Delanceyplace.com 8/4/09 - Risk

In today's excerpt - investors, both those that were supposed to be sophisticated and those that weren't, entered into complex derivative transactions. The investment banks that sold these derivatives were careful to make sure these investors received and signed legal disclosures evidencing they had read and understood the risks associated with them. Yet when these investments went sour, some investors brought lawsuits against these investment banks claiming that they didn't understand the risks and that the investment banks should have known that the derivatives were not appropriate for them. In the case below, the investment bank had sold a derivative to an Indonesian noodle maker that now stood to fail because of a loss of tens of millions of dollars on the investment:

"Did the investor understand [the risk]? Most of the money managers should have; as professionals they were paid to know things, after all. The thing was that they wanted the forbidden fruit. The widows and orphans were different; Mr. and Mrs. Smith of Omaha, Nebraska - did they know all this? They generally salivated at the high interest rates offered. Had the Indonesians understood what the dealers had structured for them?

"We always got the client to sign all sorts of papers saying that they were sane, doing this of their own free will and had been given a 'product disclosure statement' (PDS) outlining the risks of the investment. The clients generally never read the statements. [A colleague of mine], in one of his diligent moments, had taken it upon himself to vet my carefully crafted description of one of our products for a PDS. 'What is this shit?!' He thundered. 'If I read this crap I wouldn't know what I was buying.' I took this as the highest compliment. A small army of lawyers had vetted the PDS and had passed it as legally correct. In some countries, regulators had also reviewed it and passed it fit for investor consumption, but it was unreadable gibberish. The detail was in the drivel.

"Our tax lawyer, a 50-something woman from the most expensive law firm in town, was my role model. On her wall was a framed excerpt from a judgment in a case concerning a clause that she had drafted. The judge had commented that he had found the clause to be of 'stupefying legal density beyond human comprehension'. She was pleased with her efforts. I had a long way to go."

Satyajit Das, Traders, Guns, and Money, Financial Times/Prentice Hall, Copyright 2006 by Satyajit Das, p. 48