Monday, July 27, 2009 4 comments ++[ CLICK TO COMMENT ]++

Opinion: Unregulated derivatives pose a grave threat to America

This was going to be a quick article referencing a story about how derivatives are concentrated in a few banks in America. Well, it turned into an opinion piece...

Once upon a time in America, there were thousands of banks and assets were distributed more widely across those banks.

Well, unlike countries like Canada, there are still thousands of banks in America but the assets are concentrated in a few major banks. My understanding is that the so-called "New York banks" had sizeable assets a hundread years ago but that pales in comparison to the present situation.

This basic history lesson, admittedly from someone who is neither a historian nor an expert on banking, is important in light of the following story.

Naked Capitalism pointed me to a story from CFO magazine about the concentration of financial derivatives in America:

Members of Congress probing threats to the global financial system — especially the threat of concentration of risk — will have a lot to ponder in newly mandated disclosures highlighted by a Fitch Ratings report issued last week. While derivatives use among U.S. companies is widespread, an "overwhelming majority of the exposure is concentrated among financial institutions," according to the rating agency's review of first-quarter financials.

Concentrated, in fact, among a mere handful of financial-services giants. About 80% of the derivative assets and liabilities carried on the balance sheets of 100 companies reviewed by Fitch were held by five banks: JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley. Those five banks also account for more than 96% of the companies' exposure to credit derivatives.

This is important because if these go down, the whole American banking system will be under threat. Even more of a concern is the following:

About 52% of the companies reviewed disclosed there were credit-risk-related contingent features in their derivative positions. Such features require a company to post collateral or settle outstanding derivative liabilities if there's a downgrade of the company's credit rating.

A mistake is a mistake, and losses will have to be borne by someone. But what separates an AIG from an Ambac—for thost familiar, both insured mortgage bonds and are sitting on potential losses of hundread of billions of dollars—is that AIG had to post collateral upon rating downgrades. The fact that some 50% of the reviewed companies say they would have to do this is kind of worrisome. However, it's not clear what percentage of their derivatives transactions require this and I'm not sure how many of them are banks.

Concentration You Say?

I always knew that nearly all the derivatives in America were written by a few banks (recall how in the Turtle Awards post I said Jamie Diamond is one of the top executives in America but given how JP Morgan has the highest nominal exposure to derivatives, it's too soon to say how good he is.) Although I don't have details about the 100 companies reviewed by Fitch (i.e. I don't know if they are leaving out key players), I'm surprised that 80% lies with 5 banks.

I am not too knowledgeable about derivatives and I may be perceiving the risk to be greater than it is, but I just wonder. A lot of the derivatives seem to be pertain to interest rates, and such derivatives are thought to be safe. But then again, soverign bonds were thought to be safe 10 years ago until LTCM found out the hard way; and pooled mortgage bonds were thought to be safe, until everyone owning them started blowing up two years ago.

We Can't Rely On the Zero-Sum View

The good thing about derivatives is that it is a zero-sum game. So if one bank falters, another profits so the net effect is zero. However, there are two issues to consider.

One is counterparty risk. If someone is unable to pay up, the so-called hedges that banks keep referring to, will dissapear instantly. Similar to how most hedge funds don't hedge, the banks will be shown to have no hedges. What one perceived as safe may not be so. When the monolines, as well as multi-line insurers like AIG, blew up, the banks, who relied on them for hedging, soon discovered they didn't have any hedges and were fully exposed. So, the theoretically zero-sum nature of derivatives may turn out to be false.

Secondly, regulators and the government may be unable to cushion any blows. The numbers may simply be beyond the ability of even the largest economy in the world. Furthermore, if profit from the derivatives keep flowing overseas, the public may force the politicians and the central bankers to avoid doing anything. For instance, some Americans are unhappy that hundreads of billions that were used to cushion the blow from AIG, flowed directly to foreign interests (mostly banks in Europe.) From a global point of view, what the American government is doing is good (it minimizes systematic risk). But from an American taxpayer's point of view, it is questionable.

Are Derivatives Modern Day Bucket-Shops?

I don't always agree with Charlie Munger—he's right-leaning and I'm left-leaning—but I think he may be onto something in suggesting that derivatives may be the modern-day bucket shops. Writing for the Washington Post early this year, Munger had this to say:

But the new trading in derivative contracts involving corporate bonds took the prize. This system, in which completely unrelated entities bet trillions with virtually no regulation, created two things: a gambling facility that mimicked the 1920s "bucket shops" wherein bookie-customer types could bet on security prices, instead of horse races, with almost no one owning any securities, and, second, a large group of entities that had an intense desire that certain companies should fail. Croupier types pushed this system, assisted by academics who should have known better. Unfortunately, they convinced regulators that denizens of our financial system would use the new speculative opportunities without causing more harm than benefit.

