Let’s not have the energy industry copy the financial one

I’d like to share a bit of my work history with everyone to show some parallels between the financial services industry in the 90’s/2000’s and where we’re at today with the energy industry. Note that in many areas here I’m simplifying things greatly, especially when talking about financial instruments and models.

The Story
For many years I’ve worked as a software developer in financial services. And for a long time I was very pro-markets, as were a lot of people. This was the time of the Clinton Administration deregulating a lot of markets, of Alan Greenspan being worshipped as a God, and America as a nation was letting loose a money-making and GDP-exploding phenomena across the world.

At the same time, I was young and naive way back then. I believed nearly everyone had the world’s best interests in mind when they did things, that “evil” people or villains were just things you saw on TV. Real life people were just folks doing their jobs.

I didn’t realize that some people have incredibly strong drives to better their own fortunes, and they don’t care who gets in their way on the way there. If they were in the way they were just a problem to be taken care of. I saw a lot of it when I worked at a famous brokerage (now defunct) for 3 1/2 years in the mid to late 90s.  At bonus time we’d all go out drinking at noon and people would be driving to Atlantic City or a car dealership to blow half of it. People obsessed over what you drove. The head of a trading operation was known to take a personal helicopter into work occasionally. And in the new (lack of regulatory) environment, these driven people were concocting all sorts of money making schemes. Making money off of short term lending. Making money off of increasingly complex derivative products. Make money off of anything your brain could dream of. And with the increasing speed and power of computers people like me helped make it happen. We built the networks, the algorithms, the pricing systems that helped shore all this up.

All of this was made possible by the relaxing of regulation and increase in computer power. We leaped far ahead of what the government even understood what we were doing, and they didn’t care. “Let the market speak!”. There was light regulation but is seemed to be mostly prima facie stuff and not all that serious.

While I was proud of what I built I always had nagging suspicions in the back of my mind. There were always scandals going on, and some aspects of deals seemed a bit….dirty. Or at least very fogged up. Lots of money flowed around and it was devilishly hard to track. It bugged me and I eventually burned out, drifted away and around for awhile in other jobs.

As more regulations get relaxed, the industry gets more…creative

I then worked for another big financial firm in the 2000’s for 7 1/2 years.  I worked in the credit derivatives IT department.  My group worked with the quants to do the risk models that valued all the increasingly complex financial instruments.  Along the way I learned about how various credit derivatives worked.  I often came away really puzzled.  For examples a Credit Derivative Swap (CDS) is really just insurance on a bond.  So if you buy an IBM bond and are worried IBM is in financial trouble and might default, you get insurance on that investment.

But in my head I thought “But what if the insurance company defaults?  Why is the insurance company more reliable than the bond issuer?”.  I was told not to worry about that, no big deal, the model will cover it.

Mostly we just made money, but occasionally someone would actually default and there’d be an “oh shit!” moment. It was before my time but I heard than when Parmalat went bankrupt nobody’s default models actually worked. The whole system was broken and IT people had to scramble like mad to fix them. Not at one company but across all of Wall Street.

In any case I learned about about more complex things like “Indexes”, “Baskets” and “Collateralized Debot Obligations” (CDO). Indexes were just a bunch of CDS’ piled together. It gave you “default protection” across an industry or otherwise related companies.

The more complex ones were bundles of companies that were sliced into what are called “tranches”. Let’s take a gross made example of a basket of IBM, Ford, and Apple Computer.

You buy a basket of these, and you are protected from them going bankrupt. For this protection you pay X dollars a month for some amount of time (often 5 years). Think of the money like insurance premiums.

But with a basket, it’s a little complicated. You don’t just buy protection on a group of companies going bankrupt. You can pick a percentage of companies that go bankrupt too. You might say “this only applies for the first 33% of companies”. So in reality you’d get paid if any any one of the companies went bust, but then the deal was off.

