Sins of the Father (24 page)

These funds differed from bank and thrift deposits in one important respect: they were not protected by FDIC deposit insurance. Nevertheless, consumers liked the higher interest rates, and the stature of the funds’ sponsors reassured them …

Business boomed, and so was born a key player in the shadow banking industry, the less-regulated market for capital that was growing up beside the traditional banking system. Assets in money market mutual funds jumped from $3 billion in 1977 to more than $740 billion in 1995 and $1.8 trillion by 2000.
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The Glass-Steagall Act, along with limiting interest rates, had also ‘strictly limited commercial banks’ participation in the securities markets, in part to end the practices of the 1920s, when banks sold highly speculative securities to depositors’.
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Most of these regulations were phased out in the 1980s and ’90s, with the Gramm-Leach-Bliley Act in 1999 one of the final nails in the regulatory coffin. This Act ‘allowed banks to affiliate for the first time since the New Deal with firms engaged in underwriting or dealing with securities’.
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On 15 December 2000, the US Congress passed the Commodity Futures Modernization Act. This allowed for the deregulation of the Over-The-Counter (OTC) derivatives market. It also extended the 1992 pre-emption of State laws relating to derivatives, ensuring that they could not be declared as illegal or, indeed, as gambling. The Bill’s promoter, Senator Phil Gramm, told Congress that:

[The] enactment of the Commodity Futures Modernization Act of 2000 will be noted as a major achievement by the 106
^th
Congress. Taken together with the Gramm-Leach-Bliley Act, the work of this Congress will be seen as a watershed, where we turned away from the out-moded, Depression-era approach to financial regulation and adopted a framework that will position our financial services industries to be world leaders into the new century.
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The Act ‘shielded OTC derivatives from virtually all regulation or oversight’.
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It led to a boom in the trade of these products, especially credit default swaps. These successful moves towards deregulation ensured that financial markets had such scant supervision as had not been seen since before the Wall Street Crash and Great Depression. In 2011, the Financial Crisis Inquiry Commission concluded that the Commodity Futures Modernization Act of 2000 and the rapid expansion of the derivatives market ‘was a key turning point in the march towards the financial crisis’.
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Charlie Munger, Vice-Chairman, Berkshire Hathaway Corporation, May 2008.

At its simplest, an OTC derivative is a contract between two parties which involves a transfer of risk. With regard to financial markets, risk is associated with the volatility of prices over time. Currencies change in value, for example, on a daily, hourly, even minute-by-minute basis, and are subject, in times of extreme crisis, to crashes. Similarly, the value of bonds, shares and securities are subject to fluctuations in price and the threat of bankruptcy and default on the part of the issuer. OTC derivatives are used by those who trade in financial products as a way of hedging the risk associated with financial products, of limiting exposure to risk and to the inherent market volatility of financial assets or rates. However, unlike standard derivatives (also known as ‘plain vanilla’ derivatives), OTC derivatives are traded outside of the regulated exchange environment. The contract is between two parties only, and remains that way. The two parties ‘agree on a trade without meeting through an organised exchange’.
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They are ‘neither registered nor systematically reported to the market. Thus the full risk exposure in the system is not known until the crisis hits.’
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OTC derivatives are custom-made to meet the risk-hedging requirements of the customer. They are the
haute couture
of the securities world – each one unique and mathematically ornate. And the construction and sale of each OTC derivative yields a handsome fee.

