Derivatives at the Bottom of Every Chasm

Readers of my book and regular visitors to the Financial Armageddon blog know that I've long believed that derivatives -- especially the over-the-counter variety -- would play a critical and continuing role in the Great Unraveling.

In my view, these paper promises -- along with the vast, Wild West-like markets that built up around them -- had all the ingredients necessary to spark an incendiary explosion in the financial system and the economy, including high levels of complexity and lack of understanding about unintended consequences, in-built leverage (often of an astonishing scale), valuations and structures based on incomplete or false assumptions, a lack of transparency, and the ease with which they allowed all sorts of counterparties, products and markets to become connected to one another.

In "Derivatives Is an Industry Tainted by its Side Effects," the Financial Times' Tony Jackson, who seems far more sanguine than I am about how this will all end, details just a few of the unwelcome consequences stemming from the era of Frankenstein finance.

At times like these, spare a thought for derivatives salesmen. It has been clear for a while that their wares can prove toxic. But it must be dispiriting for the poor devils that almost every time a fresh chasm opens in the financial landscape, derivatives are at the bottom of it.

Most obviously, the harm inflicted on the investment banks has been derivative-based, as last week’s further losses from UBS reminded us. So too, of course, was the Société Générale affair.

In the US, the FBI is now investigating the subprime disaster, including the part played by Wall Street derivatives merchants.

That aside, the deepening crisis of the monoline insurers results from them insuring credit derivatives instead of the humdrum municipal bonds they were set up to handle. And as a final insult, an academic study now argues that credit default swaps have the effect of pushing more firms into bankruptcy.

More on that last point shortly. But first, observe that several of those cases involve the imputation of fraud – the “bezzle”, as JK Galbraith called it. As he remarked, the bezzle rises and falls with the cycle. “In good times, people are relaxed, trusting, and money is plentiful. But there are always many people who want more.”

For such people complexity is a magnet, since it offers more scope for escaping detection. And there are few things in finance more complex than structured derivatives; witness the fact that the trading desks of the big banks are largely staffed by maths and physics PhDs.

The UK’s Financial Services Authority warned last week that there was probably more fraud on the way, either because of misdeeds surfacing from more lax times or because individuals were now pressed into wrongdoing by falling markets.

Place your bets on how many cases will involve derivatives.

As to the University of Texas study on the dangers of CDSs [credit default swaps], the vexing thing is that these seemed the one fairly simple and benign corner of the credit derivatives jungle. But as it turns out, they can have perverse results.

In the old days, if you had $100m invested in a company’s bonds it was very much in your interests to avoid bankruptcy, which might leave you with – say – 40 cents in the dollar. Now, if you also have CDSs insuring your entire holding, you have an incentive to vote for bankruptcy rather than an out-of-court settlement, since default will trigger the derivative and pay all your money back.

Worse, suppose you have CDSs worth $200m – that is, you are $100m long of protection. In that case you have an incentive to push not just for bankruptcy, but for a version which puts the lowest possible value on your bonds. For to collect on that extra $100m, you must hand over bonds to the equivalent face value. The cheaper you can buy those bonds in the market, the bigger your profit.

Meanwhile, the counterparties who wrote that protection have an equal incentive to vote the other way. But instead of the bondholders having the same interests as the company – as in the old days – they are now split 50-50.

Control rights and economic rights have been decoupled. And since the existence of CDS holdings need not be disclosed, it is no longer clear who holds the power of foreclosure. As the study puts it, “a decade ago, no one thought debt decoupling raised serious economic concerns. The benefits were clear, but some important costs were not”. Just so.

All this raises the question of what role credit derivatives in particular should play once the dust has settled. This matters particularly for London, which profited from being the world capital of credit derivatives trading, besides having the dubious distinction of crafting almost all the world’s structured investment vehicles.

For some time, the more complex forms of derivatives such as collateralised debt obligations have been open to the charge of amplifying the credit cycle.

Not only do they tend to expand the supply of credit in the upswing, they have the undeniable effect of choking it in the downturn. And now, it seems, even the humble single-name CDS can have a similar effect.

The counter-argument is that because credit derivatives are so novel, this is the first time they have been tested in a downswing.

In other words, these are teething problems, if on a somewhat heroic scale.

There may be something in that. But if so, the derivatives industry has two jobs to do.

First, it must work harder in reminding us of the benefits of spreading credit risk more widely. Second, they must come up with fixes for the damaging side effects. In some cases at least that may be feasible. But I still doubt the industry will ever be the same again.

Comments

[Ben Bittrolff]

I've updated my post and charts: Fed CHANGES Really Scary Fed Charts
(http://benbittrolff.blogspot.com/2008/02/fed-changes-really-scary-fed-charts.html)

Removing TAF makes a significant difference.

$50 billion to be exact.

TAF operations are ongoing. So this discrepancy would just continue to grow.

LIBOR is also starting to misbehave, again. Nothing too serious yet (not like before Christmas) but you get my drift. Stress is creepying back into the system.

The (counter trend) rally in risky assets should just about be over, if I've interpreted this correctly.

TheFinancialNinja

[Brian P Woods]

I'm been chuckling like mad at your reference to an incendiary explosion involving 'paper derivatives' - paper being cellulose and all!

Cellulose nitrate - ignites easily, burns rapidly, explosive in some circumstances! Nasty substance!!

However, Cellulose perchlorate - touch sensitive, does not need an ignition source! A real beauty!!

Well done.

Brian P