the warning
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Why Derivatives Were Created and What Went Wrong

Mark Brickell Chair, International Swaps and Derivatives Association (1988-1992)

Mark Brickell

Every business faces risk when it opens its doors. If you're running an automobile manufacturing company and you borrow money at a floating rate of interest in U.S. dollars, you're at risk if interest rates rise because your borrowing costs will increase.

But you're at risk indirectly, exposed to other kinds of financial risks indirectly as well. … The U.S. automaker who competes with Japanese firms is hurt when the yen declines in value against the dollar because that allows the Japanese car manufacturer to sell his cars more cheaply in this country.

Now, those risks exist in the economy before derivatives appear on the scene. And what the derivatives do -- and the policy-makers understand this -- is they allow parties, companies, financial institutions, governments, to shed the risks that they don't want to take and take on other risks that they would prefer to be exposed to. And managing risk is a big part of business. It's part of managing financial institutions; it's part of government.

So the innovative element of swaps is that they allow people to manage the risks to which they're already exposed at a lower cost more efficiently than they were able to manage them before derivatives came on the scene. …

There are series of epiphanies as you realize we could manage commodity price risk, equity price risk, the risk of changes in weather, the risk of changes in the credit quality of a borrower, by using these same techniques. And as we apply the risk-management approach to more and more kinds of risk, the business grows.

That's how the business has grown from nothing in 1980 to $600 trillion of contracts today.

Henry Kaufman Director, Lehman Brothers (1995-2008); author, The Road to Financial Reformation

Henry Kaufman

When I was at Salomon Brothers in the senior management we were really the innovators of the interest-rate swap. … It was a simple thing. We were a broker. We put someone who wanted a fixed rate versus someone who was willing to pay a floating rate and we took a fee for putting those two participants together.

Not much later on after we started this, we were willing to do this as a dealer and take the risk in between. And we did it for relatively short maturities. I remember sitting in our executive committee meeting and a group run by [bond trader] John Meriwether who came in and wanted a larger amount to position and with short maturities, and we gave them a larger amount to position in our portfolio, as inventory.

And then he wanted a larger amount; then he wanted to do longer maturities and somewhat more complicated interest rate swaps. And other things came along. And then after a while, those positions became so big that you had to be very careful as to the risk you were taking or positioning in government securities, in corporate obligations and so on. You could just go so much before you might have had problems with your lenders.

It was kind of a nifty business, because you could do a relatively large volume of business with a moderate amount of overhead and secure a very significant profit. And that was very enticing.

It became a big wholesaling operation after a while. So, this took over with credit default swaps, which JPMorgan went into, and so on in the 1990s and drove very hard.

When you saw the evolution take place and it becomes slicing and dicing them, handing them to AIG, what were you thinking? What were you worried about?

My concern about all of this was, even in the days of Salomon when I was on the executive committee, how big do you want to be in this? How far a position do you want to take? How much do you want to dominate the market in this? And what will it do to other activities that you were involved in? How much risk do you want to take in total?

And there never seemed to be a ceiling in the process. There was always another form of derivative that you could create and another way of laying off a little bit of the risk and so on, just like, for example, Goldman Sachs laid off some of the risk with AIG. There was always another way of diminishing the so-called risk taking.

It was very difficult for participants to realize the totality of this risk taking in the system. And the central bank didn't realize it -- either didn't realize it, didn't want to realize it or didn't have the capacity to realize it. That, I think, was part of my concern.

Blythe Masters CFO, JPMorgan; in 1997, she was part of a group at JPMorgan who created credit derivatives

Blythe Masters

Let's take Exxon as a case. You were involved directly in that idea; that was one of the first [credit derivatives]. ... Walk me through it.

Exxon was the client at the bank, and we had credit exposure associated with that relationship in conjunction with a letter of credit that had been issued by JPMorgan on behalf of the company. A letter of credit creates credit risk. If Exxon were to fail on their obligations, then JPMorgan would have to step in and make good on those obligations on their behalf. It was a large amount of exposure, and there was a significant amount of risk associated with that.

And the idea was that we wished to purchase protection from others. In this case, the example that was made public was from the EBRD, which is the European Bank for Reconstruction and Development. And so we paid them a fee in return for their assuming the credit riskiness of Exxon, in this case. And that was it, very simple concept.

Why did JPMorgan do that? Because we wanted to free up our capacity to do more business for Exxon. Why did EBRD do that? Because they felt that Exxon was a strong company whose business model they understood. I believe it was AAA rated at the time. They would receive compensation from JPMorgan from taking on or assuming credit risk to Exxon and felt that that was a good risk/reward proposition.

They took on a modest amount of risk; we reduced our risk. They didn't create a significant concentration in their case, and so risk was essentially dispersed.

