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The world according to derivatives, part 2 of 7: A Faustian bargain
By Geraldine Perry In one hallmarkexample, Warren Buffet related the events surrounding a leveraged andderivatives-heavy hedge fund called Long-Term Capital Management in his 2002Hathaway Berkshire Newsletter. In this newsletter Buffet recounts how LTCM -- thougha relatively small firm employing “only” a few hundred people and boasting twoNobel prize winners among the principle shareholders -- nevertheless caused theFed to orchestrate an emergency rescue in 1998. In the following excerpt,Buffet provides some good insight into the kinds of issues raised byderivatives in general and leveraging in particular: Oneof the derivatives instruments that LTCM used was total-return swaps, contractsthat facilitate 100 percent leverage in various markets, including stocks. Forexample, Party A to a contract, usually a bank, puts up all of the money forthe purchase of a stock while Party B, without putting up any capital, agreesthat at a future date it will receive any gain or pay any loss that the bankrealizes. Most importantly, itwas not the spectacle of speculators “blowing themselves up” that caused Buffetto worry that derivatives were such potent weapons of financial massdestruction. It was the “daisy chain” of counter party risk attached to themand the fact that these highly speculative, highly leveraged, privatelynegotiated contracts are not backed by any type of collateral. Instead, as Buffetlater says, “their ultimate value depends on the credit worthiness of thecounter parties to them.” Said value has precious little to do with actualassets. Moreover and as Buffet correctly warned, one weak link in theunplumable chain of counter parties could potentially lead to global economicmeltdown. Counter party risk hasexpanded in recent years to include broker-dealers, multinational corporations,hedge funds, and insurers. Using the derivatives business GenRe Securities thatcame attached to his purchase of the parent company GenRe as an example for howdifficult it can be to close down a derivatives business, Buffet says thatafter ten months of effort to wind down its operation, GenRe Securities stillhad 14,384 contracts outstanding -- involving 672 counter parties around theworld. Counter party risk iscommonly believed to be minimized by having an organization or entity withextremely good credit act as an intermediary between the two parties, since itis 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 Stearnswill serve as intermediaries. But we all know what happened to Bear Stearns,despite its having survived the Great Depression. September has broughtwith it wave after wave of more bad news, including the announcement thatmortgage giants Freddie Mac and Fannie Mae would be placed underconservatorship of the government. One week later, we watched as the venerated158-year-old Lehman Brothers was allowed to go under -- making this the biggestbankruptcy in U.S. History. We also watched as the privately owned Fedorchestrated an $85 billion dollar bailout (or as some posit, purchase) ofinsurance giant AIG -- and as Bank of America arranged for the purchase of theailing 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 feltcompelled to inject an additional $180 billion -- for a total of some $247billion -- of taxpayer money as part of the international effort beingcoordinated by central banks around the world to prevent total seize up of theglobal financial system. None of this wasenough, and on Friday, September 19, Treasury Secretary Hank Paulson announceda new plan for what he described as a comprehensive program intended to get atthe root of the problem, which was centered in the derivatives markets. Somepundits have begun referring to this initiative as the “nuclear option” and, inthe figurative sense at least, it may well be. An estimated $700billion of yet more taxpayer dollars are to be used to purchase problematic derivativesecurities as the government assumes an unprecedented level of responsibilityfor 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 toa massive bailout of Wall Street, and the government will assume the role of“intermediary” using the full faith and credit of its properly panickedcitizens as backing. Among the beneficiaries: the Union Bank of Switzerland,China’s Central Bank, the Saudi and Dubai Sovereign Wealth funds and otherinternational financiers. Princeton ProfessorMarkus K. Brunnermeier makes some noteworthy observations about thepredictability of the current derivatives-based liquidity crisis in theconclusion of a May 19 draft article for the Journal of Economic Perspectives: Whileeach crisis has its own specificities, it is surprising how “classical” the2007-08 crisis is. From the trigger set off by an increase in delinquencies insubprime mortgages, a full-blown liquidity crisis emerged, primarily because ofa mismatch in the maturity structure that involved banks’ off-balance-sheetvehicles and hedge funds. What was new about this crisis was the extent ofsecuritization. Not only did it make more opaque the exposure of institutions’structured credit products to credit counterparty risk, but it also made theseproducts more difficult to value . . . Of particular interesthere is Dr. Brunnermeier’s assertion that while the current crisis contains“classical similarities” to past crises, it is the extent of securitization -- andthe concomitant, “unplumable chain” of counter party risk -- which sets thiscrisis apart from others. Thus, the turmoil spilling over to the real economycould have “potentially sizable macroeconomic implications.” More than a decadeearlier, John Kenneth Galbraith had provided an astonishingly clear if somewhatgrim picture of “classical similarities” for previous U.S. panics, and alsoprovided some clues as to why contemporary gurus such as Warren Buffet andscholars such as Dr. Brunnermeier are so apprehensive -- and so seeminglyprophetic: Speculationoccurs when people buy assets, always with the support of some rationalizingdoctrine, because they expect prices to rise . . . This process has a pristinesimplicity; it can last only so long as prices are rising. If anythinginterrupts the price advance, the expectations by which the advance issustained are lost or anyhow endangered. All who are holding for a further rise-- all but the gullible and egregiously optimistic, of which there areinvariably a considerable supply -- then seek to get out. Whatever the pace ofthe preceding build-up, whether slow or rapid, the resulting fall is alwaysabrupt. Thus, the likeliness to the ripsaw blade or the breaking surf. So didspeculation and therewith economic expansion come to an end in all of the panicyears from 1819 to 1929 . . . Today, it is not justcountry banks or even the big financial centers in select cities that areseriously threatened by collapse -- said collapse