Many readers of my books and visitors to my two blogs, Financial Armageddon and When Giants Fall, are aware that my early concerns about the health of our financial system stemmed, in part, from research I had done on the subject of derivatives. In fact, I incorporated some of my findings into an article I wrote in November 2005, entitled "The Coming Disaster in the Derivatives Market."
Well, as it happens, an old friend recently stumbled across some other things I had to say on the subject, which appeared in a May 2006 Wall Street Journal Online "Trading Shots" feature, "Are Derivatives Weapons Of Mass Financial Destruction?" and he included a link to it in an email he sent to me. After reading through the column, based on an exchange I had with Roger Nusbaum, a money manager and publisher of the Random Roger blog (a regular stopping point of mine), I thought FA visitors might find it interesting.
Is a Meltdown Cooking in Exotic Assets, Or Can Markets Handle the Next LTCM?
On the eve of Berkshire Hathaway's annual meeting this weekend, it is worth remembering that, three years ago, Warren Buffett warned that the global financial system was held hostage to ticking "time bombs" and at risk of a "megacatastrophe."
He was talking about financial derivatives: the options, swaps, forwards and more-exotic investment tools that have blossomed into a $270-trillion global market. He warned they had created a "daisy chain risk," that one Long Term Capital Management-style pratfall would topple the whole global house of cards.
But the Oracle of Omaha's crystal ball seems to have been cloudy -- so far, at least. Three years since his warning, there have been no such meltdowns, and global financial markets have blissfully avoided systemic apocalypse. In fact, there are some deep thinkers -- including former Federal Reserve Chairman Alan Greenspan -- who, while acknowledging some potential pitfalls, believe derivatives are generally good medicine, helping investors share risk. We asked two outspoken Wall Street veterans, author Michael Panzner and money manager/blogger Roger Nusbaum, to explain their very different positions on this subject.
Answer: They are all knowledgeable and well-respected individuals who have warned about the structural deficiencies and systemic risks associated with the burgeoning market for over-the-counter derivatives.
Now, for a tough one: What do David Li and Nicole El Karoui -- both of whom have been profiled in the Wall Street Journal -- have in common?
Hint: Mr. Li is a Stanford professor widely credited with developing a computerized model that helped turn credit derivatives into the fastest-growing segment of a $270 trillion global market. (See Mr. Li's profile.) Ms. El Karoui is a French mathematics professor whose courses have become, as the Journal noted, "an incubator for experts in the field." (See Ms. El Karoui's profile.)
Answer: Both have warned that some of those who buy and sell these complex instruments don't fully understand the risks involved. Instead of reducing their exposure to unwanted perils, they may well be adding to it.
Unfortunately, the very nature of these synthetically created securities makes it difficult for those outside Wall Street to debate their merits. For some, the definition alone is enough to cause eyes to glaze over. Essentially, derivatives are risk-shifting agreements whose value depends on -- is "derived" from -- an underlying asset, financial instrument, or event.
Making matters more difficult, however, is the fact that the value of certain complex varieties, such as options, asset-backed securities, and credit-default swaps, depends on many inputs. That often necessitates the use of complicated formulas and high-powered computers, especially when portfolios of derivatives are involved.
Yet the mathematical certitude this conveys is misplaced. In truth, pricing often depends on fickle or otherwise fast-changing financial relationships, less-than-adequate histories of how certain markets will perform under a wide range of scenarios and guesstimates about how volatile conditions will be in future.
That means a major financial institution with significant derivative exposure could easily find itself hit with a very expensive and potentially destabilizing loss if even one of its assumptions is wrong -- as, for example, a large hedge fund [GLG Partners' GLG Credit Fund] did when a multi-billion dollar portfolio shed 14.5% in May 2005, reportedly because of a "flawed model."
A lack of transparency and inadequate regulation, particularly where OTC derivatives are concerned, make it difficult to identify where the dangers lie. Historically, banks, Wall Street firms and hedge funds have been left to their own devices, on the assumption they were sophisticated operators who would act appropriately.
Unfortunately, as the classic example of the "tragedy of the commons" suggests, one firm's self-interested behavior, especially when large amounts of money are involved, is not necessarily in everyone else's interest.
When you add it all together -- the complexity, the opacity, the warnings, and the miscalculations -- it paints a rather unsettling picture.
In the next few years we could see another Procter & Gamble or Gibson Greetings arise, where a company claims they did not know what they were buying and then seeks restitution from their counter-party. [editor's note: P&G and Gibson Greetings, along with Federal Paper Board Company and Air Products and Chemicals, lost hundreds of millions of dollars in bad derivatives bets in the mid-1990s. The four companies sued their shared investment bank, Bankers Trust, now part of Deutsche Bank, accusing it of not disclosing the risks associated with derivatives.] None of those episodes resulted in a deathblow.
The fear is not derivatives, but the misuse of derivatives via too much leverage.
In fact, the market has already faced a potential derivatives meltdown in 1998 with the LTCM saga. The fund was leveraged at about 100-to-1, made a fatal (for itself) trade that threatened economic instability and blew up.
The S&P 500 was at a high when this happened and dropped a painful 19% in just six weeks. But the S&P 500 retraced what was lost in less than three months. In fact, looking at a long-term chart, the magnitude of that decline does not stand out as being particularly noteworthy. So there was pain, but no meltdown. It is also worth pointing out that LTCM was not the only crisis that summer; the market was also dealing with the dislocation caused by the Russian debt crisis.