And if you imagine that example multiplied by hundreds of different examples, you can see how concentrated risks on the balance sheet of one bank, in this case JPMorgan, begin to make their way into the hands of investors at prices that those investors are comfortable with and pleased with.

And in many cases, this represents credit risk that those investors could not themselves have originated directly. Exxon was not issuing large amounts of corporate debt at the time. So the existence of this letter of credit, which was a bank market product, meant that that credit asset, if you will, was really not available to an institutional investor like the EBRD was at the time.

In that deal, how did JPMorgan make money?

In that particular example, it would have been essentially between the price at which we originated the credit and the price at which we laid it off.

Or alternatively, imagine that that was a flat proposition, meaning that they were the same prices. The opportunity that was created was the opportunity to do more business with our customer and to get paid by the fees associated with that incremental business. Had we not laid off this risk, we would have been full up with that credit risk and unable to do more business. So the future revenue-generating opportunity would have been curtailed.

… How does EBRD make their money?

They're acting as an investor. They have an investment portfolio. In their case, they had, at the time, various restrictions in terms of the nature of credit risk that they were permitted to take on. In particular, they were required to meet a very high credit standard. So, access to an AAA corporate that was not active in the corporate debt market, did not have a lot of public debt outstanding, was a unique opportunity for them, also at an attractive price.

So their job was to, for a living, take credit risk, to make investments. But they were constrained as to the availability as to what they could do. There wasn't another way to take on Exxon credit risk in this form at the time. So that was the opportunity for them. They had capital to deploy. If they didn't deploy it, they'd earn no return on it. …

Importantly, they made the decision as to whether or not they were comfortable at this pricing with Exxon's credit risk because they're a major sophisticated institutional investor in this context. That wasn't an act of persuasion on JPMorgan's part. What we were providing them was a means to an end where the end was defined by them. Their end was they had an investment objective and we achieved it for them. …

Were you worried about the potential for harm in those early days? Could you project out that jeez, in the hands of others and securitizing the wrong stuff, this could be a problem?

No. And I think the most important way to understand why that's the case is if you look back through history and look at mishaps in financial markets, many of them have at their root credit-origination standards slipping for some reason or another. So lending in the Latin American debt markets, or crisis in the oil patch, the bursting of the tech bubble -- many of these events have had to do with the deployment of leverage, excess leverage, and the decline of risk-management standards often associated with competitive pressure.

Credit derivatives per se didn't change any of that. It didn't increase or reduce the propensity for people to make unwise, underlying credit decisions, or at least that was the thinking at the time. It was really more that you created a transparent pricing mechanism for credit risk and filled the void, rather than it really influenced the propensity of people to make unwise lending decisions in the first place. Obviously, subsequently, some of that evolved along a different path, and that proved to be wrong.

Timothy O'Brien The New York Times

Tim O'Brien

Derivatives, particularly because of the current meltdown, have become demonized. They're seen as sort of Satan's little plaything.

But it's really important to remember that there are a lot of good, practical uses for derivatives. In fact, the average person who's a homeowner owns a derivative. It's the insurance policy on their house, and it's essentially a contract that you enter into with an insurer that pays you a certain amount of money if some kind of damage or calamity happens to your home. And you pay a little bit of money, or a lot of money depending on the size of your home, each year for that policy.

Wall Street has all sorts of contracts like this. Derivatives, in essence, are insurance policies that various players on Wall Street and in the business world enter into to protect themselves from unforeseen calamities, whether it's wild interest-rate swings, changes in the values of currencies, someone's debt going bad. …

And that's a good thing. When people have protection from things they can't control, it enables them to take sensible risks, which allows them to grow their business and allows more money to get created and creates jobs. These are all good things, as long as that's what these things are being used for.

The problem is, no one really knows exactly what derivatives are being used for because it all exists in a black box. They're unregulated; the contracts aren't traded on exchanges; they're entered into between private parties. No one knows whether or not one company, let's, for example, call them AIG, a big insurance company, has entered into so many of these contracts that if an unforeseen financial hurricane comes and hits the house known as Wall Street and suddenly AIG is required to make good on … so many of these policies that they don't have enough money to do this, and they run into danger of going belly up. Which is exactly what happened at AIG.

The only way you can get a handle on what the nature of the derivatives market is and whether or not some of the players are taking on more than they can swallow is if you have transparency. And we have not had transparency in the derivatives market for a very long time.

And the reason for that is?

I think one of the reasons is because the people who write derivatives contracts make a lot of money off of it. And you make more money off something that people can't comparison shop for. It's just like a car dealership. If you go in there and you know what the Blue Book value of the car is, you're in a strong negotiating position with the dealer. If you don't, you're a little bit at his mercy in terms of what the right price for the car is.

