The following is an excellent excerpt from the book “THE DEVIL’S DERIVATIVES: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . and Are Ready to Do It Again” by Nicholas Dunbar from Chapter One “The Bets That Made Banking Sexy” on page 1 and I quote:
“Starting in the late 1980s, a new emphasis on shareholder value forced large banks to improve their return on capital and start acting more like traders. This sparked an innovation race between two ways of transferring credit risk: the old-fashioned “Letter of credit” versus a recent invention, the credit default swap (CDS). Behind this race were two ways of looking at credit: the long -term actuarial approach versus the market approach. The champion of the market approach, Goldman Sachs, quickly moved to exploit the CDS approach and was richly rewarded for its ambition–and ruthlessness.”
“Something Derived from Nothing – There was a burst of tropical thunder in Singapore on the autumn night in 1997 when I met my first credit derivative traders. Earlier that day, there had been a lot of buzz in my hotel’s lobby about an imminent Asian currency crisis. People were muttering about the plummeting Thai baht, Malaysian ringgit, and Korean won. Suharto’s Indonesian dictatorship–only a thirty-minute boat trip away across the Singapore Strait–was lurching toward default and oblivion.
But there were also people who were planning ahead. They were the attendees of the finance conference I had come here to write about, and they were sequestered away from the tropical humidity, in the air-conditioned, windowless suites of the conference’s main hotel. They wore tags and listened attentively to presentations on managing risk. Many of them worked for companies that imported and exported to the region, or had built factories there. You could see evidence of this globalization in the fleets of freight ships endlessly passing through the nearby Singapore Strait. As the writer Thomas Friedman put it, the people at this conference had figured out that the world was flat, and there was money to be made everywhere.
Well, maybe not quite. There were still a few bumps to pound smooth. The troubles in Thailand, Korea, and Indonesia had just injected a big dose of uncertainty into the world’s markets, which the acolytes of globalization at this conference didn’t want. For companies that become big and global, financial uncertainties inevitably creep in: uncertainty in foreign exchanges, the interest rate paid on debts or earned on deposits, inflation, and commodity prices of raw materials. One might accept that betting on these uncertainties is an unavoidable cost of doing business. On that day in Singapore, however, the looming Asian crisis had heightened fears to the point where most people wanted to get rid of the problem. Delivering presentations and sponsoring the exhibition booths nearby were the providers of a solution: financial products aimed at shaping, reducing, or perhaps even increasing the different flavors of financial uncertainty. These products went under the catchall name of derivatives.
They were called derivatives because they piggybacked on–or “derived” from–those humdrum activities that involved exchanging currencies, trading stocks and commodities, and lending money. They weren’t new–in fact, they were centuries old–and they were already routine tools in many financial markets. For example, imagine trying to buy a million barrels of oil, right now, in the so-called spot market. Leaving aside the financing, a deal (and hence a price) is only feasible if you have a place to store the commodity you buy, and there is a seller storing the commodity nearby waiting to sell it to you. A forward contract specifying delivery in, say, a month from now, gives both sides a chance to square up the logistics.
The important thing about these contracts is not that they refer to transactions in the future–after all, contracts do that–but that they put a price on the transaction today. The derivative doesn’t tell you what those barrels of oil will actually cost on the spot market in a month’s time, but the price that someone is willing to commit to today is useful information. And with hundreds of people trading that derivative, discovering the forward price using a market mechanism, then the value of the contracts becomes a substitute for the commodity itself: a powerful way of reducing the uncertainty faced by individual decision makers.
Thus, while bureaux de charge might offer spot currency transactions (for exorbitant fees), big wholesale users of foreign exchange markets prefer to buy and sell their millions in the forward market. Because these buyers and sellers are willing to do that, many analysts believe the rate of sterling in dollars or of yen in euro next week is a more meaningful number than its price today. Gradually, banks offering foreign exchange and commodity trading services extended the timescale of forward contracts out to several years.
For example, German airline Lufthansa might forecast its next two years’ ticket revenues in different countries and the cost in dollars of buying new planes and fuel. Lufthansa, which works in euros, then uses forward contracts to strip out currency and commodity risk. The attraction of controlling uncertainty in this way created an efficient, trillion-dollar market. The derivatives market.