Then there were Collateralized Debt Obligations (CDO). These were very different. These were basically individual pieces of debt that package together, and then you got the cash flowing out of all of them. It could be personal loans, mortgage, credit card debt, whatever. These were tranched too, but a little different. If you were at the bottom and someone defaulted, you just lost that portion of the cashflow. If you were higher up you were protected until N number of people defaulted. At the very top end you’d be protected unless a huge number of the loans or whatever went bust.

As a result the bottom tranches cost very little because they were risky.

The top ones cost more money because they were viewed as safe.

Then they got even fancier and you could have a CDO where each “debt” wasn’t just one debt, it was actually another CDO! This was called a CDO2, short for “CDO-squared”.

People would occasionally mention how crazy some of these securities were. They explained it like this.

All this stuff comes with risk, and what investors do a lot is figure out how much risk you’re willing to take and invest based on that.  You could buy very risky things cheaply. Or you could buy very safe things for more money.

Back to CDO2.  The top end of these things – where like 20% of people had to default – were seen by investors as ultra-safe.  They were rated AAA.  They said “hey, no way 20% of the general population is going to default”!. But they also had high yields.  Low risk and big rewards – sounds awesome!  People bought them in droves.

But as people explained it, there was a reason they had such high yields.

It turned out that by having a CDO of CDOs, investors only looked at the first level (the top end) but not so much the underlying the CDOs in the individual buckets.

And what banks did was solve a problem they had had for awhile.  There’s a lot of junk debt out there.  High risk people with home mortgages.  Low level office workers with $30K credit card debt.  No one would buy this stuff.

But what if you bundled all of them together.  Then you took the riskier ones – the lowest tranches with first defaults.  And then you got an other bundle like that from another basket.  And a third from yet another basket.  You literally skim the worst parts of each.  And you assemble them into your new shiny CDO2, and you sell the top end of that as AAA.

This is just what a lot of CDO2 securities were.  Not all, but some.

They were all junk from the top to the bottom.  Normally you have a random mix of people in a basket, so the tranche model made sense.  But here the debt was uniform – they were all people with poor credit who would likely default en-masse if there was any bumps in the economy.

It was a bit of sleight of hand. Not illegal but bad things were hidden where ordinary large scale investors would be unlikely to find them.

The ratings agencies were involved in all this by assigning this stuff AAA.  I have no idea why but they did, but this helped. As it turns out companies pay for their ratings from Moodys or S&P or whoever. So there’s a bit of conflict of interest there. Especially since firms could shop around for ratings. And there was no regulation to reign this in.

And as a result cities and pensions and insurance companies and mutual funds all bought into them. Around this time I started to feel rather uneasy about my job.  I was no longer proud of my work.  And my job suffered since I didn’t believe in it anymore.

It hits the fan.

Then 2007 and 2008 happened.  What people described actually happened.  The housing bubble burst.  House prices plummted.  People went underwater.  Liar’s loans were a big part of that and go all the way back to Clinton’s degulation.  People started defaulting on their mortgages, on their credit cards, on their car loans.

Things didn’t just come apart financially. Just like with Parmalat, it turned out the models didn’t really work. Not in that environment at least. Everyone’s values were wrong based on a shared incorrect model.

All that debt was sold to pensions and insurance companies and mutual funds as AAA debt at the highest levels of protection went bust. The impossible scenario happened because the sleight of hand didn’t match reality.

The final icing on the cake were “naked” derivatives.  This was buying a derivative without actually owning anything.  You could buy CDS insurance without having a bond.

The problem there was that people bought more CDS insurance then there were actual bonds.  It was like buying insurance for a house – but you don’t own the house. It’s not totally insane – it was integral to hedging strategies and why companies loved the derivatives so much.

In the end there were many times more derivatives than actual bonds that needed protection. As the markets stressed more people were called to pay 10x more money out than they had in collateral. It was impossible.