Derivatives as financial instruments date back centuries, but the market for them was small until 1971, when interest and currency exchange rates became highly volatile in the wake of the Nixon administration’s decision to end its association with the Bretton Woods system. This system had been established in 1944, when the major industrial countries of the world agreed to adopt a common monetary policy. Each major currency maintained a fixed exchange rate with the US dollar, which acted as a reserve currency and which itself was fixed to a gold standard rate. The International Monetary Fund and World Bank were created under this system to help countries bridge temporary balances of payments. The decision in 1971, known as the ‘Nixon Shock’, soon saw significant fluctuations in the exchange rates between currencies – a costly and damaging process for multinational companies who dealt with multiple currencies on a daily basis. These unpredictable fluctuations in exchange rates affected costs and profits. In 1972, the Chicago Mercantile Exchange began trading futures contracts on currencies, as a way of companies limiting their exposure to the market volatility of currency prices over time. The volatility generated by the Nixon Shock offered new opportunities. ‘Money could be made out of that instability using financial derivatives,’ writes Dr Jan Toporowsaki of the University of London, ‘and no one has yet invented a foolproof way to prevent people with money from using it to make even more money no matter how ruinous the consequences may be for society.’
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The sale of these contracts was given a boost in 1973, when Fisher Black of the University of Chicago and Myron Scholes of MIT published a paper in the
Journal of Political Economy
entitled ‘The Pricing of Options and Corporate Liabilities’. They had developed an algorithm which advanced the way traders could price futures options in a way that limited risk exposure. It assumed ‘ideal conditions’ in the market for the stock and the option, and concluded that under these assumptions, ‘it is possible to take a hedged position on the option, whose value will not depend on the price of the stock, but will depend only on time and the values of known constants’.
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The algorithm was further advanced by the economist Robert C. Merton in his 1973 article ‘Theory of Rational Option Pricing’.
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This modified formula became known as the Black-Merton-Scholes model, for which Merton and Scholes received the Nobel Memorial Prize in Economic Sciences in 1997 (Black had died in 1995, and the award is not awarded posthumously).

The effect of the Black-Merton-Scholes model was to give mathematical security to risk-hedging. One way to eliminate risk is to make two bets: one that covers you if the outcome is favourable and one that covers you if the outcome is unfavourable. The trick is to work out the correct pricing so that the winning bet covers the loss of the losing bet. Black-Merton-Scholes allowed traders to perform this task. ‘Almost immediately,’ wrote the economist René M. Stulz, ‘[the model] was found useful to price, evaluate the risk of and hedge most derivatives, plain vanilla or exotic. Financial engineers could even invent new instruments and find their value with the Black-Merton-Scholes pricing method.’
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In 1974, Texas Instruments brought out a calculator that used the Black-Merton-Scholes model. ‘Soon, every young trader, many as second-year college drop-outs fresh from their first finance classes, was using a handheld TI calculator to trade options and was making more profit in a day than the college professors made a year.’
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The development of computers in the 1970s, and the exponential growth in speed, power and programming, made it easier not only to use Black-Merton-Scholes to price derivatives, but also to develop new and ever-more complex financial products, even to adapt them for individual clients. All of this was done with one purpose in mind: both the buyer and seller of OTC derivatives were trying to beat the market. They were trying to eliminate risk. The growth of the derivatives market also turned derivatives into financial assets in themselves. The sale of a derivative generates revenue. ‘The contracts can be traded, further limiting risk but also increasing the number of parties exposed if problems occur.’
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Furthermore, ‘losses suffered because of price movements can be recouped through gains on the derivatives contract’.
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Instead of helping to limit risk, however, ‘The models were used to justify a bigger appetite for risk’.
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Writing in 2002, the economist Henry C.K. Liu said that although the trade in derivatives ‘grew up alongside new forms of capital flows as part of an effort to better manage the risks of global investing’, it also facilitated new compositions of capital flows ‘by unbundling risk and redistributing it in commensurate return/risk ratios to a broad market’.
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In other words, derivatives, particularly OTC derivatives, not only added a level of insurance to existing financial products, they facilitated the creation and expansion of new financial products by enabling risk, seemingly, to disappear. Liu continued:

At the same time, derivatives create new systemic risks that are potentially destabilizing for both developing and advanced economies. While the risk shifting function of derivatives initially served the useful role of hedging and thereby facilitating fund flows, the prevalence of derivatives is now threatening the stability of the global economy as a whole.