Same thing with derivatives. Someone's selling these things, has an interest in there being less open information about them because they get a bigger fee for it, and they can control the pricing in a better way.

Joseph Stiglitz Council of Economic Advisers (1993-1997)

The derivatives were a major source of revenues for a few big banks, and those who were making lots of money out of it obviously wanted to continue with the source of money.

You have to ask the question, did the economy really grow so poorly in the decades before we invented derivatives? Answer: We did actually pretty well. We did better in that quarter century after World War II before we had derivatives than we've done since then.

You have to ask the question, what are financial markets supposed to do? They're supposed to allocate capital; they're supposed to manage risk; they're supposed to do this all at low transaction costs.

In retrospect, we can see that our financial markets misallocated capital, mismanaged risk, created risk, and did it all at high transaction costs. It's very clear that they were involved in trying to maximize transaction costs. That's their revenues; that's their profits. Some of the innovations in risk management had the potential of enabling firms to undertake more risk than they otherwise would have by shifting the risk off to others, and that would have facilitated the growth of the real sector of our economy.

On the other hand, these derivatives are instruments for gambling: non-transparent, difficult to see what's going on. And in that case, they are increasing risk, diverting attention from the real functions of the financial markets and leading to poor performance of the economy.

Without regulation, you're going to wind up with the negative aspects of derivatives and not the positive aspects. And that's precisely what happened. So while they were a potential instrument for improving financial markets, if they are not used correctly, they are a potential -- as somebody said -- weapon of mass financial destruction. And that's what they turned out to be. …

Let me give you another example of the lack of transparency, so not transparent that the financial institutions themselves didn't know what was going on. And if they didn't know what was going on, how can ordinary investors know what's going on? How can the regulators know what's going on? How can we have a well-functioning financial system?

The financial institutions that were creating these derivatives, these gambles, they would bet this bank would go down. "I'll bet you so much, a couple billion dollars." And then they would change their mind and say, "No, no, let's cancel that bet." But rather than cancel the bet, the other party would make a bet going the other direction. So if I bet you $10 and you bet me $10, the net is zero. So that's how you got these gross numbers that were in the trillions. They said, "Don't worry; these net out." That's true, except if one thing happens: if one of the two parties goes bankrupt. If A owes B and B owes A, but A goes bankrupt, then A doesn't owe B, but B still owes A. They don't net out.

If you ask them, they would have said: "Who could believe that any of them would go bankrupt? These are the biggest companies in the world -- AIG, the biggest insurance company in the world." But then you ask, what were they betting? They were betting on the demise of each of these companies. That's what the market was. So they at the same time said it would never happen, and yet the market was bets about that it did happen. Total schizophrenia.

Joe Nocera The New York Times

Joe Nocera

The technical term for the kind of derivatives that really got us into trouble is bespoke derivatives. Bespoke means one of a kind. And these were complicated contracts that covered a particular, you know, one deal only. It couldn't be replicated. It wasn't like buying a share of IBM that is exactly the same as every other share of IBM. You bought a credit default swap; it would be built around a particular series of deals. It would have a particular set of terms. It would be one of a kind.

This is, by the way, why this stuff became so untradable. How do you trade a one-of-a-kind? There is no real market for them. It has a utility as a contract on a one-on-one basis. But there is no trading function. And that has been part of the whole problem. They don't mark to market, i.e., because there is nothing to compare it to. What's out there that you can compare this one thing to? So they mark to model. They come up with fancy, financial models every quarter. And they mark this thing to the model.

And for many years the model said they were worth more, worth more, worth more, so you mark them up. And then finally the model said: "Uh, you know what? Foreclosures are up. Subprime is down. We have got to start marking them down." You start to blow up. But even though they are blowing up, you are still stuck with them. There is nothing you can do with them. You can't trade them.

Now why would Wall Street want them mark to model? And why would Wall Street want these bespoke contracts? Well, one reason is you make more money with the bespoke contract, with a bespoke derivative. You are coming up with a one-of-a-kind. The other party can't exactly shop it around for a better price. It is almost like you had a monopoly on this thing.

So you charge more. It's a higher-margin product. It is really pretty simple, whereas when you trade a share of IBM, the broker makes pennies. And if these derivatives had been standardized and put on an exchange, they would have a, been more transparent, and b, you would have had a real market and not this fake, mark-to-model market.

So one of the big problems with the rise of credit derivatives is that Wall Street was terribly resistant to the idea of standardizing contracts and allowing them to be traded on an exchange, because it would hurt their profits.

So instead, they fought tooth and nail to keep them as over-the-counter products where nobody could see what the real price was, nobody could see what they could trade for. And nobody really understood how much of them were out there until we got to the financial crisis and it was hundreds of billions, it was trillions of dollars in notional value.

posted october 20, 2009

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