To me, the best summation of the whole fiasco with derivatives was the statement of my friend Ted Doll of Hubco. He said, "Everyone forgot the connection between the intense sales effort to get investors to buy derivatives and the fact that these salesmen took home $1.3 million a year."
This, not any real need for these complex instruments, it turned out, was the real reason why they became so popular and eventually caused such damage.
I should have known, and realized this 30 years ago.
At that time I wrote a monograph talking about bank capital debentures, which were just coming on the scene. I said they were not only a cheap source of capital, but also a cheap source of funds.
My phone rang one day.
"Hello, Professor Nadler, please help me. I want to sell Morgan Bank on issuing debentures."
"Do they need capital?" I asked. The answer: "I don't know."
"Do they need cheap funds?"
"I don't know."
Then why do you think they would want you to sell debentures for them?
"I want the commission," he responded.
In a similar vein, many banks got into trouble with foreign lending for the simple reason that the lenders wanted to make loans and not because the credits were justified.
It was a simple situation.
The officers represented their U.S. banks in South America or some other exotic location. In the overseas branches they were kings. They lived well, off the expense account, in a bank-owned home and were social trophies for local businesspeople.
But there were no good loans available. So they faced a dilemma. They could report that there was nothing worth lending on and would then be called back home - back to a three-hour commute and sitting on the ninth floor of the bank all day looking at credit files. Or they could make what was probably a nonbankable proposition into a loan despite the prospect of possible failure later.
To stay abroad, they took the optimistic path, and the rest is history - the LDC loan debacle.
Federal Reserve Governor John LaWare, who was then with Shawmut, admitted to me that his bank fired a man who had saved them millions by not making loans, because they then no longer needed him.
Similarly, today, the salesmen who like their $1.3 million a year, and the "rocket scientists" who sliced and diced simple agency securities into pieces with complex claims because their firms could sell pieces separately for more than they would bring intact, created the demand for derivatives.
Ironically, today they are buying back the pieces at sharp, depressed value discounts and putting them back together to sell again as whole securities - making a further profit on the buyer's misery.
But can you blame these Wall Street people?
Wall Street hires the best and brightest, pays them well, and then sends them out to pit their knowledge against investment officials who may earn as little as 2% of what the salesmen or rocket scientist does. No wonder so many were hoodwinked by so few.
So with this perspective, we can see how the derivative fiasco developed, just as we can understand why so many well-meaning international lenders tried to make credits in lesser-developed nations bankable to avoid coming home to long commutes on New Jersey Transit or Metro North.
But the legacy of that era has both a good side and a fearful one.
The good news is that few, if any, investors - in banks, public bodies, or corporations - will be taken in again by fast-talking salesmen, at least until we forget the derivatives era.
But the fear is that we will go too far the other way and avoid using derivatives altogether.
As a well-structured hedge, derivatives are useful and to some companies vital. There is a good reason why Federal Reserve Chairman Alan Greenspan has stated that eventually all banks will have to use them - properly, of course.
But the fear today is that bank boards will turn so conservative that the industry will not be able to use a needed vehicle because of wholesale proscriptions against the derivative instrument. The real proscription should be against meeting the fast-talking bond salesmen, who sit at your desk thinking of what this transaction will mean to their personal income and bottom line, rather than to the bottom line of the bank they are visiting.
Mr. Nadler is a contributing editor of American Banker and professor of finance at the Rutgers University Graduate School of Management.
