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Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works
— Mr John Mills, an article read before the Manchester Statistical Society, December 11, 1867
A trillion here, a trillion there and pretty soon you’re talking real money
—paraphrase of a quote attributed to Senator Everett Dirksen
Should we save General Motors? Let me rephrase that. Suppose we must choose between salvaging American International Group (AIG) or General Motors (GM) but we can’t save both. Put that way, there is no choice—clearly we must save the automakers, though not in their present form. I am going to take the long way around through the global derivatives market to explain how our priorities got so out of whack. This is a follow-up to last week’s analysis No, We Can’t?
How does the scorecard read so far?
So far the auto industry — GM and Chrysler — have received $17.4 billion in U.S. funds after much gnashing of congressional teeth. Meanwhile, American International Group snapped its fingers and over the weekend some Treasury officials gave it another $30 billion — bringing its total to $180 billion. But thanks to the worst February in 27 years, the auto industry is going to catch up fast.
Last week I argued that the undue political influence of FIRE economy promoters like Larry Summer is responsible for the tragic misallocation of capital toward insolvent banks. Nouriel Roubini provides strong support for this point of view.
News and banks analysts’ reports suggested that Goldman Sachs got about $25 billion of the government bailout of AIG and that Merrill Lynch was the second largest benefactor of the government largesse. These are educated guesses, as the government is hiding the counter-party benefactors of the AIG bailout. (Maybe Bloomberg should sue the Fed and Treasury again to have them disclose this information.)
But some things are known: Goldman’s Lloyd Blankfein was the only CEO of a Wall Street firm who was present at the New York Fed meeting when the AIG bailout was discussed. So let us not kid each other: The $162 billion bailout of AIG is a nontransparent, opaque and shady bailout of the AIG counter-parties: Goldman Sachs, Merrill Lynch and other domestic and foreign financial institutions.
Summers, who is Obama’s top economic adviser, helped create the preconditions for the financial crisis.
During his tenure as Treasury Secretary [under Bill Clinton], Summers oversaw the repeal of the Glass-Steagall act, which prevented commercial banks from investing depositors’ funds in risky derivatives. He also advocated deregulation of derivative trading. Many experts blame the repeal of this act and deregulation for the banking credit crisis and resultant recession.
Derivatives. These are the magic contracts that allowed your local bank—mine was National City—to get into big, big trouble. How does this relate to bailing out GM? It’s pretty obvious when you think about it: the auto companies have the potential to make things that can be helpful in changing our energy future whereas banks deemed too big to fail, as currently structured, do not.
Hopelessly Unproductive Works
Wikipedia provides a satisfactory definition of derivatives.
Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) — see inflation derivatives), or other items (e.g., weather conditions, or other derivatives). Credit derivatives are based on loans, bonds or other forms of credit. The main types of derivatives are forwards, futures, options, and swaps.
Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.
Keep in mind the distinction between hedging and speculation. I give you Figure 1.
Figure 1 — from the Office of the Comptroller of the Currency (OCC) Quarterly Report on Bank Trading and Derivatives Activities as of Q3, 2008. The dotted line is estimated total U.S. output in this quarter. Total notional value of all derivatives contracts is $175,842,000,000,000. Interest-rate swaps account for 78% of derivatives contracts.
The OCC tells us that “derivatives activity in the U.S. banking system is dominated by a small group of large financial institutions. Five large commercial banks represent 97% of the total industry notional amount and 87% of industry net current credit exposure.” The five banks in question are JP Morgan Chase, Bank of America, Citibank, Wachovia and HSBC. Wachovia is now defunct, having been acquired by Wells Fargo, which is now writing down acquired losses. Parts of Glass-Steagall were repealed in late 1999. Credit derivatives (notional value) increased from $287 billion at that time to $15.861 trillion in the Q3, 2008 according to the data in Figure 1.
Global totals for derivatives contracts are much higher. Official statistics come from the Bank for International Settlements, whose last report was for Q2, 2008. Slate cites an astronomical number for October, 2008 in $596 Trillion! Slate asks how can the derivatives market be worth more than world’s total financial assets? The answer hinges on the distinction between notional and market value.
… financial experts have to make an educated guess about the total amount at stake in all these contracts. One method simply adds up the value of the assets the derivatives are based on. In other words, if my contract allows me to buy 50 barrels of oil and the current price is $100, its “notional value” is said to be $5,000—since that’s the value of the assets from which my contract derives. If you make that same calculation for every derivative and add those numbers together, you get something around $596 trillion—the “notional value” of the world’s over-the-counter derivatives at the end of 2007, according to the Bank of International Settlements. (“Over the counter” derivatives refer to contracts that are negotiated between two parties rather than through an exchange)…
An alternative way to measure the size of the derivatives market is to calculate the instruments’ market value—which refers to how much they would be worth if the contracts had to be settled today. Gross market value of all outstanding derivatives was $14.5 trillion at the end of 2007, less than one-fortieth of the $596 trillion estimate.
The numbers become less scary when interest-rate swaps are removed, as Newsweek explains in $600,000,000,000,000?
Above all, derivatives fill a need, and most are not explosive. Of the $668 trillion, most are interest-rate swaps, which, at the end of 2007, had a total notional value of $393 trillion (and a market value of $7.2 trillion). These are relatively plain-vanilla hedges against changes in interest rates, which will force a crisis only in the event of highly unlikely spikes in interest rates or inflation, experts say.
Don’t you love it when experts say? If I had a dime for every misstatement by an “expert” analyzing the long-term oil markets, I would be a very rich man. The level of danger for interest-rate swaps depends on what “highly unlikely” means. Interest rates and inflation move gradually, but I wonder what would happen to the CPI if a war or nuclear terrorist attack closed the Strait of Hormuz for 3 months.
