How Derivatives Brought On the Crash

The global financial crisis has restarted debates over economic policy and ideology that were once forgotten in the happy glow of globalisation. The era of Thatcher and Reagan is now said to have come to an abrupt end; and along with it, a resurgent Keynesianism has overturned the reigning free market philosophy of Friedrich von Hayek.

The origins of the crash, like those of the Great Depression, will be debated endlessly. Was greed and unregulated capitalism the ultimate cause? Or was it the unavoidable impact of low long-term interest rates, fuelled by savings from China and the petrodollar states?

One thing seems clear. As economist Robert J. Shiller has noted, the chain of immediate causes which created the global financial recession began with the meltdown of the US housing market in 2006, and the fallout on the sub-prime mortgage sector.

Yet this story of how shonky mortgage lenders targeted credit-risky borrowers in the USA (and elsewhere) is familiar territory. So is the story of the fallout on Wall Street and the crash of giant banks like the bankrupt Lehman Brothers, the takeover of Bear Stearns, the meltdown of global stock markets, and the savaging of bank balance sheets by the trillions.

Similarly familiar is the dramatic tale of how world governments responded to the financial crash and the subsequent recession. A new era of state intervention was inaugurated with nationalisations, bank bailouts, easy monetary policy and massive state spending to stimulate the economy.

But what has remained a mystery, so far, is a far more practical and mundane question relating less to ideology than to the nuts and bolts of financial regulation. How did the toxic assets resulting from the sub-prime meltdown do so much damage to the world financial system? According to Gillian Tett’s excellent book Fool’s Gold, the answer lies with the development by the big investment banks of financially engineered products that became a global conduit for these toxic assets.

During the 1990s, in the powerhouse laboratories of Wall Street banks, financial engineers developed products which had seemingly transformed the nature of risk. Credit Default Swaps and Collateralised Debt Obligations delivered vast profits to the banks, but at the same time created greater unknown risk to the overall system.

The failure to regulate them, Tett argues, was one of the main causes of the global recession. If Tett is right, the key to taming the engine of global finance will be an understanding of how these financially engineered products outpaced the capacity of regulators to fulfil their role as guardians of financial stability.

Credit Derivatives

Gillian Tett is a journalist at the Financial Times and holds a PhD in social anthropology from Cambridge. She took her anthropological eye into the largely ignored world of derivatives almost by accident in the mid-1990s. She soon sensed that this highly mathematical area of high finance had been unfairly ignored and she set about to understand this new world of credit.

Tett’s new book Fool’s Gold is a history of how financiers at J.P. Morgan developed and applied the idea of what are now known as credit derivatives. It is also a story about how this idea rapidly spread to other investment banks in the years leading to the market meltdown in 2007 and 2008.

These young financiers, the “Morgan Mafia”, saw themselves as modern-day alchemists of money, working on new financial technologies which they thought would disperse the risk of lending, thereby liberating capital to create a new era of prosperity:

The J.P. Morgan derivatives team was engaged in the banking equivalent of space travel. Computing power and high-order mathematics were taking the business far from its traditional bounds, and this small group of brilliant minds was charting the outer reaches of cyber finance.

Like scientists cracking the DNA code or splitting the atom, the J.P. Morgan swaps team believed their experiments in what bankers refer to as innovation, meaning the invention of bold new ways to generate returns, were solving the most foundational riddles of their discipline.

At the heart of their new financial creation was a three-step process which allowed investment banks to increase the number of loans they brokered and yet sell the increased risk to a third party.

Credit derivatives were a dream come true for the banks at a time when interest rates were low and competition intensifying; the investment banks were chafing under internal capital limits and international regulations which prescribed the amount of capital they had to keep in reserve for their loans.

In particular, the Basel Accord of 1998, which prescribed that 8 per cent of any loan had to be kept in reserve, was one of the chief targets of these young financiers. They soon discovered that their new creation could do the trick, allowing them, as Tett says, to “dance” around these rules, which had been developed by the Bank for International Settlements, based in Basel.

The first step—creating the credit default swap—was largely hatched in 1994 at Boca Raton, a luxurious resort in Florida, where the Morgan team had gathered to drink champagne, jet-ski and discuss new ways of making derivatives profitable.