This is because:

Derivatives are unlike securities and other assets because no principle or title is exchanged. In their essence, nothing is owned but pure price exposure based on ‘notional’ values. They are merely pricing contracts. Their price is derived from an underlying commodity, asset, rate, index or event, and
this malleability allows them to be used to create leverage and to change the appearance of transactions
[my emphasis]. Derivatives can be used to restructure transactions so that positions can be moved off balance sheet, floating rates can be changed into fixed rates (and vice versa), currency denominations can be changed, interest or dividend income can become capital gains (and vice versa), liability can be turned into assets or revenue, payments can be moved into different periods in order to manipulate tax liabilities and earnings reports, and high-yield securities can be made to look like convention AAA investments.

OTC derivatives may appear to limit risk for the individual client, but the risk does not go away. It does not leave the system. It is merely passed on to somewhere (and someone) else. ‘You as an individual can diversify your risk,’ said Lawrence B. Lindsey, former Governor of the Federal Reserve. ‘The system as a whole, though, cannot reduce the risk. And that’s where the confusion lies.’
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And in the case of financial markets, risk is not a by-product of the process of buying and selling, it is risk which makes the act of buying and selling financial products possible. Without risk, financial markets as constituted today would cease to exist. Nobody has an edge. There is nothing of which to take advantage.

OTC derivatives increased the amount of leverage that a bank could utilise on its assets. They allowed ‘financial services firms and corporations to take more complex risks that they might otherwise avoid – for example, issuing more mortgages or corporate debt’.
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However, OTC derivatives did not diversify risk; instead, they had the effect of concentrating systemic risk within the handful of financial firms that dealt in the issuing of these contracts. If one of those firms was to collapse, the effect on the rest of the financial markets would be devastating. In the words of Alan Greenspan, ‘The very efficiency that is involved here means that if a crisis were to occur, that that crisis is transmitted at a far faster pace and with some greater virulence’.
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Despite this, there was no oversight, no regulation, no checking of whether the insurers had the capital to cover any potential losses. When questioned on this lack of oversight, Greenspan responded that the chances of such an event occurring were extremely remote. And anyway, ‘risk’ he said, ‘was part of life’.
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The power of OTC derivatives to destabilise markets showed itself, seemingly, as an anomaly, but became more frequent as the twentieth century drew to a close. The multinational firm Proctor & Gamble reported a pre-tax loss of $157 million in 1994. It stemmed from OTC derivatives sold to it by Bankers Trust. The same year, Orange County, California, filed for bankruptcy. It lost $1.5 billion speculating on derivatives. Its dealer was Merrill Lynch. The county treasurer, Robert Criton, later pleaded guilty to six felony counts. In 1996, the Japanese Sumitomo business group lost $2.6 billion on copper derivatives. The Commodity Futures Trading Commission (CFTC) later fined Merrill Lynch $15 million ‘for knowingly and intentionally aiding, abetting and assisting the manipulation of copper prices’.
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In 1995, the UK-based Barings Bank was declared insolvent after it lost $1.3 billion due to the activities of one of its derivatives dealers, Nick Leeson. In September 1998, the New York Federal Reserve organised a bailout of the hedge fund management firm Long-Term Capital Management (LTCM), which had lost €4.6 billion during the 1997 and 1998 Asian and Russian financial crises. It ‘held more than 50,000 derivatives contracts with a notional sum involved in excess of $1 trillion’.
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The instability, lack of oversight, and toxic concentration of risk that was generated by OTC derivatives led Warren Buffet to declare, in 2003, that ‘derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal’. By 2007, the five largest investment banks in the US – J.P. Morgan Chase, Citigroup, Bank of America, Wachovia and HSBE – were among the world’s largest derivatives dealers. Goldman Sachs estimated that from 2006 to 2009, somewhere between 25 per cent and 35 per cent of its revenues were generated by derivatives. The American insurance corporation AIG had sold credit default swaps totalling $79 billion ‘to investors in these newfangled mortgage securities, helping to launch and expand the market and, in turn, to further fuel the housing bubble’.
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In 2006 and 2007, the top underwriter of mortgage bonds in the US was Lehman Brothers. ‘When housing prices fell and mortgage borrowers defaulted’, said the
Financial Crisis Inquiry Report
, ‘The lights began to dim on Wall Street’.
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