, if the homes burn, Mr Paul's insurance claim would merely offset the value of the homes destroyed. He would break even.

That is how insurance is supposed to work but Mr Paul wants more. He wants a profit.

To get it, he needs a wager with long odds, like betting on a horse at 100 to 1 odds. That is the deal he gets along with a chance to improve the odds by selecting slow horses to run against his own.


Step 7
As expected, the homes burn to the ground within a year. Mr Paul wins his bet and collects US$1 billion from the counter-parties.

Mr Gold pockets US$15 million for arranging it all. Two years later, he is charged with fraud for not telling investors about Mr Paul's role. Mr Paul is not charged.

This article was first published in The New Paper.