A swap is a type of derivative. Derivatives are financial assets which derive their value from other assets, such as stocks, bonds, currencies and loans. Derivatives have been around in one form or another for a long time, especially in agricultural commodities. They are used by traders to hedge or protect a financial position and for speculation. Farmers can buy futures, for example, when they agree with another party to sell their product at a fixed price, set at some future date. This can be advantageous in the event of a bumper harvest, when there is downward pressure on prices. By agreeing at an earlier date to sell their crop for a fixed price, farmers can effectively hedge their income against a fall in prices.

Likewise, options give people the right or option to buy or sell a commodity or a foreign currency or a specific interest rate at some future date. In the case of options, businesses can agree to buy foreign currencies at a specific rate in the future, a technique which allows them more certainty in purchasing in foreign markets. Similarly, an option can be struck to purchase a loan at a specific interest rate, a handy technique to lock in lower interest rates if you expect rates to rise.

Swaps are a special type of derivative which allows two parties to swap income streams from an asset without selling it. The first currency swap was brokered by Salomon Brothers in 1981 between the World Bank and IBM—it was a neat deal. The World Bank needed francs and marks, and had an excess of dollars; IBM needed dollars, but had an excess of francs and marks.

Banks increasingly needed financial instruments to hedge their investments and loans, and derivatives fit the bill perfectly.

Ever since the end of the Bretton Woods international financial system in the early 1970s, companies and governments had faced a new world of fluctuating exchange rates and financial deregulation. By 1994, the market for interest rate and currency swaps already stood at US$12 trillion; credit derivatives were about to enter the stage.

In Boca Raton, the Morgan Mafia took the process further and came upon the idea of swapping the risk of default a bank incurs when it lends money. The idea of swapping default risk essentially requires finding a third party willing to gamble that the borrower will not default. For blue chip borrowers this was often a reasonable and profitable gamble for a third party to make, because the investment bank pays a fee for someone to take this gamble. The swap does not mean, however, that the bank sells the loan, only the risk that it will default.

The Morgan Mafia soon found a suitable opportunity to apply their new idea. Following the Exxon Valdez disaster in 1989, Exxon had received a US$4.8 billion line of credit from Morgan to cover any losses as a result of the environmental disaster. But J.P. Morgan was worried about the risk of Exxon defaulting on its loan. The bank’s swaps team eventually convinced the European Bank for Reconstruction and Development to swap that risk for a fee.

For J.P. Morgan the charm of this deal was that it allowed the bank to take the capital it was required to keep in reserve against their loan to Exxon off the balance sheet, effectively freeing the bank to make further loans. Credit default swaps were seen as the holy grail of finance because they seemed to solve the fundamental problem of banking: how to remove or minimise the risk of a loan defaulting but still make money through lending.

As Tett points out, the creation of credit default swaps was just the beginning of the story of how derivatives became what financier Warren Buffett called “financial weapons of mass destruction”.

J.P. Morgan realised that to make the idea of credit default swaps more profitable they had to increase the amount of lending. The more loans sold, the more default risk they could sign away, the higher the profit. Tett aptly describes this as a form of financial industrialisation or mass production.

So J.P. Morgan added a second step, called securitisation, an idea which had been developed in the 1960s and 1970s. Securitised assets are bundles of assets, such as bonds or mortgages or car loans or credit card debt, which can be sold as a single asset, called a Collateralised Debt Obligation, or CDO. The aim of bundling assets together into a CDO is risk dispersal. Within a CDO, if one loan defaults—say on a car payment—the income stream from any of the other loans—say on a student debt—will not necessarily be affected. Securitisation is supposed to make for a safer investment through the dispersal of risk.

Banks would securitise hundreds or thousands of loans into a pool of investments. Each loan had a different income stream attached to it. The bank would then “slice and dice” all these different loans into tranches and sell them. The safest loans, the Super Senior debt, had the lowest yields; the riskiest loans, the junior tranche, had the highest. These asset-backed securities were sold around the world to pension funds, hedge funds, money market funds, and other banks, even to governments. Morgan’s twist was to create CDOs out of pools of credit default swaps; the bank effectively wrongfooted its competitors with a new product.

