A Faustian Bargain

The World According to Derivatives: Part 2 of 7

Calamitous as the current economic crisis is — it was both predictable and predicted. History as they say is prologue. In one hallmark example, Warren Buffet related the events surrounding a leveraged and derivatives-heavy hedge fund called Long-Term Capital Management in his 2002 Hathaway Berkshire Newsletter. In this newsletter Buffet recounts how LTCM — though a relatively small firm employing “only” a few hundred people and boasting two Nobel prize winners among the principle shareholders — nevertheless caused the Fed to orchestrate an emergency rescue in 1998. In the following excerpt, Buffet provides some good insight into the kinds of issues raised by derivatives in general and leveraging in particular:

One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes.

Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.

Most importantly, it was not the spectacle of speculators “blowing themselves up” that caused Buffet to worry that derivatives were such potent weapons of financial mass destruction. It was the “daisy chain”of counter party risk attached to them and the fact that these highly speculative, highly leveraged, privately negotiated contracts are not backed by any type of collateral.

Instead, as Buffet later says, “their ultimate value depends on the credit worthiness of the counter parties to them.” Said value has precious little to do with actual assets. Moreover and as Buffet correctly warned, one weak link in the unplumable chain of counter parties could potentially lead to global economic meltdown.

Counter party risk has expanded in recent years to include broker-dealers, multinational corporations, hedge funds, and insurers. Using the derivatives business GenRe Securities that came attached to his purchase of the parent company GenRe as an example for how difficult it can be to close down a derivatives business, Buffet says that after ten months of effort to wind down its operation, GenRe Securities still had 14,384 contracts outstanding — involving 672 counter parties around the world.

Counter party risk is commonly believed to be minimized by having an organization or entity with extremely good credit act as an intermediary between the two parties, since it is they who can make good on the trade should a default on the agreement occur. Typically, banks such as J.P. Morgan and brokerage houses such as Bear Stearns will serve as intermediaries. But we all know what happened to Bear Stearns despite its having survived the Great Depression.

September has brought with it wave after wave of more bad news, including the announcement that mortgage giants Freddie Mac and Fannie Mae would be placed under conservatorship of the government. One week later, we watched as the venerated 158 year old Lehman Brothers was allowed to go under — making this the biggest bankruptcy in U.S. History. We also watched as the privately owned Fed orchestrated an $85 billion dollar bailout (or as some posit, purchase) of insurance giant AIG — and as Bank of America arranged for the purchase of the ailing Merrill Lynch. Alarm bells were also going off about Morgan Stanley, Washington Mutual and that “national treasure” Goldman Sachs. In every case, the faltering institution had become entangled with “bad debt” derivatives.

Meanwhile the Fed felt compelled to inject an additional $180 billion — for a total of some $247 billion — of taxpayer money as part of the international effort being coordinated by central banks around the world to prevent total seize up of the global financial system.

None of this was enough, and on Friday September 19 Treasury Secretary Hank Paulson announced a new plan for what he described as a comprehensive program intended to get at the root of the problem, which was centered in the derivatives markets. Some pundits have begun referring to this initiative as the “nuclear option” and in the figurative sense at least, it may well be.

An estimated $700 billion of yet more taxpayer dollars are to be used to purchase problematic derivative securities as the government assumes an unprecedented level of responsibility for their “unwinding” so that “liquidity” might be brought back to the markets. Troubled Freddie Mac and Fannie Mae are to begin the process of what amounts to a massive bailout of Wall Street, and the government will assume the role of “intermediary” using the full faith and credit of its properly panicked citizens as backing.

Princeton Professor Markus K. Brunnermeier makes some noteworthy observations about the predictability of the current derivatives-based liquidity crisis in the conclusion of a May 19 draft article for the Journal of Economic Perspectives:

While each crisis has its own specificities, it is surprising how “classical” the 2007-08 crisis is. From the trigger set off by an increase in delinquencies in subprime mortgages, a fullblown liquidity crisis emerged, primarily because of a mismatch in the maturity structure that involved banks’ off-balance-sheet vehicles and hedge funds. What was new about this crisis was the extent of securitization. Not only did it make more opaque the exposure of institutions’ structured credit products to credit counterparty risk, but it also made these products more difficult to value . . .

The additional uncertainty created by these factors later led to spillover effects in other market segments that were not directly linked to subprime mortgages. While it is difficult to say at this early stage how the crisis will ultimately play out, we should expect to see the financial turmoil spilling over to the real economy with potentially sizable macroeconomic implications…“Deciphering the 2007-08 Liquidity and Credit Crunch”, Markus K. Brunnermeier, Princeton University.

Of particular interest here is Dr. Brunnermeier’s assertion that while the current crisis contains “classical similarities” to past crises, it is the extent of securitization — and the concomitant, “unplumable chain” of counter party risk — which sets this crisis apart from others. Thus the turmoil spilling over to the real economy could have “potentially sizable macroeconomic implications.”

More than a decade earlier, John Kenneth Galbraith had provided an astonishingly clear if somewhat grim picture of “classical similarities” for previous U.S. panics, and also provided some clues as to why contemporary gurus such as Warren Buffet and scholars such as Dr. Brunnermeier are so apprehensive — and so seemingly prophetic:

Speculation occurs when people buy assets, always with the support of some rationalizing doctrine, because they expect prices to rise… This process has a pristine simplicity; it can last only so long as prices are rising. If anything interrupts the price advance, the expectations by which the advance is sustained are lost or anyhow endangered. All who are holding for a further rise — all but the gullible and egregiously optimistic, of which there are invariably a considerable supply — then seek to get out. Whatever the pace of the preceding build-up, whether slow or rapid, the resulting fall is always abrupt. Thus the likeliness to the ripsaw blade or the breaking surf. So did speculation and therewith economic expansion come to an end in all of the panic years from 1819 to 1929.

