The Silicon Valley Bank and the Human Brain

How do brilliant people repeat the cycle of financial boom and bust? Why don’t we learn?

I just watched the movie “Margin Call” last night. It is one of the few movies that give a realistic sense of the financial markets in a collapse.

When I built a trading firm we always managed risk as a primary mission.

Every morning I would assume there was a bullet coming out of the fog and aimed at my forehead. Where was that bullet coming from today? What could happen that could take me out of the game?

Does the story about Louie (not his real name) reflect the same human flaws as the management of SVG?

I hired a trader to trade options on the Chicago Board of Options Exchange (CBOE).

My trading firm had been growing on the options floor of the Pacific Exchange.

We had traders in most of the major pits. My trading system had been honed from my days at CRT (Chicago Research and Trading) and founder Joe Ritchie. We were consistently profitable every month using my options strategy.

Looking to expand, I was interested in opening a trading desk on the larger Chicago Board of Options Exchange (CBOE)

A friend introduced me to Louie, a very experienced trader who wanted to join my firm.

I flew Louie out to San Francisco and we got along well.

However, he revealed that he had “blown out” twice before in his trading career. This means he lost everything — and more.

He said that his life was in the “shitter” from a divorce, but he had learned his lesson and was eager to pick up the pieces and move on.

I believed him, so he spent three weeks training with us. Since he was an experienced trader, he picked everything up very quickly.

Louie traded outside of our risk profile.

We leased a seat on the CBOE and opened a significant-sized account for Louie to trade.

However, his positions were odd.

We had a discussion and he agreed — Yeah, a couple of big trades had come in buying overpriced out-of-the-money puts and he had oversold them. He said he would work his way out.

I understood. Yes, that sometimes happened to me too. The entire pit was short these option puts and were confident in their profits and the price started to come down.

In the heat of the pit, you must be very aggressive as a trader.

Sometimes you end up putting on more risk than you want to maintain your “pit presence” so I didn’t think too much of it.

It got worse.

The next week, our firm’s risk position showed the abnormal risk for a sharp downside move in the market and it came from our CBOE positions.

I checked Louie’s position and discovered that the out-of-the-money puts not only had not shrunk; they had gotten significantly bigger!

It was time to take the “boy” to the woodshed.

Close the position no matter what it costs.

Friday morning I told him he had to be out of the problem position by the close of business that day.

He pleaded that if he tried to get out the other market makers in the pit would “screw him royal.” I told him I didn’t care, and he was to get out by the close of business.

On Monday morning I checked the position and it hadn’t changed.

When I called him, he didn’t answer the phone or return my calls.

After the markets closed, he called me with lots of excuses about why he couldn’t get out of the position and why we should keep it because it was going to make a lot of money.

I fired him on the spot.

Neurology: How your natural wiring creates this problem.

“The Hour Between Dog and Wolf – How Risk Taking Transforms Us, Body and Mind.” John Coates demonstrates how our biological systems and brain chemistry shifts when we are on a winning streak.

Imagine a context where you are powerful, successful, and admired.

• Your success is envied.
• Your self-worth has become dependent on your social status.
• You need success to create meaning in your life.
• You have proven to yourself that you are invincible
• Your brain has been rewarded with dopamine for behavior X month after month..

Can you even see the obvious risk? No.

You can’t afford to consider the financial risk.

In that context, the risk isn’t available to your brain.

To acknowledge risk is to lose the rewards and the rush of the context of power, success, and admiration.

• The risk of interest rates going up?
• Lending long and borrowing short?
• Social media contagion?

It is hard to understand given our hindsight that this risk was not available to the SVB risk managers.

The human brain repeats the same crises over and over again. (See the list in Wikipedia)

Here is a list of what I have lived through and survived.

• Hunt silver crises
• Portfolio insurance and dynamic hedging
• Savings and Loan and Housing and mortgage crises
• Japanese asset price bubble
• Dotcom collapse
• Bear Sterns
• Covid Pandemic

Success changes our brains…and like Zombies…they spread the infection.

These are very smart people who both engineer a crisis and are unable to see the risk.