Steve Kohlhagen first left his mark on the derivatives world in the early 1980s when, as an international finance professor at the University of California at Berkeley, he developed the first currency options model with fellow professor Mark Garman. In 1983, he left academia to work in derivatives groups at Lehman Brothers, Bankers Trust and AIG Financial Products. Since 1992, he has built the derivatives business at First Union National Bank, and is now responsible for all fixed-income sales and trading, including public-finance derivatives and foreign exchange. He spoke with editor Joe Kolman in April.

Derivatives Strategy: What inspired you to develop the first currency option model?

Steve Kohlhagen: In the fall of 1979, Mark Garman and I were professors at the University of California at Berkeley. Mark told me that Hayne Leland and Mark Rubinstein, who were also at Berkeley, were using the model created for stock options to develop something called portfolio insurance for equity investors. He thought there had to be a similar application in the currency market, and no one had done that before. So we spent the summer developing the currency option model.

DS: What did you do with it once you created it?

SK: We joined forces with Terry Turner, a former Berkeley professor, who was then at Bank of America, to form a company that marketed the currency insurance idea to insurance companies. When we created the model, we didn’t think banks would realize its profit potential, and we were afraid they’d drive the profit margins down really fast, whereas the insurance companies would take quite a while to drive margins down. We also thought the banks would market it wrong—which is what eventually happened.

So we went to Hank Greenberg at AIG and proposed that he underwrite insurance against foreign exchange risk and that we hedge it for him. Marsh & McLennan agreed to do the exclusive marketing for the product, and Greenberg told us that he would be happy to hire us for $25,000 as consultants. We graciously passed and entered an agreement in principle with another insurance company, which agreed to do it but eventually backed out. In the end, the people there didn’t want to take on the risk of the model not working. I don’t blame them—we were just a couple of professors from Berkeley.

DS: Because they didn’t understand what you were doing?

SK: They insisted on having a copy of our model at their headquarters. Obviously, we wouldn’t do that, because the model was all we had. After that, Terry went back to BofA, where he eventually became treasurer. Mark and I continued putzing around as academics and then published our option-model paper. Now, 20 years later, insurance companies are starting to look at those kind of risks. With the benefit of hindsight, either of those insurance companies could have been rewarded for being ahead of its time.

DS: How did the banks market it wrong?

SK: They pitched it at extremely low spreads. In addition, Bank of America came out with currency options about a year after we created ours. The people there initially thought they could sell puts and then hedge them by selling calls.

DS: Did they find out that they were losing money?

SK: I certainly didn’t tell them. A little while later, I left Berkeley and went to Lehman Brothers. Lisa Polsky at Citibank and I were in the market offering currency options. Bank of America was offering them too, and the treasurer at Apple Computer was arbitraging BofA’s bad pricing. He would buy them cheap from BofA and sell them to us closer to fair value, since BofA wouldn’t sell them to us directly.

DS: Why did you leave Berkeley in 1983? What lured you away?

SK: My experience on the White House staff in 1978–79 helped me understand that I liked decision-making and action more than academia. Lehman convinced me it had an environment in which I could learn investment banking—so much so that I turned down an offer to become Salomon’s chief economist in London to go to Lehman. At that time, Lou Glucksman, Shel Gordon and Dick Fuld were trying to bring capital markets into an investment banking environment at Lehman, and at the same time Charlie Sanford and Eugene Shanks at Bankers Trust were trying to do the same thing in a commercial bank. They both had similar models, but nobody knew where things would go—they were trying to marry financial theory, sales and trading within a banking environment.

“The treasurer at Apple Computer was arbitraging BofA’s bad pricing. He would buy currency options cheap from BofA and sell them to us closer to fair value.”

This was 1983, remember, before the word derivatives had become popular, and the only person in the world doing currency options correctly was Lisa Polsky at Citibank. Lehman didn’t have any idea about what it wanted to do with me, and I had no idea about what I wanted to do. So I created Lehman’s currency options department. Nine months later, Shearson bought Lehman, and I eventually moved to Bankers Trust.

DS: What sorts of things did you do at Bankers Trust?

SK: I started a little unit that thought up ways of creating transactions with embedded options in them. It was the start of getting investors to sell options as a way of enhancing their returns. Initially, they were caps embedded in 12-year issuances and other structured notes.

DS: How did investors react when they were pitched these early products?

SK: They were enthusiastic. Investors were willing to sell options, whether it was a 12-year cap or three-month currency option, against events they thought would never happen—such as Libor going to 10 percent or the Deutsche mark moving to a certain level—in exchange for a pretty good return.

In fact, when I was at Lehman a client gave us the idea for the first 12-year cap, because the client wanted to own the 12-year options and couldn’t get anyone to sell them. The client proposed that Lehman underwrite a capped floater, which the investor would buy. The issuer would be protected against the cap being hit, and Lehman would sell the cap to this client. By the time that came on the market, I was at Bankers, and Steve Gruber and Mike Rulle at Lehman brought us into the deal.