The market fears the unknown; some sort of problem from too much leverage with derivatives is not an unknown.
Past episodes have caused painful disruptions, not meltdowns. The investment community as a whole has become more sophisticated, as have the products. There are derivatives on countless types of investment products, not just one derivatives market.
The take-away here, from my point of view, is that someone's misuse of the product, which is likely to happen, has a very low probability of triggering a widespread meltdown.
Undoubtedly, the fact that the United States has weathered all sorts of challenges and threats in its long history gives some basis for optimism. Nonetheless, the idea that because a meltdown has not yet happened, despite a plethora of known systemic risks, mirrors the logic subscribed to by many people before Hurricane Katrina hit last summer. In other words, since the long-forecast "big one" had never come, it never would.
The idea that Wall Street now has the skills, experience, and emotional resolve to cope with anything that might crop up also fails to take account of reality. Emotions such as fear and greed haven't gone away, and the likely response to the next crisis will be the same as always. People will panic, liquidity will evaporate, and fear will run rampant.
The difference this time, though, as opposed to when LTCM imploded, is that it will be very difficult for the New York Fed chief to gather myriad global financial operators into a room and "persuade" them to pony up the billions -- or perhaps the trillions -- necessary to stabilize the situation.
Do you really believe that if a derivatives bomb is unleashed by the failure of a London-based hedge fund, a banker in the Cayman Islands, an investor in Japan, an insurer in Germany, and a regulator in France will feel similarly inclined to respond, or even to take the lead in resolving a crisis -- assuming, of course, they even realize what is going on or why it may be relevant to their own interests?
Finally and perhaps most importantly, there are key differences between then and now. For one thing, the absolute level of risk has reached hitherto unseen levels. Total U.S. debt, for example, is more than three times output, the U.S. current account deficit is 7% of gross domestic product, unfunded U.S. retirement-related obligations add up to more than $50 trillion, and the notional value of derivatives outstanding is approaching the $300 trillion mark.
At the same time, risk has become more concentrated with respect to firms, markets and "events." In 1997, for example, the 10 largest banks controlled less than 34% of industry assets; by 2005, it was 44%. At the end of last year, the top five banks accounted for more than 96% of outstanding derivatives contracts versus 83% in 1998. And reportedly, there are more than $200 billion of credit default swaps riding on the financial health of General Motors alone.
To paraphrase the old cliché, this time will likely be quite different when the derivatives levee breaks.
I would also add that history does show that market reactions to events similar to past events are less severe. Compare the reaction in the U.S. to the September 11, 2001, terror attacks to the reaction in Spain to its bombing and the U.K. to its bombing.
In terms of trying to manage against reasonable probabilities, the chance of a financial Armageddon is quite low.
For one thing, globalization and industry consolidation have ensured that many different markets, financial systems, and economies are more closely linked than ever before. Moreover, increasing sophistication and an aggressive hunt for higher returns have spurred hedge funds and proprietary trading desks to exploit a growing array of intermarket arbitrage opportunities, which frequently depend on derivatives to circumvent structural and operational hurdles.
More important, perhaps, is the fact that despite their differences, the one thing many synthetic securities have in common, as Roger seems to have alluded to earlier, is an inherent leverage component. In that respect, he may have made a more salient point. Maybe derivatives won't be the trigger for financial disaster. Maybe they represent just one small part of a far greater threat: too much debt.
Now that is a problem that has led to financial Armageddon--again and again throughout history.
It does create more chances for a single player in these markets to have a problem, which circles back to what I said before, that there reasonably is some institution out there taking a risk they can't afford to take.
When Barings Bank blew up, it was due to bad, and then hidden, trades with futures contracts (a type of derivative product). It was a big trade that went bad and caused a localized problem. No one should expect localized problems are gone forever, but I still feel no realistic concern that a localized problem will domino into a systemic problem.
From Deb Riechmann of the Associated Press on January 8, 2009:
"Vice President Dick Cheney says that his boss, President George W. Bush, has no need to apologize to the American people for not doing more to head off the financial calamity, SAYING NO ONE SAW THE CRISIS COMING.
During an interview Thursday with The Associated Press in his West Wing office, Cheney defended the administration’s performance on an economy that is growing weaker daily and which recently collapsed in spectacular fashion. Cheney said that 'NOBODY ANYWHERE WAS SMART ENOUGH TO FIGURE IT OUT.'"
"Dick Cheney's Revisionism Of The Financial Crisis"
http://www.boom2bust.com/2009/01/08/dick-cheneys-revisionism-of-the-financial-crisis/
Posted by: Boom2Bust.com | April 09, 2009 at 11:28 AM
I do not believe that the problem has gotten to the point of societal impact that Michael thinks is coming but I WAY underestimated the impact they would have, WAY underestimated.
I posted the same comment on the SA version of this post--not to violate etiquette but to acknowledge being more wrong than right about this.
Posted by: Roger Nusbaum | April 09, 2009 at 06:51 PM
It is curious that Buffett warned on a blowup for years, and then sold big puts near the top of the market. He has been complaining about Americans selling pieces of this country in return for trinkets, yet is glib about us bouncing back. He supported TARP 1 though the version he foresaw was not the same as Treasury announced. Bill Gross has obviously taken a lot of money from the public trough. Congratulations, right or wrong they seem to win.
Posted by: Erich Riesenberg | April 11, 2009 at 11:53 AM