… Also, as the nineteenth century passed and gave way to the twentieth, speculation became less of a local, more of a national, phenomenon. Land speculation occurred in the farm country and on the frontier. So did that which anticipated or followed the arrival of the railroads. The collapse of such speculation affected primarily the country banks. Securities speculation, in contrast, was the business of the financial centers. Loans to buy securities were made by the big-city banks. These banks also underwrote and bought stocks and bonds. When these collapsed in price, it was the banks of the cities that were affected, and it was their depositors who took alarm and came for their money.Money Whence It Came, Where It Went, revised edition 1995, by John Kenneth Galbraith.

Today, it is not just country banks or even the big financial centers in select cities that are seriously threatened by collapse — said collapse always being due to bank leveraging of their loans, it might be pointed out. Since Galbraith penned his words, the potential for mass financial destruction has been magnified exponentially by “innovative forms of derivatives” which are heavily traded through what amounts to a global casino.

Moreover, as Dr. Brunnermeier points out, the extent of securitization and the attendant uncertainty created by counter party risk and lack of transparency has already led to spillover in market segments other than housing and, further, that we can anticipate still more of the financial turmoil spilling over into the real economy. The turmoil is global, but the effects will this time around be quite acutely felt in the United States.

In the case of real estate, especially housing, this turmoil is painfully evident as overly inflated housing values continue to plummet and millions of defaulting homeowners and hapless renters alike are kicked to the curb. But housing is hardly the only asset class whose values are impacted by the irrational exuberance which has for years permeated throughout the global derivatives market. The spillover is also appearing in year-over-year escalation and increased volatility of prices for key commodities — you know the kind of things we need to carry on daily activities, things like food and gas — and it is derivatives which are again playing a crucial role in valuations.

An April 16 staff report for the online Westport News put it this way when discussing derivatives and energy prices: “Over the last five or six years investment banks, hedge funds and pension funds have forced up demand in [oil and energy] contracts above and beyond the basic rules of supply and demand …” Many experts, including Steve Forbes, agree with this assessment. Although estimates vary as to just how much of current oil prices are reflective of pure speculation, author and researcher F. Wm. Engdahl recently asserted that “perhaps 60% of today’s oil price is pure speculation.”“Perhaps 60% of Today’s Oil Price is Pure Speculation”, F. William Engdahl. See also the August 21, 2008 Washington Post article titled “A Few Speculators Dominate Vast Market for Oil Trading” by David Cho.

The Westport News report mentioned above also makes these important observations: “The price for these commodities [including food] is actually set on international commodities markets such as the New York Mercantile Exchange (NYMEX) and other exchanges around the world… What’s problematic about this situation is that traders from all over the globe can play with our energy [and commodities] market … And, these are commodities, not stocks or bonds or other financial instruments. We have to buy them.”“Free Market or Free-For-All?– westport-news.com

In other words the global casino — propelled by the privately negotiated, highly speculative, heavily leveraged “off-balance sheet” derivatives market and controlled by a relative handful of players — is determining to a remarkable degree the value of the necessities of life.

What is especially troubling is that the potential profits from derivatives are magnified many times over through heavy, multi-tiered leveraging with no actual investment in an asset required, or even desired, making their appeal almost irresistible. Moreover, derivatives extract their value from fluctuations in the value of assets such as bundled mortgages and loans, stocks, bonds, currencies, interest rates, indexes and other assets which often are not themselves fixed or tangible. Derivatives have become, in every sense, bets on bets — extracting value rather than preserving or enhancing value through real investments in the real economy.

Conversely, the real economy is a reflection of the goods and services produced and consumed by real people and it depends on the viability of tangible and/or fixed assets. The true value of these assets can be and are dramatically affected by the activities of the global financial economy. Tangible, fixed assets of course include things like land, homes and other buildings, gold, platinum, and so forth. Other tangible — but less fixed — assets include farm crops and livestock, gas, oil, and even water.

Of course, fixed assets require a degree of care and maintenance — and the financial value of less fixed assets expires once they are consumed. But we need them nonetheless. Perhaps we could think of these types of assets as “value added,” because they often give back as much as they take out of the economy.

Derivatives on the other hand are “bookie transactions” with mere promises to make some “fast money” with no real investment in, appreciation of, or concern for the underlying asset. In the obsessive pursuit of fast money, derivatives can and do — to a large degree at least — artificially drive up prices for the very things we must buy and use everyday, even as they exponentially expand debt and the “off-balance sheet” money supply through an increasingly volatile global casino.

Perhaps even worse, both the elevated risk associated with derivatives and the faceless aspect of the global casino create a fertile breeding ground for environmental and human rights abuses, as well as rampant corruption and crime. There can be no mistaking the fact that derivatives speculation requires a good deal of dancing with the devil.

Geraldine Perry is the co-author of The Two Faces of Money and author of Climate Change, Land Use and Monetary Policy: The New Trifecta. Read other articles by Geraldine, or visit Geraldine's website.

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