Tell me if this story sounds familiar to what probably went on in the AIG Financial Products Group back in late 2007 or early 2008.
When I first got a front office job (meaning trading and sales) I worked for a particularly heinous woman. To be fair to this "person", she was the one who plucked me out of the middle-office to work on the trading desk so I kind of owed her......and she made sure that I always remembered that! Anyway, she covered a lot of hedge funds. One day one of the real sharp hedge fund came to us and said;
"We just did this exotic option structure with J.P. Morgan where we will buy from you a one time payout (for the sake of the story lets say $50 million, back when that was a lot of money!) if in the next five years the S&P 500 goes below 500 and 3m Libor sets above 6%. This trade works for us as it hedges some long term macro risk exposure we have in our book. Would you be interested in showing us a level where you would sell that option structure?"
Of course as a sales person, my boss said, "Absolutely!" She then ran around the desk to our brilliant yet troubled equity derivative trader and gave him the terms of the trade she wanted priced. The trader looked at her and said,
"No way. These guys are killers and you can definitely get killed pricing and hedging this crap. Tell them to go to Goldman or Lehman."
My boss, being the team player that she was, ran directly into the big bosses office and said something like;
"When you hired me and told me to bring in all my great hedge fund relationships, you promised me that we were gonna be big leaguers! The equity derivative desk is a big bunch of minor league pussies! The first time I bring them a real trade from MY CLIENTS they won't do it!"
Now, the sound of this woman's voice when she got going could pretty much make another human being do just about anything to just make her stop, which is what the big boss did. He went out and told the trader to price the trade. Without going into any more detail, the trade got priced in a couple of days (one risk management lesson should be any trade that takes more than one day to price probably shouldn't get done!). The equity derivative desk had to borrow a model from the London desk to deal with the Libor part of the trade. Finally, the trade gets priced, checked and checked again. Finally, the desk said to make no money (we call that break even) we would charge $3 million. Because of the risk involved, we would offer the structure to the hedge fund at $6 million.
Armed with that offer my boss got on the phone and said, "Based on where the S&P is right now, with Libor here, we would offer you that option at $6.25 million." The hedge fund said thank you and told my boss would call back in a few. As my boss and the trader paced nervously (and I don't think my boss told the trader she put an extra $250,000 it the trade) visions of millions danced in their heads. Finally the hedge fund called back. "Hi, we can do that there at $6.25 million...are we done?" "Yes you are done!" Now my boss and the trader are happily dancing around, she's sweetly telling me to put a term sheet together when the phone rings again. It's the hedge fund;
"Hi, would you guys be interested in upsizing that trade, we'd like to double it if you care?"
At that moment I swear you could have heard a pin drop until the trader yelled something like "Holy F**K!!!" He realized that something must be wrong for them to come back so quickly, especially after they told us that once they did that size they were done (its important for traders to know if a big customer has done his full size on a big trade and it's nice for the hedge fund to tell the truth). Sure as shyt, the trading desk realizes that they didn't calibrate one of the volatility curves properly (yes, Buffett is right, these are financial weapons of mass destruction!) and we should have charged around $10 million to break even, not $6.25 (which we though had $3.25 million of profit and reserves in it). So suddenly the trading desk realizes that they have lost $3.75 million AND they will have to hedge this contraption for the next five years, with no reserves put aside. My boss, again being the team player, runs into the big bosses office and blames the trading desk for everything.
The trader thinks fast and then he goes into the big bosses office. While I was not in the office, my sources for what was said are solid. The trader said;
"Listen, I didn't want to do this trade in the first place. You let her bully you into doing this trade, I had to use a model I didn't create and now I'm down $3.75 million (which again, back then, was a lot of money!). It's April and I'm not going to work for the next eight months just to have my bonus crushed by this trade. I have a real complicated book out there and a pretty young group of traders who don't know where all the bodies are buried. Guarantee my bonus right now or I leave today!"
And the big boss guaranteed the bonus and at the time, it was probably the wise move because that trader made sure that no one had a complete picture of his book, which was big and scary. I bet you anything that these bonuses that are going to AIG Financial Products Group were guaranteed under a very similar threat. "Guarantee us all $x million or we leave today." Nice world isn't it?