Yet for that audience in Singapore, forward contracts weren’t quite enough to control financial uncertainty in all the ways they wanted to control it. There were presentations on options, which, in return for an up-front premium, gave the right, but not the obligation, to sell or buy when one needed to–a bit like an insurance policy on financial risk. And there were swaps, which allowed companies to exchange one type of payment for another. This last derivative, in addition to providing a price information window into the future, had a potent transformational property: the ability to synthesize new financial assets or exposures to uncertainty out of nothing.
Consider the uncertainty in how companies borrow and invest cash. A treasurer might tap short-term money markets in three-month stints, facing the uncertainty of central bank rates spiking up. Or they could use longer-term loans that tracked the interest rates paid by governments of their bonds, perhaps getting locked into a disadvantageous rate. Imagine that once you had committed yourself to one of these two financing routes, an invisible toggle switch allowed you to change your mind canceling out the interest payments you didn’t want to make in return for making the payments that you did. Thus was the interest rate swap, the world’s most popular derivative, born.
Swaps first proved their value in the 1980s, when the U.S. Federal Reserve jacked up short-term interest rates to fight inflation. With swaps, you could transform this short-term risk into something less volatile by paying a longer-term rate. Swaps again proved useful in 1997, when Asian central banks used high short-term interest rates to fight currency crises. Just how heavily traded these contracts became can be gauged from the total “notional” amount of debt that was supposed to be transformed by the swaps (which is not the same as their value): by June, a staggering $356 trillion of interest rate swaps had been written, according to the Bank for International Settlements. As with forward contracts on currencies and commodities, the rates quoted on these swaps are considered to be a more informative way of comparing different borrowing timescales (the so-called yield curve) than the underlying government bonds or deposit rates themselves.
Derivatives–at least the simplest, most popular forms of them–functioned best by being completely neutral in purpose. The contracts don’t say how you feel about the derivative and its underlying quantity. They don’t specify that you are a hate-to-lose-money corporate treasurer looking to reduce uncertainty in foreign exchange or commodities. A treasurer based in Europe might have millions in forecast revenues in Thailand that wants to hedge against a devaluation of the Thai currency. A decline in those revenues would be “hedged” by a gain on the derivative. But if there weren’t any revenues (after all, forecasts are sometimes wrong), the derivative didn’t care. In that case, it became a very speculative bet that would hit the jackpot if Thailand got into trouble, and would lose money if the country rebounded.
Saying a derivative is “completely neutral” in purpose is true, but misleading. The derivative doesn’t care which side of the bet wins, but a person who sold the derivative certainly cares about making a profit. In the Singapore conference room that week, there were many people who didn’t work for corporations but instead were employed by hedge funds engaged in currency speculation. For the community of secretive hedge fund traders, which included people like George Soros, financial uncertainty was a great moneymaking opportunity. Governments–Malaysia’s in particular–were already railing and legislating against currency speculation, but derivatives invisibly provided routes around the restrictions. A derivative didn’t care whether you were a treasurer with something to hedge but then decided to use derivatives not as insurance but rather to do some unauthorized speculation. Right from the start, derivatives carried this potential for mischief.
That’s why some people felt they needed to be regulated. One answer was to quarantine derivatives in a special public venue called an exchange, a centuries-old innovation to ensure that markets work fairly and safely. But it was too late to box derivatives in that way–by the time I attended that conference in 1997, a fast-growing alternative was already eclipsing exchange-traded derivatives. These were over-the-counter (OTC) derivatives traded directly and privately with large investment banks, with the interest rate swap being the most obvious example. The banks that created and traded OTC derivatives did not want to take only one side of the market, such as only buying yen or only lending money at a five-year interest rate. The derivative-dealing banks set themselves up as secretive mini-exchanges. They would seek out customers with opposing views and line them up without the other’s knowledge. The bank sitting between them would not be exposed to the market’s going up or down and could simply skim off a percentage from both sides, dominating the all-important pricing mechanism that was the derivatives market’s big selling point. There was so much to be skimmed in this way, and so many ways to do it. But perhaps the most lucrative way of all was to invent new derivatives.