The third step solved the problem of finding a third party with which to swap the risk of default. J.P. Morgan came across the idea of creating an off-balance sheet bank, called a Special Purpose Vehicle, which would buy the risk of default. Even though they were created by banks, SPVs did not face the same capital reserve requirements.

Regulators nodded their approval once they were assured that the risk of default on the safest tranche of debt, the Super Senior debt, could be swapped with insurance companies, like AIG. Even if the banks kept this Super Senior debt on their books, they would only have to hold US$1.60 in reserves for every US$100, instead of US$8 for every US$100.

J.P. Morgan called their creation “Bistro”, or Broad Indexed Secured Trust Offering, and unveiled it in a 1997 deal which involved a CDO worth US$9.7 billion, built out of the debt of 307 companies. The default risk was offloaded to an SPV, which required only US$700 million in reserve capital. The banks had effectively danced around the Basel rules. The joke soon did the rounds that Bistro really meant “BIS Total Rip Off”.

The J.P. Morgan ideas spread throughout the financial community, allowing banks and companies to sell their risk to other parties who were prepared to gamble on default. As the era of low interest rates beginning in 2001 set in, the CDS industry boomed. The “J.P. Morgan Guide to Credit Derivatives” soon became the industry bible.

But the banks then took a disastrous step. Confident that the housing market was safe, they began using residential mortgages to create CDOs.

The securitisation of mortgages boomed. About 80 per cent of the US$2.5 trillion in mortgages written since 2000 then flowed into securitised pools. These investments were snapped up around the world. Very few bankers asked questions about the stability of the housing market because they were confident that credit default swaps had covered their risk. When the crash came, the companies which were supposed to pay in the event of default were themselves going broke because the sub-prime crash had devastated their balance sheets.

Cassandras

There were a few financial Cassandras, but their warnings went unheeded. After the crash of the hedge fund Long Term Capital Management in 1998, the world’s financial officials had been distracted. They saw speculative hedge funds as the real problem, rather than the complex nature of CDOs and credit default swaps or the housing market. They were also loath to regulate derivatives because they viewed risk dispersal as a positive thing for the market.

The most serious warnings came from the Bank for International Settlements, the central bankers’ bank, an elite world body which has monitored the international financial system from its well-manicured perch in Basel since 1930. BIS’s senior economists had became deeply worried about the credit bubble by as early as 2003, but their views were brushed aside by the Federal Reserve as alarmist and pessimistic.

At Alan Greenspan’s Fed, there was great faith that the system was evolving into something that could better withstand financial shocks, such as the 1987 stock market crash or the end of the dotcom boom or 9/11. Besides, Greenspan did not believe a central bank could judge whether a bubble economy should be burst or not. As well, banks were the best judges of whether derivatives trading posed a risk, not central banks.

In 2003, the BIS’s chief economist, the Canadian William White, took on Greenspan’s ideas at an annual meeting of central bankers at Jackson Hole, Wyoming. White warned his audience, which included Greenspan, that the Fed’s hands-off policy of easy money and the widespread securitisation of mortgages posed a major risk to the world economy. He urged the bankers to take action against the bubble economy before it was too late, but to no avail.

Perhaps the most famous warning was issued by Brooksley Born, the chairwoman of the Commodities Futures Trading Commission, the regulatory body based in Chicago which regulates futures and options. In 1998, Born urged the Clinton administration to begin to think about regulating the gigantic global derivatives industry, but was rudely shot down by Lawrence Summers, the (then) Deputy Treasury Secretary. Summers, the (then) Treasury Secretary Robert Rubin and Greenspan thought that any attempt to regulate derivatives would cause a flight of the business abroad.

Summers, Obama’s chief economic adviser, now recognises that he erred, as has Greenspan. “There’s no question that with hindsight, stronger regulation would have been appropriate,” Summers told Newsweek in March. “Large swathes of economics are going to have to be rethought on the basis of what’s happened.”

