Who pays when the revolution comes?

Determining who is responsible for the most frightening financial meltdown since the Great Depression requires some clarification of the facts. The first is this: blaming America’s housing collapse for the crisis is simplistic and deceptive. The Economist reports that by 2006 the total value of sub-prime mortgages amounted to $600-billion. That total had probably increased to nearer $1-trillion by 2008; an inconceivably huge number that would take you 10 000 years to count to if you attempted the foolhardy feat (True. Look up the proof in previous post “Can You Count to a Trillion?”). However a bailout of say $700-billion, 70% of the full value of sub prime mortgages, should settle things down nicely, right? Sure, provided that the crisis is a sub prime mortgage crisis. It’s not. The prevailing queasiness is the unmissable clue.

The truth is that the US financial system was extremely vulnerable to credit risk not because of sub prime mortgages but because of complex financial contracts known as credit derivatives. In the first posting of the current trilogy I pointed out that credit derivatives are traded by taking up highly leveraged positions. In other words for a relatively small amount of capital down you become eligible for very large rewards. But you are also exposed to commensurately large risks. So, for example, for a mere $2-trillion down the world’s financial institutions can be exposed to $58-trillion of debt through derivatives called credit default swaps. Now that’s leverage and a set of numbers that might plausibly drive a handful of the most venerable banking institutions all the way to and, oops, over the edge.

To be fair credit derivatives represent an elegant innovation that spreads a lenders default risk as well as the lenders potential rewards to other investors. These characteristics could plausibly produce greater stability in markets, and they charmed the previous Chairman of the Federal Reserve, Alan Greenspan. Warren Buffet, however, saw something more sinister. Five years ago the world’s wealthiest investor famously warned that derivatives are “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” He wasn’t just guessing either, he had case studies.

In 1998, for example, the hedge fund Long Term Capital found itself on the wrong end of derivatives contracts that effectively rendered them bankrupt. There is nothing particularly remarkable about investment firms failing. The free market is self-regulating after all and it’s the natural process for losers to be weeded out. Only this case was notable for two reasons. Firstly, Long Term Capital was founded and run by the leading lights in derivatives trading. These guys counted Nobel Prize winners in their company; they were geniuses, the smartest guys in the room. Secondly, because they were so highly regarded, just about everyone who was anyone on Wall Street had invested with them and consequently everyone was now dangerously exposed. Long Term Capital was bailed out in a deal facilitated by public institutions, which mobilised 12 private sector firms to provide almost $4-billion in capital. A bailout? Interesting strategy.

The potential consequences of highly leveraged investments is frightening, but that was not Warren Buffet’s only concern. There was also the extreme complexity of derivative contracts. The math involved was so convoluted that most parties on either side of these contracts were unable to explain just what it was they were agreeing to. Only the financial engineers with their PhDs in mathematics really understood these instruments. And complexity, combined with a complete absence of regulatory oversight (you’ve read that correctly dear readers: one of the largest financial markets in the history of capitalism has never been and is still not regulated in any way) meant that there was ample room for abuse. Predictably, there are case studies of abuse too.

In December 1994 Orange County, California filed for bankruptcy after its highly leveraged $7.8-billion investment fund, which was well stocked with derivatives called floating rate notes, plunged $1.6-billion in value. Ultimately the total losses to the county were estimated at over $2-billion. The county eventually settled a criminal investigation of Merrill Lynch & Co., which had sold them the derivatives contract, by accepting a $30-million payment. Frank Portnoy, a professor of law at the University of San Diego, in his book Infectious Greed, describes in detail how the ignorance of Orange County Treasury officials was exploited to secure the contract that resulted in the largest bankruptcy of local government in US history. Interestingly a study by authors Halstead, Hedge and Klein published in 2004 demonstrates that this particular derivatives-related disaster led to a “contagion in the bond market that resulted in significantly negative abnormal returns for municipal bond funds without direct exposure to Orange County and for non-Orange County municipal bonds.” In addition, their findings suggest that the contagion spilled over to the common stocks of investment and commercial banks that dealt in or used derivatives. Now where have we seen this pattern lately?

Sub prime mortgages played their part of course, and this is how. With the ability afforded by derivatives to securitise and sell debt risk on to investors, lending to borrowers with poor credit histories became more reckless. The performance of sub prime loans securitised before 2004 remained relatively solid, but the loans post 2004 were toxic. Mortgage brokers and originators were focused on writing as many loans as possible and forwarding them to arrangers who in turn parcelled them into securities. The arrangers then worked relentlessly, selling the securities on to investors. As the debt was sold on and on via a proliferation of complex instruments — CDOs, CDOs-squared, CPDOs — the distance between borrower and bondholder increased, as did the opacity of the composition and quality of the underlying debt.

In 1997 the chairperson of the Commodities and Futures Trade Commission (CFTC), Brookesley Born, sensing the threat posed to the financial system by derivatives, began pushing for some regulation and public oversight of these instruments. Her efforts were vehemently opposed by Alan Greenspan and Robert Rubin, Secretary of the Treasury at the time. Rubin and Greenspan ultimately got congress to strip the CFTC of regulatory authority over derivatives.

The corporate failures of the 1990s that witnessed the downfall of Enron did prompt a spike in regulatory activity with the introduction of Sarbannes-Oxley for example. But the truth is that these fleeting efforts at oversight were an anomalous spike in a steady trend of deregulation that had been rampant since the Reagan administration. Alan Greenspan was the constant figure of authority throughout these years, presiding over deregulation and the most ambitious economic experiment next to its antithesis — the imposition of a command economy in the USSR. Greenspan consistently expressed his faith in free markets to “regulate themselves”. It is apparent from their policy decisions that this principle typified all regulators in the US under Bush 2, including the Environmental Protection Agency and the Consumer Product Safety Commission. It finally led to the decision that would expose the entire economy to a fatal level of risk.

In 2004 the brokerage units at financial institutions approached the Securities and Exchange Commission (SEC) with a request for exemption from the regulations that limited the amount of debt they could take on. The SEC agreed and effectively outsourced oversight to the firms themselves. The SEC’s diluted monitoring of derivatives trading nevertheless did raise red flags shortly before the catastrophe hit, in particular with the “concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain capital standards” and Bear Sterns. But a devotion to the doctrine of encouraging self-regulation effectively constrained the SEC from taking any action. As the chorus of rumours predicting the bank’s immanent collapse rose, the SEC reassured itself that with $17-billion in cash and assets Bear Sterns were well prepared to weather the storm. Three days later, drained of its capital base, JP Morgan were compelled to launch their rescue effort and the perfect storm began.

The part of the regulators in this dramatic sequence of events was played by dogmatic priests blinded by the superstitions of their limited ideology. Here are their confessions and rationalisations:

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.” Alan Greenspan, previous Chairman of the Federal Reserve

“All of the forces in the system were arrayed against it. The industry certainly didn’t want any increase in these requirements. There was no potential for mobilising public opinion.” Robert Rubin, previous Secretary of the Treasury.

“The last six months have made it abundantly clear that voluntary regulation does not work.” Christopher Cox, Chairperson of the SEC.