In Singapore on the night after the conference, I joined a group of conference delegates on a tour of some of the city’s famed nightspots. With me were a pair of English expat bankers who worked on the emerging market bond trading desk of a Japanese bank. They told me about a derivative that had been invented two years earlier. It was called a credit default swap. Rather than being linked to currency markets, interest rates, stocks, or commodities, these derivatives were linked to unmitigated financial disaster: the default of loans or bonds. I found it hard that night to imagine who might be interested in buying such a derivative from a bank. The nonfinancial companies whose activities in the globalized economy exposed them to financial uncertainty didn’t seem interested. The derivatives that were useful to them–futures, options, and swaps linked to commodities, currencies, and interest rates–had already been invented. It seemed to me as if the credit default swap was an invention searching for a real purpose. As it happened, the kind of companies that found credit default swaps most relevant were those that had lots of default risk on their books: the banks.
Losing That Hate-to-Lose-Money Mind-Set – Back in the early 1990s, the world’s biggest banks were still firmly rooted in an old lending culture where the priority above all else was to loan money and get paid back with interest. Like the small banks on Main Street, USA, these Wall Street banks were run by men who hated to lose money. There was just one problem with that fine sentiment: despite the vaunted conservatism of the traditional banker, money had a habit of getting lost anyway. In the 1980s, Walter Wriston, the chairman of Citibank, declared that “sovereign nations don’t go bankrupt.” A few years later, Mexico and a host of Latin American nations defaulted on their loans and put Citibank on its knees. By the time I flew to Singapore for that conference in 1997, the big bankers knew all too well about the dangers of emerging market lending and were looking for ways to cut their risks.
By then, the traditional banker had already become a mocked cliche on Wall Street, the cranky grandfather ranting at the Thanksgiving dinner table about “those damn kids today . . . !” And in the same way that only the neoclassical facade of an old building is saved from demolition, commercial banks like Chase or J.P. Morgan studiously gave the appearance of being powerful and prudent lenders. But behind that crumbling facade, the real business of banking was rapidly changing.
One way around the problem was to make more loans but then immediately distribute them to investors in the form of bonds. As long as the bonds didn’t go bad immediately, the credit risk was now the investors’ problem, not the bank’s. This was the world of the securities firms: Goldman Sachs, Morgan Stanley and Lehman Brothers. The Glass-Steagall Act, which kept commercial banks out of securities, was about to be demolished in 1999 and was increasingly irrelevant anyway: by using new products like derivatives, or by basing subsidiaries outside the United States, American banks could do as much underwriting and trading as they liked.
And yet, the Goldman Sachs model of underwriting securities and selling them to investors was no panacea: market appetite for bonds could dry up, and in some areas, like Europe, companies preferred to borrow from banks rather than use the bond market. So as the new breed of multinational bank took shape and branched out into new businesses, the credit losses kept coming. In early 1999, I flew from London to New York City to interview Marc Shapiro, the vice chairman at Chase Manhattan. He was a lanky Texan whose off-the-rack suits and home-spun manner personified the hate-to-lose commercial banker. After we’d talked, I was taken to meet the bank’s chief credit officer, Robert Strong, who talked about his memories of the1970s recession and how cautious he was about lending. I knew why Chase was selling me this line so hard. A few months earlier, it had lent about $500 million to the massive hedge fund Long-Term Capital Management (LTCM), which was on the brink of bankruptcy and threatened to bring much of Wall Street down with it until a consortium of banks (including Chase) bailed it out. At the time, Chase was mocked for being so careless with its money, and Shapiro was keen to signal that this had been a one-off.
