Mr. Head Honcho

I was fortunate to hear a Wall Street legend speak last week. This is a guy who has forty plus years in the business and now leads one of the country’s largest banks. I was struck by his absolute charming demeanor and more importantly, by his humility. Because it was a private event, for the purposes of this article, I will call him “Mr. Head Honcho” or “HH”.

In talking about the current environment, HH noted that in all of his years in the industry, this is has been by far the most challenging environment that he has faced. Considering that he has guided his firm through every major crisis, including the crash of 1987, the Asian crisis, the collapse of LTCM, 9-11, the dot-com crash, it was an amazing statement. However, it was his candid description of the subprime crisis and its explosion and reverberation that struck a chord in me. Many of us have wondered how some of the best and brightest titans of the financial services industry could have been nailed so badly by what was essentially one bad trading idea. The answer was fascinating and one from which we can all learn.

Mr. HH described how the smartest analytical folks in his firm talked about a strategy, which was essentially the purchase of subprime notes, packaged, sliced and diced and a corresponding hedging strategy that would protect the initial position. There were detailed flip charts highlighting the mathematical models supporting the idea. HH said that he recalled that one of the engineers of the strategy noted that statistically, the risk level was quite low. In fact, it would take “a-once-in-a-lifetime series of events to blow up the trade.”

Of course we now know that the “once-in-a-lifetime series of events” not only blew up the trade, it cost the firm and many like it, billions of dollars. HH paused and looked at us and said, “you know, just because we are professionals in this business does not mean that we can not become blinded by the numbers. What I really learned in this crisis was that it is imperative that any investor who is about to make a decision understand the true risk involved—to ask, ‘what am I doing here? What if the worst case scenario occurred…is the outsized loss, even though statistically unlikely, worth the upside?’”

HH smiled and noted that one of the reasons that he loves this business is that nobody can be right all the time and that it forces him to keep learning. “Markets humble us every day and when you forget that fact, I can promise you that your next hard lesson is just around the corner.”