Later on, I worked at AIG Financial Products under Howard Sosin at a time when AIG was pretty famous for doing very large and very long-dated derivatives. They were options-based—the same thing we were doing at Bankers but larger and longer-termed. We were basically trying to get investors and issuers to sell options.

DS: The deals were also quite controversial.

SK: Hank Greenberg at AIG was willing to accept the long-term risks that Howard was putting him into, because Greenberg thought they were being well managed. And I believe they were being well managed. But the risks were a little rough if you took on 30-year credit risk.

DS: Particularly on municipal bonds.

SK: Some were munis, but a number of them were well-known Fortune 100 companies. We did extremely large deals with Sears, Procter & Gamble, and other well-known firms. The structures all had large credit risk in them, so Hank had a reason to be concerned about credit exposure.

DS: Why did everything unravel?

SK: It unravelled after I left. Howard was an extraordinarily good businessman, and he cut a really good deal with Hank Greenberg and found a way to make lots of profit for both parties. In the end, I would speculate, a large corporation needs to control what it’s got, and Howard didn’t want to give that up.

DS: The big controversy was whether or not Sosin’s long-term options book was managed or valued appropriately.

SK: I left in January 1993, and Howard left shortly thereafter, but from everything I saw, it was managed well and valued properly. Remember, Greenberg was looking at it like an insurance executive, and we were all looking at it like derivatives professionals. That’s a totally different way of looking at the world.

Insurance executives think in terms of taking a lot of risk and then buying reinsurance on it. A derivatives person does a deal and then buys reinsurance through an intellectual model that hedges the deal over time, but he’s not diversified. If you’re an insurance executive, that doesn’t look like diversification to you. It looks like a mathematical model that may or may not work.

“Derivatives professionals have a history of treating bankers badly. That’s a tried-and-true way to not get customers.”

Insurance executives today still look at things in terms of insurable risks. They’ll do derivatives and then hedge those exposures by diversifying over a lot of products, and they’ll buy reinsurance somewhere else. Today we’re beginning to see an evolution in which a lot of the insurance companies are building derivatives shops that think like insurance shops. So the evolution has gone Hank Greenberg’s way, in a sense.

DS: Yet you left the insurance world to go back to the capital markets. There must have been some interesting opportunities to lure you back.

SK: Terry Turner and I have been friends since Berkeley, and, along with Mark Garman, we had started the investment-banking business in the late 1980s that I mentioned before had failed for various reasons. So we had always wanted to try to build a successful business together. In 1992, Ed Crutchfield of First Union asked Turner to build a derivatives business for his $39 billion bank in North Carolina. Terry convinced me this was what we’d always wanted to do, and I’ve been here ever since.

DS: What kind of client business does a bank like First Union have?

SK: Our basic plan was to do what no one had ever succeeded in doing—bringing derivatives to the middle market, to entrepreneurial real-estate developers and other $10 million to $100 million companies. Our average swap size the first four years was $5 million, vs. $100 million to $500 million at AIG. We do small, vanilla deals for customers who had not been introduced to the concept before and who are extremely loyal and only do deals with us.

DS: Why haven’t others been able to succeed as well?

SK: Derivatives professionals have a history of treating bankers badly. That’s a tried-and-true way to not get customers. From day one, our basic philosophy has been to treat bankers and customers extremely well. We wanted to assure bankers that derivatives were a complement to their normal set of products, not a threat. Now we’re doing about 100 deals a week, with a staff of 110, and our budgeted revenues for 1999 are $260 million.

DS: Do you have any reservations about your move to Wall Street?

SK: Many bright people have been channeled to Wall Street, securities firms and banks. I don’t think anyone has sat back and thought about how huge a misallocation of society’s resources there has been—away from producing real goods and services and toward trying to make money in financial markets. Every year my colleagues and I around the Street hire the best and brightest kids right out of school, and they come in and generate value for their shareholders and the securities markets. Imagine what a different world it might be if half those kids had been working in the U.S. automobile industry or rocket technology or medicine.

“Many bright people have been channeled to Wall Street, securities firms and banks. I don’t think anyone has sat back and thought about how huge a misallocation of society’s resources there has been.”

DS: What does this mean for the future?

SK: If the financial volatility ultimately gets wrung out of the markets and we wind up in an extremely stable financial world, we’re going to have an interesting problem: Thousands, maybe millions, of really bright people will be working in an industry where the payoffs aren’t high anymore.

DS: I don’t think I’ve ever heard anybody in the derivatives business say that.

SK: But on the other hand, it’s a huge amount of fun. People always ask me if I miss anything about Berkeley or teaching, and the answer is, No. Half of what you do if you’re going to be successful in business is teach, and there are just as many smart people in the financial world as there are in academia. Believe it or not, they are often driven to do intellectually stimulating things as well as make money.

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