FIASCO: The Inside Story of a Wall Street Trader (1997)

This book is essentially Liar's Poker for the 1990s. It's a well-written and enjoyable read, and Partnoy does a great job of explaining the types of derivatives deals done by investment banks during the 90s. He avoids getting bogged down in detail, and manages to portray the realities of the investment banking culture without resorting to the cheap, titillating anecdotes used in many similar books. The book covers similar ground to "Traders, Guns & Money" by Satyajit Das --- but does a much better job.

The overall message of the book is clear: the financial derivatives dreamed up by the investment banks are little more than legalized fraud, allowing shady clients to make extremely risky bets without explicitly disclosing them. A simple example, explained in the book, is the derivative known as an "equity swap". The idea is that one party holds a stock that they would like to sell. However, if they sell the stock they realize a capital gain and will have to pay tax. This is where the investment bank comes in: instead of selling the stock, they continue to hold it, but enter an agreement with the bank to exchange the future gains/losses from the stock against a fixed interest payment. For all intents and purposes, it's exactly as if they had sold their stock -- except that they avoid paying any tax. The investment bank is happy, because in return for providing this service they earn a nice juicy fee. And they aren't sweating the future movements in the stock price, since they can hedge their exposure by simply selling short an equal amount of the stock in the market.

The equity swap is an extremely simple example -- derivatives can become an awful more sophisticated and convoluted. But the essential principle remains the same: investment bank facilitates a transaction which circumvents a regulatory hurdle and earns bumper fees. The net result is a transfer of wealth (via lost tax revenue) from Joe Public to the already wealthy (the client) and the soon-to-be-wealthy (the banker).

It gets worse: Partnoy describes a series of trades carried out by American investment banks in Japan in the mid-nineties. Here the objective was to realize a phoney short-term profit while simultaneously shoving the offsetting loss far into the future. The parties responsible get credit for the "profit" now, and by the time the sushi hits the fan further down the line they are long gone. There's really no grey area here: this is outright fraud, and it's telling that some of the most venerable Wall Street banks were in it up to their eyeballs.

Reading about this in a post-GFC world you can't help but feel a sense of outrage: the book was written in 1997 and yet the problems it highlights were to be played out in almost identical form a decade later. It makes you wonder what books the politicians and regulators are actually reading, and what real hope there is for grass-roots reform in this industry.