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Economic bubbles are not recognized by those inside of
them, and the entire Western world has become quietly trapped inside the
largest economic bubble in history.
The global financial crisis that began in 2008 has been attributed to sub-prime mortgage
lending and mortgage backed securities (MBSs), such as collateralized debt obligations (CDOs), which were
revealed as toxic assets. While
the root cause of the financial crisis is assumed to have been the residential
real estate asset price bubble, the underlying systemic risk, and the primary
reason for the “too big to fail” doctrine whereby governments
were compelled to save financial institutions at any cost, lies in over the
counter (OTC) derivatives. The suspension of the US Financial
Accounting Standards Board (FASB) mark-to-market rule in 2009 preserved the value of bank balance sheets, i.e.,
of their mortgage portfolios, but what was of far greater importance was that
it prevented triggering the conditions of thousands of OTC derivatives
contracts, such as credit default swaps (CDS), that would have wiped out
virtually all of the largest banking institutions in the world.
Chart ©2010 Hera Research, LLC
OTC derivatives can serve a straightforward
role as financial insurance policies covering real business risks. In a hedging scenario, an investor
that has exposure to a variable interest rate can transfer the risk to a
second investor (the counterparty) by entering into an interest rate
swap. A swap is simply an
agreement to exchange cash flows.
If the interest rate goes up, the second investor pays the difference
while the first investor pays the original rate (to the second investor)
along with the cost of the swap.
Of course, if the second investor becomes insolvent, the original
investor is still liable to the lender and will have lost the insurance from
risk provided by the second investor as well as any net amount paid to the
second investor. Taken in
isolation the risks to both investors are limited, but the second investor
can offset their risk through a third investor, and so forth, giving rise to
a web of interconnected risks.
Other types of OTC derivatives include currency exchange rate swaps
and forwards, which are essentially non-standard futures contracts, as well
as credit default swaps (CDS).
OTC derivatives can be used for speculation, as well as hedging. In a speculative scenario, OTC derivatives
are analogous to wagers, e.g., a bet that a certain company will default on
its bond obligations. Speculation
in OTC derivatives involves no connection to an underlying asset or to a real
business risk, but the liabilities and risks they create are real. Under state gaming laws the
speculative use of OTC derivatives, such as naked
CDS (similar to naked
shorts) and synthetic
CDOs, was illegal in the US until state
gaming laws were preempted by the federal government’s Commodity
Futures Modernization Act of 2000 (CFMA).
Derivatives on different underlying assets are traded in the absence
of clearing houses, i.e., in unregulated markets. Since they are not exchange traded,
derivatives, such as CDS, are not widely understood. In OTC markets, counterparty default
risk generates a network of interdependencies among market actors and
promotes risk volatility. The
resulting emergent property of the financial system is systemic risk, which
became apparent in 2008 when Lehman Brothers Holdings, Inc. failed.
Officially, roughly $604.6 trillion in OTC derivative contracts, more than ten times world GDP ($57.53 trillion), hang over the financial world like the sword of
Damocles, but to the average investor the derivatives bubble is
invisible. From the perspective
of those outside the bubble, the explosion of OTC derivatives is a mania.
The inherent lack of transparency in OTC markets impairs price discovery and obviates the efficient markets hypothesis, i.e., that financial instruments are almost always
priced correctly, thus OTC derivatives and the risks associated with them may
be priced incorrectly, as in the case of American International
Group’s CDS contract premiums.
Although media attention continues to focus on the political theme of
economic recovery and residential real estate, the true cause of what came to
be known as the credit crisis continues unabated, outside the purview of the
central banks and governments.
An attempt by the CFTC to regulate OTC
derivatives in 1998 was rejected by Alan Greenspan, then Chairman of
the Federal Reserve, Robert E. Rubin, then Secretary of the Treasury, and
Lawrence (“Larry”) H. Summers, then Assistant Secretary of the
Treasury. At the time, regulation ran counter to
the dominant ideology in Washington
D.C., which reflected the views
and interests of the banking and financial services industry.
Despite early warnings such as the bankruptcy of Orange County,
California, the Proctor & Gamble lawsuit against Bankers Trust and the failure of Long Term Capital Management
(LTCM), the President’s Working Group on
Financial Markets described OTC derivatives
in November 1999 as an important innovation that had “transformed the
world of finance, increasing the range of financial products available to
corporations and investors and fostering more precise ways of understanding,
quantifying, and managing risk.”
In 2000 Greenspan, Rubin and Summers backed deregulation of OTC derivatives.
 The regulatory rationale
for OTC derivatives stems from the use of derivatives to circumvent existing
regulations and tax laws.
Investors prohibited from investing in certain financial instruments
can assume virtually identical positions in unregulated OTC derivative
markets. By changing the type,
source or timing of income, OTC derivatives can have different tax results
compared to investments in underlying commodities or financial
instruments. OTC derivatives can
also create moral hazard and perverse incentives. Moral hazard may exist when an entity
assumes more risk than it would have otherwise without regard for the effects
on counterparties because executives know they will be bailed out should the
firm become insolvent. An example
of a perverse incentive would be where an entity stands to gain, e.g., in the
CDS market, if a certain company defaults on its bond obligations but
concurrently has other relationships with the company that influence the
outcome, e.g., as a creditor.
Widespread speculation puts financial firms and the financial system
itself in jeopardy while forcing governments to choose between bailing out
irresponsible investors and allowing the economic disruption that would
result from the failure of the financial system. Regulation of OTC derivatives, i.e.,
placing them on regulated exchanges, would increase transparency, force
standardization of contracts and provide legal certainty. Since derivatives can be a source of
off balance sheet financing, regulation would also make the true leverage of
financial firms visible to investors.
Regulation can also ensure that counterparties can cover losses and
would therefore help to contain speculation and greatly reduce systemic risk.
Exponential Risk
If every market actor seeks to hedge their risks in a like manner, the
total notional value of all OTC derivatives can grow exponentially. Considering the notional values of
existing contracts, speculation clearly represents a substantial portion of
all OTC derivatives. As the
number and total notional value of OTC derivatives grows, systemic risk
increases because more interdependencies, complexity and credit exposure are
created, i.e., the systemic impact of a particular party’s failure
grows, simultaneously becoming less predictable.
Rather than distributing risk, it became clear in 2008 that OTC
derivatives increased the magnitude of financial system instability and the
probability of systemic failure due to the complexity and lack of
transparency of the contracts, disproportionate leverage exposure and
dependencies on other markets vulnerable to disruptive forces. It also became clear in 2008 that the
reasons OTC derivatives promote systemic instability are fundamental.
Since the terms of derivatives contracts involve market factors that
can change independent of the actions of the counterparties, OTC derivatives
create contingent credit exposure and therefore involve an intrinsic element
of uncertainty in addition to counterparty risk. What is more important, however, is
that because counterparties tend to participate in the same markets, an
implicit correlation inevitably exists.
This deeper level of risk, endogenous risk, occurs when funds or institutions with similar positions
also have similar risk tolerances and preferences, thus create unexpected
correlations between economically diverse and otherwise uncorrelated
positions.
At the same time, risks transferred between parties remain present in
the financial system but exist in different, and perhaps less well-understood
forms. Regardless of the
techniques used to model risk, and despite the theory of risk cancellation,
i.e., two risky positions, taken
together, can effectively eliminate risk, market actors naturally seek to transfer higher risks to
counterparties while paying less than fair value, if possible, and accepting
only lower risks in exchange for premiums when taking on liabilities. Used irresponsibly, OTC derivatives
expose counterparties to risks they would never accept if they had all of the
relevant information. Maximizing
profits in an unregulated environment means exploiting misalignments of risk
that correlate positively with system instability. Since it is impossible in principle
for all market actors to win the competition to shed risk while maximizing
profits, some portion of market actors will always misprice risk and be rendered
insolvent. The failure of a
market actor, however, can trigger a domino effect through their network of
counterparties, potentially taking down winners and losers alike. Both risk obfuscation and competitive
dynamics thrive on a lack of transparency and ultimately destabilize the
system.
Since Gaussian distributions do not
reflect the real world, large
changes up or down are more likely in the stock market than a normal
distribution and standard deviation (sigma) would suggest. However, it is possible to model risk
using statistical techniques such as the Monte Carlo method.
Diagram courtesy of Wittwer, J.W.
(Monte
Carlo Simulation Basics)
The Monte Carlo method, named for the
casinos in Monte Carlo, is a stochastic
method, meaning the state of a model is determined by both
predictable and random elements.
The Monte Carlo method provides a
way of analyzing uncertainty, e.g., in the craps dice
game. For example, the Monte
Carlo method can be used to analyze the effects of random
variation or errors on the sensitivity, performance or reliability of a
system. Monte Carlo
simulations can be used to simulate real problems, e.g., using historical
data, and to predict future outcomes.
Probability
distributions, used as inputs to the simulation, are generated randomly
or derived from historical data.
The results can, in turn, be represented as probability distributions
and used, for example, to estimate value at risk (VaR) in
an investment portfolio, i.e., a prediction of the worst likely loss under a
given confidence
interval over a specified time horizon. Of course, Monte
Carlo simulations and VaR estimates depend on historical price
trends and volatility.
At a particular point in time, the global financial system is most
like a closed system; essentially an idealized representation of wealth and
economic activity that, in reality, exists largely outside the financial
system. In other words, the
financial system is itself abstract and therefore has properties like those
of a model. As a result, patterns
that occur in financial markets never perfectly represent the world and every
pattern that exists in the financial system is potentially vulnerable to
inconsistencies with the underlying world, which is not only non deterministic
but subject to change without notice.
The problem is not variation within a domain but variation of the
domain itself, i.e., structural rather than cyclical change.
British journalist Dr. Gillian Tett, in her Financial
Times article Mathematicians Must Get out of
Their Ivory Towers, observed that
“…when finance has borrowed ideas from physics, it has been an
old-fashioned Newtonian branch of physics, not the Theory of Relativity. So, just as the Theory of Relativity
has forced scientists to recognise that space and time can expand or shrink,
[…] calculations of probability can shift according to
context.” The implication
is that virtually any statistical model of financial risk can be
invalidated. In contrast,
investors who apply fundamental analysis, such as Warren Buffett, rely
primarily on data from the underlying world rather than on trading patterns
that reflect only the financial system, which is an abstraction.
A model that is correct n -1
times out of n is insufficient to
allay risk if case n is a
catastrophic failure. According to Warren Buffett, “If you hand me a gun with a thousand
chambers or a million chambers in it and there’s a bullet in one
chamber and you said put it up to your temple, how much do you want to be
paid to pull [the trigger] once; I’m not going to pull it. You can name any sum you want. It doesn’t do anything for me on
the upside and I think the downside is fairly clear. So, I’m not interested in that
kind of a game, and yet people do it financially without thinking about it
very much. … I think it’s madness.”
The failure of LTCM in 1998 demonstrated that risk modeling need only be
incorrect to a degree, in a single respect or over a limited time horizon to
invalidate a model, i.e., models are as fragile as the underlying world is
complex. As Eric Rosenfeld, former LTCM
principal, explained “The risk
management was wrong. The risk
management managed to the sunny days.
You have to manage to the bad days.” Referring to LTCM’s partners Warren Buffett said:
Those guys would tell me … a six sigma event
wouldn’t touch us, or a seven sigma event, but they were wrong. History does not tell you the
probabilities of future financial things happening. They had a great reliance on mathematics
and they felt that the beta of the stock told you something about the risk of
the stock. It doesn’t tell
you a damned thing about the risk of the stock in my view; and sigmas do not
tell you about the risk of going broke in my view and maybe in their view now
too. … The same thing in a different way could happen to any of us
probably, where we really have a blind spot about something that’s
crucial because we know a whole lot about something else. It’s like Henry Kauffman said
the other day. He said “the
people that are going broke in this situation are of two types, the ones that
knew nothing and the ones that knew everything.” It’s sad ina way.
The risks of OTC derivatives, according to George Soros,
“…are not always fully understood, even by sophisticated
investors”, which Mr. Soros
most certainly is. In the 2002
annual report of Berkshire Hathaway, Inc., Warren Buffett famously wrote:
The derivatives genie [having been deregulated two years
prior] is now well out of the bottle, and these
instruments will almost certainly multiply in variety and number until some
event makes their toxicity clear. … Central banks and governments have so far found no effective way to
control, or even monitor, the risks posed by these contracts [emphasis
added]. We [are] apprehensive
about the burgeoning quantities of long-term derivatives contracts and the
massive amount of uncollateralized receivables that are growing
alongside. In our view, however,
derivatives are financial weapons of mass destruction, carrying dangers that,
while now latent, are potentially lethal.
In August 2007, central banks took emergency action to head
off a global credit crisis, but their efforts were in vein.
By June 2008, the notional value of OTC
derivatives was more than $683 trillion, after more than doubling in the preceding two years. The event that Warren Buffett
anticipated in 2002 occurred on Sunday, September 14th, 2008, when Lehman
Brothers filed for bankruptcy, the largest corporate bankruptcy in US
history. The failure of Lehman
Brothers set off a derivatives chain reaction
affecting Lehman’s counterparties and directly caused the credit crisis. Since it is impossible for market
actors to know what risks or how much leverage their counterparties have, OTC
derivatives render credit ratings meaningless. The flow of credit and lending
activity halted on a worldwide basis, causing sharp contractions in economic
activity and deflation.
Until Western governments took action, it remained possible that
virtually every major financial institution in the Western world would go bankrupt
simultaneously. The imminent
collapse of the global financial system threatened to destroy wealth and
damage economic activity more severely than the Great Depression. Members of the US Congress reported
having discussed financial and economic Armageddon
and martial law with former
Secretary of the Treasury, Henry Paulson, and Federal Reserve Chairman, Ben
Bernanke. In later testimony
before the Congress, Mr. Paulson explained that “…when a financial
system fails, a whole country’s economic system can fail” thus the interconnecting web of OTC derivative
contracts can “…lead to chaos or people even questioning the
basic system.”
Mr. Paulson was widely criticized for his alleged hyperbole but the
blame has been at least partially misplaced. For example, despite historic efforts
to support the financial system, the credit crisis virtually halted
international shipping almost overnight.
The breakdown in letters of credit, used by importers to pay suppliers, was reflected
in the Baltic Dry Index, which tracks international shipping prices of
various dry bulk cargoes on a worldwide basis.
While it is not possible to know precisely what would have happened
had governments and central banks not bailed out the global financial system,
real economic activity would certainly have contracted more quickly and more
severely, and financial markets would have behaved accordingly, declining
more sharply and destroying more wealth.
Since the failure of the global financial system was narrowly averted,
commentators have often underestimated the seriousness of the problem and its
potential consequences.
The argument that bankrupt institutions should have been allowed to
fail, while true to the tenets of capitalism and to free market principles,
is often made without appreciating the fact that virtually all of the largest
banks in the Western world might have been wiped out leaving governments to
deal with the depositors and investors.
Further, history shows that serious economic disruptions have tragic human consequences, such as
widespread starvation.
In the final analysis, Western governments were
effectively held hostage by large banks. The resulting, bitterly
disputed bank bailouts (which are still ongoing) came at a staggering cost of
roughly $5.3 trillion in the EU and as much as $23.7 trillion in the US (officially $4 trillion).
Speaking at a meeting organized by The
Economist at the City of London’s modern and impressive
Haberdashers’ Hall, George Soros said that “The success in bailing out the system
on the previous occasion led to a superbubble, except that in 2008 we used
the same methods. Unless we learn
the lessons, that markets are inherently unstable and that stability needs to
be the objective of public policy, we are facing a yet larger [sovereign
debt] bubble. We have added to
the leverage by replacing private credit with sovereign credit and increasing
national debt by a significant amount.”
For taxpayers in Western countries, the multi-generational debts
incurred have come in addition to loss of wealth in stock portfolios and
asset values, along with other losses resulting from severe economic
recession, such as loss of business revenues or insolvency, personal
unemployment or bankruptcy, etc.
The political consequences have yet to play out. The citizens of affected countries can
find little comfort in the knowledge that the situation could have been worse
when the root cause of the problem was and remains a massive economic bubble
fueled by what has been revealed as reckless speculation, grossly out of
proportion to real economic activity.
The colossal debts incurred by Western governments are only a fraction
of a percent of the potential liabilities stemming from OTC derivatives that
still exist in the global financial system. Warren Buffett recently said that “when the financial history of this
decade is written, it will surely speak of the internet bubble of the late
1990s and the housing bubble of the early 2000s. But the US Treasury bond bubble of late
2008 may be regarded as almost as extraordinary.” US Treasury debt continues to grow as
emergency measures continue well beyond their expected durations. Federal Reserve Chairman, Ben Bernanke, said in a recent
address that “It is
unconscionable that the fate of the world economy should be so closely tied
to the fortunes of a relatively small number of giant financial firms. If we achieve nothing else in the wake
of the crisis, we must ensure that we never again face such a
situation.”
Sadly, Mr. Bernanke’s point is moot. Two and a half years on, virtually
nothing has been done in the aftermath of the global financial crisis to
regulate OTC derivatives or to control the extreme risk they pose. With several US states and European
countries now virtually bankrupt, the capacity of Western governments to bail out financial
institutions has been exhausted.
The risk of systemic failure is higher at present than before the
crisis began in 2008, as there is now no backstop for the global financial
system other than debt monetization, which would result in high inflation or
hyperinflation. History may yet
remember the global financial crisis that began in 2008 as a fateful choice
between failed banks and failed nations.
 In an effort led by Representative Barney Frank in
the House and Senator Chris Dodd in the Senate, a vast array of financial
system reforms have been compiled into a single bill that is more than 1400
pages long. The massive bill
subsumes numerous common-sense provisions, such as restoring the prohibition
on bank holding companies that prevented them from owning other kinds of
financial businesses (enacted in 1934 as a part of the Glass–Steagall
Act and repealed on November 12, 1999 by the Gramm–Leach–Bliley
Act) and Representative Ron Paul’s widely supported bill to audit the
Federal Reserve (formerly HR 1207 and S 604). However, the bill stops short of
rolling back changes to the Commodity Exchange Act (CEA) made by the
Commodity Futures Modernization Act of 2000. Backed by Greenspan, Rubin and
Summers, the Commodity Futures Modernization Act of 2000 is what let the OTC
derivatives genie out of the bottle and resulted in the global proliferation
of financial weapons of mass destruction.
The 1,410 page bill (S 3217), entitled
“Restoring American Financial Stability Act of 2010,” contains roughly 150 pages related to financial
derivatives, but numerous counterproposals to specific provisions are being
discussed. Not surprisingly, measures to control OTC derivatives and to prevent depository institutions
from engaging in OTC derivatives trading are opposed by banks, which are
actively lobbying against reform.
The failed financial ideology of Greenspan, Ruben and Summers, which
led to the financial crisis that began in 2008, remains deeply entrenched in Washington
D.C. While election year political rhetoric
focuses on “consumer protection,” reforms vital to the stability
of the basic system are being quietly lobbied away. A proposed ban on swaps, for
example, was dropped early on. Current economic advisor
to President Barack Obama, head of the President’s Economic Recovery
Advisory Board, and former Federal Reserve Chairman, Paul Volker, recently
said that “the provision of derivatives by
commercial banks to their customers in the usual course of a banking
relationship should not be prohibited.” Similarly, plans
to establish a bailout fund to prevent US taxpayers from again being held
hostage by “too big to fail” banks have been scrapped, along with
plans to break up “too big to fail” banks; and the effort to audit the Federal
Reserve is being watered down to a one-time disclosure.
Trading derivatives on regulated exchanges
would be a major step forward, but it may no longer be enough. Economic bubbles are not recognized by
those inside of them, the Congress of the united
States being no exception. The $604.6 trillion derivatives
bubble, which is equal to more than ten times world GDP, is a global
issue. If existing OTC
derivatives remain in place and there are no restrictions on what banks can
trade derivatives, there is no actual or immediate reduction of systemic
risk. Thus, the risks that led to
the financial crisis in 2008 are likely to remain present in the global
financial system for years to come.
In fact, many
banks have more CDS risk now than in 2008. Passing a bank-approved version of the
financial reform bill, while it may be portrayed as a political victory or
serve to calm financial markets temporarily, is unlikely to prevent another
global financial crisis.
Ron Hera
Hera Research
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by Ron Hera
Ron Hera is the founder of Hera Research, LLC, and the principal author of the Hera Research
Monthly newsletter. Hera Research provides deeply researched analysis to help
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