The Spider Network Read online

  The art of making money through this so-called proprietary trading was partly in the timing: Bet on something that’s cheaply priced, protect yourself with an offsetting position, get rid of the original asset just as it reaches its peak value, extricate yourself from the offsetting hedge position, and pocket the proceeds. In the ideal scenario, savvy traders managed to construct enough overlapping hedges that they virtually eliminated any downside risk and guaranteed themselves a small profit, regardless of which way markets moved. Traders with advanced math skills, able to swiftly calculate and recalculate the ever-changing odds of a wide range of bets and to craft computer programs to identify opportunities for profits, enjoyed an enormous advantage. And you didn’t need to win consistently: Billionaire Ken Griffin once said that he expected the stock market bets of his employees at hedge fund Citadel to pay off just 52 percent of the time. The great news for the trader was that, if his positions gained in value, he would share in the spoils. And if his bets didn’t pan out, the worst-case scenario was that he lost his job. That rarely happened and, when it did, it tended to be pretty easy to find a new gig, without having to explain much about the reasons for his sudden departure from the prior job. As a result, traders were basically in a no-lose situation.

  Hayes cannily accepted the UBS operations gig, but when he returned to Nottingham in the fall, he started applying for trading jobs at other banks: the Royal Bank of Scotland, J.P. Morgan, Goldman Sachs, and Deutsche Bank. He landed interviews everywhere other than at Goldman. When the Scottish bank offered him an entry-level position as part of the bank’s training program, he accepted and informed UBS that he no longer wanted the back-office assignment.

  Hayes told his mother about his newfound career ambitions. She was opposed in principle to the idea of her son working for an investment bank and spent hours trying to talk him out of it. Hayes’s father wasn’t thrilled, either. Hayes shrugged off their concerns.

  He was hardly alone in being tempted by the potential riches of a career in finance. All over the Western world, promising students, especially those with math and engineering backgrounds, were flocking to banks, seduced by the chance to put their technical skills to use in creative ways, while hauling in fat paychecks. The shift accelerated amid the moribund U.S. economy of the early 1990s, when aspiring engineers realized that jobs in their hoped-for fields, such as aerospace, weren’t nearly as plentiful or remunerative as they had expected. At Caltech, one of the country’s premier engineering schools, banks were showing up in droves at campus job fairs. “The bottom line is, it pays really well,” a Caltech engineering major, headed for a bond-trading job at investment bank Salomon Brothers, explained to the Los Angeles Times in 1993. It didn’t matter that much of what the industry was doing served little purpose beyond enriching itself. Larry Summers, the Treasury secretary in the Clinton administration, noted that starting in the 1970s, the finance industry was “transformed from a field that was dominated by people who were good at meeting clients at the nineteenth hole to people who were good at solving very difficult mathematical problems that were involved in pricing derivative securities.”

  One of Hayes’s classmates at the University of Nottingham was a young man named Kweku Adoboli. The Ghana-born son of a United Nations peacekeeping official, Adoboli grew up in the Middle East and then England. At Nottingham, he majored in computer science. Afterward, he got a summer internship at UBS and then was offered a full-time operations job. Unfortunately for both men, their lives would continue to follow parallel trajectories.

  * * *

  After graduating from Nottingham in July 2001 with honors in math and engineering, Hayes flew to the United States. It was his second trip there, following a 1998 visit to South Carolina to visit his father’s relatives. This time, he had stops in Miami and New York City before heading to Washington, D.C. His uncle, Chris Salmon, had been sent on a temporary assignment by the Bank of England to work at the International Monetary Fund, just down Pennsylvania Avenue from the White House. Hayes wasn’t terribly close to Salmon, but they had shared interests in economics and finance, and Hayes spent the brief visit talking with him about how he envisioned building a career as a bank trader.

  Hayes started at the Royal Bank of Scotland that fall. RBS’s office was on the bustling eastern edge of the City, just across a busy street from the Bishopsgate Police Station. Hayes’s starting salary was about £35,000, along with an expected £15,000 bonus—a substantial take for someone just out of university.

  Hayes was in a training program that sent its aspiring millionaires cycling through various trading desks to get a taste of the different flavors of the bank’s businesses. Hayes spent most of his time doing menial tasks. There was a lot of data entry. He learned to use Microsoft Excel, whose spreadsheets served as the backbone for many of RBS’s trading models. He also scurried around doing personal favors for established traders—he got their keys cut, fetched their coffee, delivered their clothes to the dry cleaner, purchased gifts for their parents and girlfriends. Hayes, like plenty of grunts on trading desks, endured merciless mockery. One subject of harassment was his clothes—he still dressed too well. He wore a jacket and tie to work while most colleagues opted for a business-casual look of slacks and a light-colored button-down. One trader threatened to cut off his necktie if he wore it again.

  There were no classes where wannabe traders were taught the ropes. They were supposed to learn through osmosis, by watching veterans do their jobs. And the lessons Hayes picked up were similar to those absorbed by a generation of traders across Wall Street and the City of London: Make money at all costs. Traders’ performances were evaluated based on two factors: their ability to manage risks and their ability to maximize revenue. There were really no other criteria. Traders were encouraged to go the extra mile to wring out extra profits, trained like bloodhounds to sniff out that edge. It could be in the form of unique information, or unique relationships with huge clients, or unique access to naïve and gullible customers, or a unique way to massage indexes or benchmarks to make trades more profitable. Whatever the edge was, you had to find one. The way you dressed, the way you behaved—those might make you a target for teasing, but they were irrelevant when it came to how much you got paid. And that was the ultimate yardstick of success. When it came to obeying the rules, the only check was the bank’s legal and compliance department, which was supposed to make sure employees knew the rules—statutory, not moral—that they had to follow. That department—a sort of internal affairs bureau—wasn’t exactly a force to be reckoned with. During compliance training sessions at RBS, traders hunched over their BlackBerrys playing the addictive “Brick Breaker” game. The goal was to knock out each layer of tiles, brick by brick, the high score the only measure that mattered.

  Chapter 2

  The Hall of Mirrors

  Mohammad Reza Pahlavi needed cash. In fact, he needed $80 million of it.

  Two years earlier, in October 1967, dressed in full military regalia and wielding a scepter, Pahlavi had anointed himself Iran’s Shahanshah, or King of Kings; he would henceforth be known as the Shah for short. His coronation ceremony was held at Tehran’s mosaic-and-mirror-covered Golestan Palace. The Shah marked the occasion, which also happened to be his forty-eighth birthday, by donning a large, jewel-encrusted crown over his graying hair. He also placed a sparkling platinum crown on the bowed head of his third wife, Empress Farah. His golden throne glittered with 26,733 jewels. “I feel closer than ever before to my noble and patriotic people,” he declared to his subjects.

  The Shah had inherited the title from his father, Riza. Riza Shah the Great, as he liked to be called, was a military general who deposed the previous ruling dynasty and changed the country’s name to Iran from Persia. After taking over from his father, Shah Pahlavi briefly lost power when a democratically elected government, Iran’s first, came to power in the early 1950s. That government, led by socialist prime minister Mohammad Mossaddegh, nationalized Iran’s vast p
etroleum industry. Believing his politics smacked of communism, in 1953 the CIA orchestrated a coup and reestablished the Shah’s supremacy. If that wasn’t enough to leave the Shah in the West’s debt, the massive amount of American military and economic aid pouring into his country surely did the trick.

  Now the Shah was looking for an $80 million loan to finance a new government agency. To facilitate the deal, one of the Shah’s emissaries got in touch with a tall, mouse-faced man named Minos Zombanakis. Born in 1926 in a poor town on the Greek island of Crete, Zombanakis endured the German occupation of his country during World War II and then, without a college diploma, worked his way up through the Greek banking system, including a stint at the central bank. As a twenty-nine-year-old, he showed up in Cambridge, Massachusetts, and talked his way into a Harvard University graduate program, where one of his classmates was Henry Kissinger. Afterward, he returned to banking, working in Rome and the Middle East, fostering connections in Iran, before settling in London with his wife and son. By the 1960s, he had emerged as a pillar of the city’s banking industry, someone with a reputation for innovating and taking risks. In 1969, when the Shah was seeking the loan, Zombanakis had just opened the London outpost of Manufacturers Hanover, a large New York bank that would later become part of the J.P. Morgan Chase empire.

  The $80 million that the Shah wanted was too much for one bank to just fork over, even if the would-be borrower happened to be a government leader backed by a superpower. So Zombanakis lined up a couple dozen Western and Middle Eastern lenders to make the loan as a group.

  Now the question became what interest rate to charge the Shah. This was the type of problem that was increasingly vexing London’s banking industry. The City, whose labyrinth of narrow, windy streets largely dated back to Roman times nearly two millennia ago, had always played a leading role in global finance, thanks to London’s status as an imperial capital. But globalization was accelerating the transcontinental flow of cash and cementing London’s role as a global financial crossroads. As business boomed, bankers like Zombanakis came up with creative ways to meet customers’ diverse financial needs and, in the process, to make a lot of money for themselves. One invention was the use of a group of banks, known as a syndicate, to jointly make loans. That had the advantage not only of reducing the amount that any individual bank had to kick in, but also of sidestepping rules that capped the amount of risk that banks were allowed to take with individual clients.

  Normally, a big loan would carry a fixed interest rate, one that didn’t change at all over the life of the loan. That had the benefit of simplicity, but it left the banks vulnerable to changes in prevailing market interest rates in the years before the loan was repaid. If, for example, a central bank had set its base interest rates at 3 percent, the banks might charge their customer a fixed 5 percent interest rate for the duration of the loan. That would be enough for the banks to pocket a tidy sum. Even if the central bank then hiked interest rates to 4 percent, the banks would still manage at least a small profit. But if rates rose further still, their profits would be wiped out. If the loan was small, the loss was small, too. But when the amount was massive—and that’s what the Shah was looking for—well, that was different.

  One way to address the risk would be to have the interest rate that the banks charged fluctuate in tandem with base interest rates. That seemed easy enough; after all, central banks generally adjusted their rates only on occasion. But in London’s increasingly busy financial markets, that still left the banks exposed to changing market conditions. Most banks financed themselves by borrowing money from a variety of sources, including short-term loans from rival banks, part of the financial merry-go-round that kept the banking world spinning. These interest rates that the banks charged each other fluctuated much more frequently. The changes tended to be small, but even minuscule moves could have big impacts when applied to multimillion-dollar loans.

  Zombanakis came up with a novel idea. What if the banks that were part of the Shah’s loan syndicate regularly reported what it cost them to borrow money? Those figures could be averaged out and, every few months, the interest rate on the Shah’s loan could be adjusted to reflect the changes in the banks’ average funding costs. That would insulate individual banks from the risks of a loan becoming unprofitable due to changes in interest rates. Of course, the banks would tack on a bit of a supplemental charge above their funding costs to ensure that the loan was even more lucrative. Zombanakis convinced the other banks it was worth a try.

  This sort of rate-setting mechanism had never been tried before. As a result, the Shah got his money, a bunch of banks profited from sizable interest payments, and Zombanakis got credit for what the Economist at the time praised as a “very cunning” new financing arrangement. In Manufacturers Hanover’s newly opened London offices, the bankers celebrated the milestone with flutes of champagne and trays of Iranian caviar.

  Zombanakis and his colleagues couldn’t have imagined it at the time, but their brainchild would soon become a crucial piece of the world’s financial plumbing, an interest rate woven into countless financial contracts.

  * * *

  On the trading floor at RBS, Hayes noticed that it wasn’t the biggest clients who elicited enthusiastic laughter and applause when they called. Instead, it was small pension funds and other unsophisticated investors—so-called dumb money. They lacked access to high-quality financial data and generally weren’t as sensitive to tiny differences in the prices that banks would offer them. In other words, they were ripe for being duped, and RBS traders fought to get access to them. Shouting matches on the trading floor over who had the right to the clients were routine. Nobody thought about it in moral terms. It was just part of the game, just the way things worked: Get your TV and watch the coronation.

  Years later, as Wall Street scandals piled up, one trader after another who cut his teeth at the same time as Hayes would offer a similar description of the era’s amoral culture. “I remember that if I voiced an opinion based on moral considerations, I’d get looked at as if I were an alien,” a former investment banker explained to Dutch journalist Joris Luyendijk.

  Hayes’s promise quickly became evident. He breezed through a series of regulatory and trade group exams in late 2001 and early 2002, earning him the right to work in jobs where he interacted with clients. Because those jobs entailed responsibility for looking after clients’ finances, they were subject to extra doses of supervision from bank compliance departments and financial regulators—or at least that was the idea. In reality, London was in the midst of a revolutionary free-market experiment. The City was selling itself as something of a regulation-free zone, especially compared to its chief competitor, New York, in a bid to attract banks and other financial institutions. The laissez-faire approach was christened “light touch.” The United Kingdom’s understaffed Financial Services Authority only had a small handful of employees assigned to oversee some of the world’s biggest banks—and was mocked by a satirical magazine as the Fundamentally Supine Authority. Sandy Hayes’s boss, Gordon Brown, would become one of the idea’s loudest cheerleaders. “Not just a light touch but a limited touch,” he would declare in a 2005 speech. The approach, Brown said, “helps move us a million miles away from the old assumption—the assumption since the first legislation of Victorian times—that business, unregulated, will invariably act irresponsibly. The better view is that businesses want to act responsibly. Reputation with customers and investors is more important to behavior than regulation, and transparency—backed up by the light touch—can be more effective than the heavy hand.” It would turn out to be a disastrous misreading of capitalism.

  * * *

  One of Hayes’s peers in his training program had been a young woman named Sarah Ainsworth. She was a pretty brunette with a nice smile, pronounced cheeks, and a controlling personality. Like Hayes—who still couldn’t seem to make eye contact—Ainsworth was not only brainy but also a bit odd. The pair hit it off, became friends, and e
ventually started dating.

  Hayes forged other friendships through his job. On a rotation through one of RBS’s trading departments, he sat next to a veteran named Brent Davies. A tall, hulking man with a mane of wild blondish hair, Davies was eleven years older than Hayes. At age twenty, he had joined the banking industry, working as a clerk at a bank that one day would be folded into RBS. He slowly clawed his way up through the ranks and became a trader. By the time Hayes arrived, Davies had been there thirteen years. Davies liked the bright, quirky young man and took him under his enormous wing. He would buy Hayes beers after work if he’d endured a tough day. When Hayes and Ainsworth had problems (which was often), he listened and sometimes dispensed advice. Hayes embraced Davies as a father figure. Of course, traders being traders, Davies teased Hayes about the fact that his mother still cut his hair and that he was still sleeping under a duvet cover decorated with superheroes. He suggested that his mentee read The Curious Incident of the Dog in the Night-Time, a novel whose autistic main character reminded Davies of Hayes. (Behind his back, Davies nicknamed him “Kid Asperger.” Other colleagues christened him “Rain Man.”) Notwithstanding the sometimes nasty edge of Davies’s ribbing, Hayes always smiled, seeming not to notice.

  Hayes soon landed a permanent gig among a fast-growing cluster of RBS traders who specialized in products called derivatives. Derivatives came in many flavors, but they all shared a common characteristic: They were instruments whose values derived from something else. What you were buying or selling was not the thing itself (widgets, bushels, gold bars) but something related to that thing, maybe its future value, or how it compared to something totally different. If you wanted to buy ten gold bars, that was straightforward; if you wanted to place a bet that nine months from now the price difference between ten gold bars and fifty bushels of wheat would be twice the difference between five bushels of wheat and sixteen widgets, then you were playing with derivatives.