That same trip, I went to J.P. Morgan’s headquarters on Wall Street, where it had been based for a century. The tall Englishman with a high forehead who greeted me in a mahogany-paneled room reminded me of the head of a university science department. Peter Hancock was the chief financial officer (CFO) of J.P. Morgan but his aura of sophistication and analytical intelligence was the complete opposite of Shapiro’s. Despite the sharp contrast in styles, Hancock’s bank had also embarrassed itself with imprudent lending. The difference was that the lending took place through the fast-growing OTC derivative markets. A Korean bank has signed a swap contract with J.P. Morgan that, on the face of it, looked like a reasonable exchange of cash flows intended to reduce uncertainty. But it also amounted to a bet that a local-currency devaluation wouldn’t take place. When the Korean won was devalued against the dollar at the end of 1997, the Korean bank suddenly owed J.P. Morgan hundreds of millions of dollars, and it was unable to pay. J.P. Morgan had to write that off as a bad loan and was now suing to recover the money. This was embarrassing, not because the contract didn’t say the money was owed (it did, and this was confirmed by a court), but because J.P. Morgan had not anticipated the amount’s becoming so large and had not checked to see whether its Korean client was good for the money.
Although the nature of the losses was different, the challenge for Chase Manhattan and J.P. Morgan was the same: they had had to ratchet up credit exposure in order to compete, and now they had to find ways of cutting it back again without jeopardizing revenues. Shapiro explained that this pressure came from the fashionable doctrine of shareholder value added (SVA). Invented in the 1980s and associated with General Electric CEO Jack Welch, SVA argued that nonfinancial companies should ditch low-growth businesses that tied up shareholder capital, and produce a bigger return for shareholders.
The problem with bank lending as a profit generator is simple: no business is hungrier for capital than the one that hands out money to borrowers and then waits to get paid back. Add in the capital reserve for bad loans and the regulatory cushion to protect depositors, and the income for shareholders is modest. That is the price shareholders once paid–happily–for investing in a boring but safe business. However, SVA made traditional bank lending look unattractive compared with other kinds of banking that didn’t tie up all that expensive capital. Chase and J.P. Morgan attacked the problem in fundamentally different ways: one embracing the new innovation of credit derivatives, and the other following a more traditional approach. The success and pitfalls of these two routes would reveal just how subversive the new innovation was to the way banking worked.”
(THE FOLLOWING IS ABOUT THE AUTHOR AND I QUOTE:
“NICHOLAS DUNBAR grew up in London and trained as a physicist at Manchester, Cambridge, and Harvard universities. He was inspired to become a financial journalist by university friends who took their mathematical skills from academia onto the trading floors of investment banks.
From 1998 to 2009, Dunbar was technical editor of Risk magazine, a specialist derivatives publication. In 2005, he launched Life & Pensions, a sister publication to Risk aimed at the insurance and pensions industry.
During this time, Dunbar wrote a series of exclusive stories on derivatives blowups, which cemented his reputation as an investigative journalist, and in 2007 he won the State Street award for institutional financial journalism. He has also written a column called Risky Finance for the authoritative financial commentary service Reuters Breakingviews.
In 1999, Dunbar wrote his first book, Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It (Wiley, 2000). The Devil’s Derivatives is his second book. For further information visit www.nickdunbar.net.”
MY COMMENTS: I’VE BEEN CONCERNED ABOUT THE GROWING, UNREGULATED, TOXIC DERIVATIVE MARKET AND WHAT IT WOULD DO WITH OUR BIG INVESTMENT BANKS EVER SINCE I READ ABOUT DERIVATIVES YEARS AGO IN BUSINESSWEEK MAGAZINE. THEN SENATOR BERNIE SANDERS MADE A BIG ISSUE OUT OF IT IN THE DEMOCRATIC PRESIDENTIAL PRIMARY AND ALMOST BEAT SEC HILLARY CLINTON. THE AUTHOR OF THIS GREAT BOOK WROTE THE ENTIRE BOOK JUST ON DERIVATIVES AND WHAT IT IS DOING WITH OUR BANKING SYSTEM AND WALL STREET. THIS IS NOT THE TIME TO GET RID OF THE DODD-FRANK BILL PARTICULARLY THE CONSUMER FINANCIAL PROTECTION BUREAU WHICH SENATOR ELIZABETH WARREN AUTHORED AND SET UP. SENATOR ELIZABETH WARREN IS RIGHT THE DODD-FRANK BILL SHOULD BE MADE STRONGER.
LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran