Inside the tortured mind of the investment banker

published 13 July 2012

Investment banks have a lot to answer for. They collected huge wages in the good times and huge bail-outs in the bad.

But the worst of it is, nothing has really changed. You see, the authorities are quite happy to let the banking industry continue making crazy bets bets that may blow up (and soon!), so long as it suits the authorities.

Today, I want to show you the modus operandi for your average investment banker. And I reckon it'll give us some idea of where the next eruption will come. Crucially, this is all happening with the blessing of the regulators themselves.

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Never be wrong alone

Having said practically nothing to the parliamentary committee looking into the Libor scandal, Bob Diamond was keen to get one point across before he left:other banks have been at it too.

This is part of the psyche of an investment banker. Whether it's ripping off clients, or rigging markets, everything's all right so long as everyone else is at it.

And what's even better is if you can get the blessing of the regulator. Unfortunately for Mr Diamond, the Bank of England isn't quite prepared to admit it sanctioned any of this rate rigging.

But when it's in the interests of the authorities to collude, they will. Take the whole issue of allowing the banks to leverage up their financial positions so fantastically. Nobody was prepared to say STOP. Reining in the banks could have brought on a recession so it was politically intolerable. Keeping interest rates at a safe' level would have upset homeowners/voters too again not politically appealing.

Put simply, the banks were allowed to get away with dangerous practices because it suited everyone.

Pro tip: big debt means big returns

Mere mortals like you and I may run a mile from taking on 50 times our assets in debt. I couldn't run my portfolio like that how could I sleep at night? But if you want to be a great investment banker, you need to have a cast iron stomach.

These guys laugh at traditional bankers. The thought of taking home say £70,000 for someone bringing in £250,000 for the business is anathema.

No. Much better to get fully leveraged up, make £100m for the firm... and then keep half for yourself. But at what risk and who underwrites it?

Well, in many cases, it was the traditional' side of the business that suffered at the hand of the big-boy investment side. In the case of Lloyds, it even managed to underwrite another bank it didn't yet own!

The Vickers report aims to put things right to separate the traditional bank from the casino' bank. But that's not due to be implemented until 2019. There's plenty more trouble brewing before that comes (I'll get to that in a minute).

And because trouble is always never far away, a good investment banker must be careful...

Cash out early

Doing the same sort of trades as the rest of the banking community and applying fantastic leverage is of course a recipe for disaster. At some point things go pop.

Take the arbitrage trade of the century. That was selling expensive German government bonds, and buying cheaper 'Club Med' bonds. Right up until the credit crunch, this was a fantastic bet making hundreds of billions for the banks. By the time the crisis showed up, all the European bonds were valued much the same clearly not sustainable...

And now that it's all blown up, who pays? Not the traderswho have long-since cashed their bonuses, that's for sure.

The secret (as is the same with much of investment too) is to get out while the going's good. And if things turn sour on your watch, then move to another bank, quick!

The next explosion

So, we've established that what you want is a highly leveraged gamble. And preferably you want the rest of the finance community to be betting the same way. That way you're almost guaranteed that the price moves in your favour.

But most of all, you'd like to be on the right side of the regulator. Then, whatever happens, you should be safe. And I've got just the thing.

I said that the authorities will accede to more dangerous banking activity so long as it's in their interests. And right now it's in the authorities' interests to let the banks keep pumping cash into struggling governments. They have to grease the wheels...

According to Reuters, the European Central Bankis considering a plan to make its own assessment of sovereign bonds, and ditching the established ratings firms. You see at the moment, when the big boys want to get some cheap money, they can deposit their sovereign bonds with the ECB and get a load of cash to feed their gambling habit.

The only problem is that the rules state the bonds must be of a certain quality as determined by the ratings agencies. But of course the agencies have been marking down the bonds that really matter. Nevermind says, the ECB... we'll mark the bonds ourselves!

That way the banks can continue to get fully leveraged. They can get back to lending to dodgy governments across Europe.

Everyone's a winner... The arbitrage looks like it could be back on!

And that means I, for one, won't be betting against any of Europe's sovereign debt. Don't fight the feds, as they say.

But I'm painfully aware that together the banks and the authorities are sowing the seeds of the next crisis. And what's more, these moves could unleash dangerous inflationary forces. Feeding the banks with gambling money isn't without risk.

And it's got me thinking... gold.

I'm off to see my coin dealer later. He tells me he's picked up some nice gold sovereigns for me. I'm making the most of the recent lull in the bullion price, I've got a feeling we'll have some interesting times to come.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.

He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.

Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.