In the end the Fed had to bail everybody out to the tunes of trillions of dollars. The deregulation of the Clinton years and speeded up by the Bush one ended up with standards loosened everywhere, and the financial companies ate it up. They pushed the loosened standards to the max. Except that in the end it was all a house of cards, and it blew up in their faces.

Personally I got even more disenfranchised at my job, lost interest and my job performance plummeted. In the end I was caught in a round of layoffs in 2012. Which worked out well for me in the end – I got enough money to move to where I live now in West Amwell, and start again. I still work in financial services but now I work for a financial service information and news firm. What we do is basically inject transparency everywhere we can in the system and help bring the truth to everyone. It’s a liberating change.

Don’t let the FERC ape the financial regulators of the past

Bringing this back to my original point. I’ve seen first hand that companies by themselves cannot self regulate. They want to maximize their profit and growth, and they can be incredibly innovative (and sneaky, and underhanded) to get there. You need independent regulators to define the rules and make companies abide them. In finance you see things finally changing. Now we are seeing companies going to court. Firms sued for deceptive CDO2 stuff. Companies all over Wall Street settling with the government over collusion in FX pricing. Mortgage rules are being re-instated so you can’t do liar loans anymore. Proprietary trading desks have been busted up. The government realizes they can’t be frat brothers with the finance firms. They have to be the responsible watchers and punishers.

We need the same for infrastructure regulation. We can’t rely on self-regulation or collaborative buddy systems between government and industry. The human race has it hard-wired into its DNA to angle for the edge, to shave off a few points where they can, to scrabble to get ahead. And a percentage of us will cheat to get there. It’s just the way it is, and corporations are no different.

The big problem here is the FERC. Their goal is to be just like financial regulators in the 90s and 2000s – to be cheerleaders and help companies increase their bottom line and grow GDP. To be their drinking buddies.

This is totally wrong.

Now I’m not talking about shutting down infrastructure. I’m talking about making the companies building infrastructure to do it responsibly. To double-under score that gas is a transition fuel and we need to cap it’s usage at some point. To show that fracking is incredibly harmful and also should be capped. That some day soon we’re going to have to rely on geothermal, wind, solar. Maybe nuclear if we can ever get it done right. There are enormous challenges to doing that, so I acknowledge we just can’t wipe out nat gas and oil instantaneously. But there has to be a clear plan and FERC et al have to reign in excesses.

To do that, they have do what we did in 2008 with finance. They have to get tough. They need to grow teeth. They need to dictate terms to energy companies, not ask them what they want done. Executives need to go to jail when they break the law. The FERC should stop turning a blind eye to federal guidelines and laws. Concerned residents, conservation organizations, and environmental protection agencies should not be seen as “problems” for FERC to work around.

The government, and the people, should not trust vague assurances. “We’re exerts, we know what we’re doing, we’re following industry best practices”. This is what the people behind the financial collapse said. They said trust us, this model will work – and the all fell apart when Parmalat went bankrupt. They said trust us, this model will work again – and then the Basket and CDO models went to crap when the market dove. They said no no no, wait wait, give us one more chance – and Lehman went under and the Fed started printing money 24/7 to keep the lights on for everyone.

The energy companies should finance this. The FERC budget should come from energy companies as a production tax. Their budget problems would evaporate if they got even a fraction of a percent of the production numbers.

Sounds just like PennEast and all the other drilling and pipeline companies, doesn’t it?

Congress and the administration should act too. FERCs sole-approval authority should be revoked. They should be peers to the other agencies, not above them.

Industry should not be inviting FERC directors to give presentations of projections at their conferences. The industry should be scared to death of them. That’s when you know you’re doing it right.

Published by

Mike Spille

I'm a thinker, an analyzer, a synthesizer. Maybe not in that order. I live in West Amwell NJ with my wife Kristina, our two kids Day and Z, our two dogs Fern and Cinna, and three cats Ponce de Leon, Oliver, and Doolittle.

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