always being due to bankleveraging of their loans, it might be pointed out. Since Galbraith penned hiswords, the potential for mass financial destruction has been magnifiedexponentially by “innovative forms of derivatives” which are heavily tradedthrough what amounts to a global casino. Moreover, as Dr.Brunnermeier points out, the extent of securitization and the attendant uncertaintycreated by counter party risk and lack of transparency has already led tospillover in market segments other than housing and, further, that we cananticipate still more of the financial turmoil spilling over into the realeconomy. The turmoil is global, but the effects will this time around be quiteacutely felt in the United States. In the case of realestate, especially housing, this turmoil is painfully evident as overlyinflated housing values continue to plummet and millions of defaultinghomeowners and hapless renters alike are kicked to the curb. But housing ishardly the only asset class whose values are impacted by the irrationalexuberance which has for years permeated throughout the global derivativesmarket. The spillover is also appearing in year-over-year escalation andincreased volatility of prices for key commodities -- you know the kind ofthings we need to carry on daily activities, things like food and gas -- and itis derivatives which are again playing a crucial role in valuations. An April 16 staffreport for the on line Westport News put it this way when discussingderivatives and energy prices: “Over the last five or six years investmentbanks, hedge funds and pension funds have forced up demand in [oil and energy]contracts above and beyond the basic rules of supply and demand . . .” Manyexperts, including Steve Forbes, agree with this assessment. Although estimatesvary as to just how much of current oil prices are reflective of purespeculation, author and researcher F. Wm. Engdahl recently asserted that“perhaps 60 percent of today’s oil price is pure speculation.” (“Perhaps 60 percent of Today’s Oil Price is PureSpeculation,” F.William.Engdahl. See also the August 21, 2008 Washington Post article titled “AFew Speculators Dominate Vast Market for Oil Trading” by David Cho) The Westport News report mentioned above alsomakes these important observations: “The price for these commodities [includingfood] is actually set on international commodities markets such as the New YorkMercantile Exchange (NYMEX) and other exchanges around the world. . . . What’sproblematic about this situation is that traders from all over the globe canplay 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 globalcasino -- propelled by the privately negotiated, highly speculative, heavilyleveraged “off-balance sheet” derivatives market and controlled by a relativehandful of players -- is determining to a remarkable degree the value of thenecessities of life. What is especiallytroubling is that the potential profits from derivatives are magnified manytimes over through heavy, multi-tiered leveraging with no actual investment inan asset required, or even desired, making their appeal almost irresistible. Moreover,derivatives extract their value from fluctuations in the value of assetssuch 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 valuerather than preserving or enhancing value through real investments in the realeconomy. Conversely, the realeconomy is a reflection of the goods and services produced and consumedby 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 theactivities of the global financial economy. Tangible, fixed assets of courseinclude things like land, homes and other buildings, gold, platinum, and soforth. Other tangible -- but less fixed -- assets include farm crops andlivestock, gas, oil, and even water. Of course, fixedassets require a degree of care and maintenance -- and the financial value ofless 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 theyoften give back as much as they take out of the economy. Derivatives on theother hand are “bookie transactions” with mere promises to make some “fastmoney” with no real investment in, appreciation of, or concern for theunderlying asset. In the obsessive pursuit of fast money, derivatives can anddo -- to a large degree at least -- artificially drive up prices for the verythings we must buy and use every day, even as they exponentially expand debtand the “off-balance sheet” money supply through an increasingly volatileglobal casino. Perhaps even worse,both the elevated risk associated with derivatives and the faceless aspect ofthe global casino create a fertile breeding ground for environmental and humanrights abuses, as well as rampant corruption and crime. There can be nomistaking the fact that derivatives speculation requires a good deal of dancingwith the devil. Next, Part 3: The Global Casino, Currency Devaluation and Giant Fire Sales
Online Journal Guest Writer
Oct 06, 2008, 00:19
Calamitous as thecurrent economic crisis is, it was both predictable and predicted. History asthey say is prologue.
Total-return swaps of this type make a joke of margin requirements. Beyondthat, other types of derivatives severely curtail the ability of regulators tocurb leverage and generally get their arms around the risk profiles of banks,insurers and other financial institutions. Similarly, even experiencedinvestors and analysts encounter major problems in analyzing the financialcondition of firms that are heavily involved with derivatives contracts. WhenCharlie and I finish reading the long footnotes detailing the derivativesactivities of major banks, the only thing we understand is that we don’tunderstand how much risk the institution is running.
The additional uncertainty created by these factors later led to spillovereffects in other market segments that were not directly linked to subprimemortgages. While it is difficult to say at this early stage how the crisis willultimately play out, we should expect to see the financial turmoil spillingover to the real economy with potentially sizable macroeconomic implications . .. (“Deciphering the 2007-08 Liquidity and Credit Crunch,” Markus K.Brunnermeier, Princeton University)
. . . Also, as the nineteenth centurypassed and gave way to the twentieth, speculation became less of a local, moreof a national, phenomenon. Land speculation occurred in the farm country and onthe frontier. So did that which anticipated or followed the arrival of therailroads. The collapse of such speculation affected primarily the countrybanks. Securities speculation, in contrast, was the business of the financialcenters. Loans to buy securities were made by the big-city banks. These banks alsounderwrote and bought stocks and bonds. When these collapsed in price, it wasthe banks of the cities that were affected, and it was their depositors whotook alarm and came for their money. (Money Whence It Came, Where It Went,revised edition 1995, by John Kenneth Galbraith)