Born has now received a Profile in Courage Award from the Kennedy Library, along with Sheila Bair, the current head of the US Federal Deposit Insurance Corporation, the body which regulates smaller banks. Bair, too, had repeatedly warned regulators about the dangers in the sub-prime market and that the Fed should act.

We can with hindsight see that the world financial system was essentially spinning on a pinhead of leveraged debt and risk, waiting passively for some chink in the banks’ asset armour to emerge and crack it open. That chink eventually emerged in the form of the sub-prime mortgages.

Why Didn’t Anyone See It Coming?

One of the virtues of Gillian Tett’s book is that it provides an analysis of how the world’s regulators missed the threat that credit derivative products posed. The basic problem was simple. Unlike the market for shares—the stock market—there was no central clearing house for credit derivatives, one which would provide publicly available data about price and risk. Credit default swaps and DCOs were private transactions, known as Over the Counter Trades. Sometimes they even included confidentiality clauses.

In this twilight of self-regulation, the total value of credit default swaps—effectively the value of risk covered on loans—amounted to US$57 trillion by the end of 2007. More ominously, the total value of all outstanding derivatives—credit, currency, interest rate, commodities, equities—approached US$600 trillion. For several intertwined reasons, according to Tett, few really knew or understood the dangers.

Many of the regulators, chief among them Alan Greenspan, were committed to a view that markets worked best without government intervention. The idea of free markets has always been especially relevant to finance because of the fluid nature of financial products and their essentially mathematical structure. Greenspan, for example, told Congress in 2003 that derivatives gave him “some pause”, but said he opposed regulating them because they had insulated the financial system from shocks.

The US economy was booming, and the market economy was the engine. No one was seriously questioning its efficacy. In this light, regulation was seen as impeding the creation of wealth and efficiency by ruining the effectiveness of the new financial technologies.

Indeed, Tett reveals that several of the people involved with credit derivatives at J.P. Morgan were admirers of Friedrich Hayek, the Austrian philosopher and economist whose books, such as The Road to Serfdom and The Constitution of Liberty, provided some of the intellectual heft for the Thatcher and Reagan revolutions.

J.P. Morgan’s Mark Brickell, for example, who led the bank’s lobbying in the USA to block the regulation of derivatives, admired Hayek and also Eugene F. Fama and Merton H. Miller from the University of Chicago, the pair who had founded another fundamental theorem in finance, the Efficient Markets Hypothesis. As Tett puts it, “What made derivatives so thrilling for Brickell and other true believers was that they lay outside the purview of that legacy regulation. They allowed pioneering financiers to compete freely, unleashing their creativity, just as theory advocated.”

As well, time and again the derivatives industry successfully headed off challenges from regulators and the US Congress. Their aim was to self-regulate, and also to claw back existing regulations. In both aims the banks were successful.

In 1985, the International Swaps and Derivatives Association, or ISDA, was formed as an industry body. Throughout the 1980s and 1990s, their lobbying campaigns were highly successful. The critical moment came with a report from a think-tank, the Washington-based G30, which recommended industry self-regulation in its 1993 report into derivatives. That influential report set the terms of the debate.

The Commodities Futures Trading Commission backed down in 1989 in its attempt to regulate interest rate and currency swaps. The US Congress’s effort to pass several bills to regulate derivatives trading in 1994, following serious losses at companies which had used derivatives as hedges, was also dropped.

In 2000, the US Congress passed the Commodities Futures Modernisation Act, which effectively closed the door on the regulation of swaps by the CFTC. “It was an extraordinary victory for ISDA: one of the most startling triumphs for a Wall Street lobbying campaign in the twentieth century,” Tett concludes.

But a passionate belief in free markets and successful lobbying efforts only explain part of the story.

Derivatives are by their nature very complicated, highly mathematical and of recent origin. Even George Soros refuses to trade in them, “because we don’t really understand how they work”, he says. As Stanford University economist John Taylor wrote in the Wall Street Journal in July, “We believe their sheer complexity is the core problem and that only increased transparency will unleash the market mechanisms needed to clean them up.” Many regulators and even bankers had a poor understanding of them, making it difficult to see looming dangers. They were in effect new and powerful technologies. Added to this intellectual complexity was the compartmentalised structure of banks, where silos of specialists in currencies or equities or derivatives worked away without really interacting with each other, or in fact overseeing the risky deals of others.

