How Are Those Toxic Contracts Coming Along, Guys?

When it was first proposed that banks should put all their troubled or toxic assets into separate banks or vehicles I bet some of you smarter quants were jumping for joy. Up until then you’d been playing that harmless game of “Invent a toxic contract that gives you a big bonus after one year but which blows up as soon as you have moved to another bank.” A pleasant enough game, but one that, it could be argued, had become just a little too easy, perhaps not as challenging as it had once been.

Anyway, along come the politicians who quite frankly know nothing about derivatives and risk management and they propose this plan that on the face of it looks reasonable. But to the quant it’s a very similar game to the one that they’d played before. All you have to do is invent new contracts that are sufficiently complicated that they might pose a danger, they don’t even have to be contracts with any meaningful economic justification anymore. The contract has to be ‘difficult to value.’ But what’s difficult to a government accountant is going to be easy for you guys! Once you’ve come up with a suitable contract, just sell it to a friend at another bank. Pocket the money. And then your friends says “Ohmigod, what have I bought?” And he puts it into the troubled-asset depository. Then you swap roles so he gets to trouser the cash. Result…everyone’s a winner. I leave you to work out the details. You may want to speak to a lawyer first.

There are a couple of plans on the table. Which do you think is better?

Plan A: Put all toxic contracts into separate banks/vehicles. Winners: Bankers. Losers: Taxpayer.

Plan B: Nationalize banks and change accountancy rules. Winners: Taxpayer. Losers: Bankers. (See Moral Hazard for the Masses.)

I think I can guess which one the UK government will go for, judging by their past record!

P