I never even knew what a bucket shop was until I read his piece several months ago. Even after reading up on it, I thought it was a radical view to be comparing derivatives to bucket shops. Certainly the whole banking establishment, which is dominated by the big banks, incidentally the ones mentioned above who are exposed to all these derivatives, would disagree with him (tens of thousands of employees working in this area will also lose their jobs if government cracks down.) As Munger mentions in his opinion piece, even academia seems to be against his views. But I suspect that the academics are falling by the wayside just like how the notion popularized by Alan Greenspan that derivatives diversify risk—this view was widely supported by Academica, especially the pure free-market supporters of the Chicago school followers—is sounding dumber by the day.

From my amateur investor vantage, many derivatives do seem like the bucket shop bets of the early 1900's. For instance, just like the bucket shops, you are placing bets on derivative outcomes with no underlying link to the asset and, most importantly, without it passing through any exchange or being recorded anywhere (I don't work in the industry or anything but it seems there are some services that try to provide pricing information for transactions, like Markit*, but it is not clear to me if transactions need to be reported to them or if it can be kept hidden. There are also derivative associations who attempt to oversee the players.) Furthermore, as this Wikipedia entry says of the bucket shops of the early 1900's (quoted below), I wonder if similar manipulation does not occur on a large scale right now:

The terms of trade were different for each bucket shop, but bucket shops typically catered to customers who traded on thin margins, even as low as 1%. Most bucket shops refused to make margin calls, so that if the stock price fell even momentarily to the limit of the client's margin, the client would lose his entire investment.

The highly leveraged use of margins theoretically gave the speculators equally large upside potential. However, if a bucket shop held a large position on a stock, it might sell the stock on the real stock exchange, causing the price on the ticker tape to momentarily move down enough to wipe out its client's margins, and the bucket shop could take 100% of their investments.

It's not clear to me if the banks, who definitely have the firepower equivalent to the bucket shop operators, can manipulate the underlying asset to wipe out the opposing derivative participants.

Having said all that, there is one thing that may make the derivative situation different from the bucket shops of the early 1900's. The bucket shop participants were small investors who were not knowledgeable and seem like pure speculators. In contrast, the participants in the derivatives world are thought to be sophisticated, and at a minimum, educated, participants of the market. There is no doubt that some traders working at banks or hedge funds are pure speculators. However, most will be knowledgeable about what they are doing. In a free market, participants will only act in their interest. So, perhaps, the situation isn't as devious and disastrous as the bucket shops. Even if banks on one side of a derivative contract are manipulating everything in sight, the participant on the other side may not participate or price the contract as needed. So, there is a possibility that derivatives may be better than the bucket shops that they seem to resemble.

Derivatives Are a Great Threat

Overall, derivatives may pose a great threat to America. It's a difficult problem for America because the top banks are very influential and they employ tens of thousands in the affected areas. I feel that something will have to happen. As you saw above, it's crazy to have 80% of the risk tied up in 5 banks. This wouldn't be so bad if these were some no-name investment banks no one cared about but, unfortunately, they also hold most of the citizen deposits. Hopefully society does something proactive before an actual crisis. So far, my impression is that the US government has strong-armed the derivative bodies into agreeing to list derivatives on exchanges. We'll see what happens after that.

(* I also wonder about the legitimacy of Markit, which I understand is owned by the major players in the derivatives world. To see how ridiculous this is, imagine you were betting on something in a bucket shop and the outcomes are published by the bucket shop operators. I believe there are some indepedent competitors but I'm not sure if a similar conflict of interest exists there.)

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4 Response to Opinion: Unregulated derivatives pose a grave threat to America

Daniel M. Ryan
July 28, 2009 at 1:57 AM

Actually, there have been scares of that sort long before derivatives even existed in their present form. The first potential-banking-collapse scare in postwar America was in 1970. They've become recurrent since then.

I don't think it'll end until the whole system collapses. There's too much moral hazard associated with the Fed's successful reflation efforts.

Now that you've looked up "bucket shop," I suggest you look at "one-horse shay." Your eyes may be opened further.

Sivaram Velauthapillai
July 28, 2009 at 2:11 PM


Can you explain the one-horse shay? That wikipedia entry doesn't seem to say much that seems questionable. The example given of an asset that provides some productive use and then has a terminal value of zero doesn't seem like an illegal or questionable asset like bucket shops. I don't understand... *DONT_KNOW*

Daniel M. Ryan
July 28, 2009 at 7:21 PM

The one-hoss shay symbolizes any system that supposedly is well-designed, because it doesn't need any major overhaul, but ends up collapsing in its entirety because the need for any overhaul was hidden or papered over. 

Sivaram Velauthapillai
July 30, 2009 at 11:06 AM

Forgot to thank you for the explanation... I have to look into it deeper :p

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