Derivatives trading was also highly profitable, a fact which gave swaps traders much greater status within banks like Morgan. With that came the clout to push ahead with deals despite the risks.

Ironically, J.P. Morgan did not become a victim of its own technology because its boss, Jamie Dimon, feared the risky nature of using mortgages to create CDOs. The bank’s exposure to the sub-prime fallout was relatively limited. Indeed, it was at J.P. Morgan that the first problems with the CDO model emerged when their analysts could not find any decent data on the risk of defaults in mortgage lending.

There had not been a nationwide downturn in US housing since the Great Depression, so assessing default risk was hard, if not impossible. This shortfall in data did not, however, stop J.P. Morgan’s rivals, such as Lehman Brothers, from surging ahead, despite the risk. Lavish executive bonuses played a critical role here in lulling bankers into believing that their deals were safe.

Greed, Tett concludes, played a critical role in overcoming inadequate data about risk, as did the sloppy behaviour of the ratings agencies which were slowly drawn into the interests of the big banks. As Goldman Sachs’s Lloyd Blankfein noted in April, “We rationalised because our self-interest in preserving and growing our market share, as competitors, sometimes blinds us—especially when exuberance is at its peak.”

Tett also weaves into her narrative the ongoing psychological influence of the bubble economy, the optimism that the housing boom would continue and the surging feeling that the good times would last forever. Real home prices in the USA, for example, increased by about 50 per cent in the years between 1998 and 2006, by 120 per cent in the UK and over 100 per cent in France.

This bubble psychology had a tremendous dampening effect on critics and doomsayers, which was reinforced by what Tett regards as the excessive faith in financial and economic modelling at the banks, especially the notion of Value at Risk, which ostensibly offers a mathematical snapshot of a firm’s risk profile at a given moment.

Tett in some ways strikes a false note in her call for a more holistic financial vision, one which takes into account the “dull virtues” of prudence, moderation, balance and common sense. No doubt these are worthy values, but up against the massive forces of global finance, what hope would those values have?

Conclusion

The global financial system is more complex, unstable and powerful than our brightest financial thinkers had imagined. Information technology and new ideas like credit default swaps have created a new system of finance in the early twenty-first century.

Regulators will need to adapt to a new global financial order by answering a new set of questions, particularly about derivatives and the capital base which banks require to function smoothly. In the years ahead, the answers to these questions may well redefine the role of central banks and the types of financial products that will be allowed to flourish.

What the world now faces, in short, is a new era requiring fresh ideas and policies; financial officials need an unsentimental worldview on the powerful forces at work in global finance. Smart regulation, not fine words, is the only way stop a repeat of the crisis and all the trauma it has caused to ordinary people.

Already the Obama administration has moved to regulate derivatives markets, protect consumers from reckless lenders (and themselves) and to provide new guidance for the Federal Reserve as to how it should maintain broader financial stability. The days when the Fed’s charter was just to fight inflation and maintain employment are numbered.

Pragmatically speaking, global finance—like the global economy—is here to stay. Goldman Sachs has already posted record profits in the second quarter of 2009, after benefiting from billions in bailout funds, while Obama’s financial reform blueprint explicitly recognises the need to preserve financial innovation.

The financially engineered products which J.P. Morgan pioneered will survive, albeit under the control of tighter regulations. No doubt further innovations will soon be on their way as banks continue their search for profit.

All that governments can do honestly is attempt to keep up with financial developments and adapt their regulations. Tett’s book is a terrific contribution to that effort, partly because it skirts familiar ideological divides and concentrates on the particular products and regulations which led to the financial crash.

John Maynard Keynes is often quoted as concluding his General Theory with a maxim about the importance of ideas. “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist,” he wrote. What the crash has taught us already is that in the case of the ideas of modern high finance, like credit default swaps, the practical among us are indeed slaves, except that the financial thinkers are alive and perhaps doing better than they were last year.

Lincoln Wright works in corporate affairs as a speechwriter in Sydney and is a former political journalist for News Ltd and the Canberra Times.