Wall Street quants had models that proved beyond a shadow of a doubt that the meltdown in the credit markets last September was highly unlikely. Still, let’s accept a reduced risk for using derivatives as hedges. The problem with quants was they did not—could not?—distinguish between hedging, which is a form of insurance, and gambling, which involves a game of chance.
If you accept the reassuring caveats provided by Slate or Newsweek, all the gambling takes place within credit derivatives. According to the OCC, an astonishing 99% of all credit derivatives are credit-default swaps, the very sort of financial instrument that took down AIG and threatens the Big Five banks listed above. Here are some experts getting it wrong in Newsweek.
At their core, derivatives are “insurance products,” says Columbia professor Emanuel Derman, one of Wall Street’s original quants. “You pay a premium and you get protection.” Despite this year’s setbacks, says Derman, the market for exotic derivatives, including credit default swaps, is destined to grow. “There really isn’t any alternative,” says Stephen Figlewski, a professor of finance at NYU’s Stern School of Business and founding editor of the Journal of Derivatives. In a few years’ time, derivatives could become a quadrillion-dollar market.
[1 quadrillion = 1,000,000,000,000,000. The world consumed 462 quadrillion BTUs in 2005. It is possible to replace a large percentage of those BTUs (in the U.S.) with clean, efficient carbon-free energy in 10 years according to Al Gore. Alternatively, if we assume the Universe is 13.7 billion years old, some 432 quadrillion seconds have passed since Time & Space began.]
Let us hope the self-interested Figlewski is very wrong is his prediction. Derman’s mistake is thinking that all derivatives are the same as life insurance. They are and they are not, but mostly not. Legendary investor Harry M. Markowitz could tell Derman a thing or two—
Presumably, credit default swaps are called “swaps” rather than “insurance” to avoid the level of reserves required by regulators to back insurance policies. But CDS are insurance and, in fact, should require greater reserves than does life insurance. Deaths are fairly uncorrelated events, but business risks are usually correlated. If Ford Motor Company does badly, General Motors Corporation probably will too, as will their dealers and suppliers. When risks are uncorrelated, sufficient diversification drives volatility toward zero. When risks are correlated, no amount of diversification will eliminate risk. A substantial amount of risk remains even in a broadly diversified portfolio of correlated risks.
Risks had a higher level of correlation than Mr. Markowitz suggests. Credit default swaps were taken out on mortgage-backed securities whose value depended on a never-ending bubble in the Housing market. Prices for overvalued houses eventually collapsed, as they always do in a bubble.
To really see how capital has been destroyed by its betrayal into hopelessly unproductive works by the FIRE economy, we must consult Richard R. Zabel, a forensic CPA with Robins, Kaplan, Miller & Ciresi L.L.P. And before I quote his priceless document Credit Default Swaps: From Protection to Speculation, I would like to note for the record that Zabel is “merely” a forensic accountant, which engenders in me a certain amount of trust. He is not Henry Paulson, formerly of Goldman Sachs, or Ben Bernanke, who required a refresher course on derivatives in August, 2007. He is not a self-interested party like former Lehman Brothers CEO Richard Fuld or current Citi CEO Vikram Pandit. He does not work for Barack Obama.
I can not quote Zabel’s entire article as I would like, so please follow the link above to get more information.
Credit Default Swaps (CDS) are a private contract between two parties in which the buyer of protection agrees to pay premiums to a seller of protection over a set period of time, the most common period being five years. In return, the seller of protection agrees to pay the buyer an amount of loss created by a “credit event” related to an underlying credit asset (loan or bond) – the most common events are bankruptcy, restructuring or default. Each individual contract lays out the specific terms of their agreement including identifying the underlying asset (loan or bond) and what constitutes a credit event.
Even though CDS appear to be similar to insurance, it is not a form of insurance. Rather it is an investment (more akin to an option) that “bets” on whether a “credit event” will or will not occur. CDS do not have the same form of underwriting and actuarial analysis as a typical insurance product; rather [it] is based on an analysis of the financial strength of the entity issuing the underlying credit asset (loan or bond). There are no regulatory capital requirements for the seller of protection (such as exists with insurance companies and banks).
Credit Default Swaps (CDS) were originally created in the mid-1990s as a means to transfer credit exposure for commercial loans and to free up regulatory capital in commercial banks. By entering into CDS, a commercial bank shifted the risk of default to a third-party and this shifted risk did not count against their regulatory capital requirements. In the late 1990s, CDS were starting to be sold for corporate bonds and municipal bonds. By 2000, the CDS market was approximately $900 billion [globally] and was viewed as, and working in, a reliable manner…
However, in the early 2000s, the CDS market changed in three substantive manners:
- Numerous new parties became involved in the CDS market through the development of a secondary market for both the sellers of protection and the buyers of protection. Therefore, it became difficult to determine the financial strength of the sellers of protection
- CDS were starting to be issued for Structured Investment Vehicles, for example, ABS, MBS, CDO and SIVs. These investments no longer had a known entity to follow to determine the strength of a particular loan or bond (as in the case of commercial loans, corporate bonds or municipal bonds.); and
- Speculation became rampant in the market such that sellers and buyer of CDS were no longer owners of the underlying asset (bond or loan), but were just “betting” on the possibility of a credit event of a specific asset.
The underlying, the original loan or bond for which CDS protection was sought, which might have served some useful purpose on Main Street, had been forgotten on Wall Street. A gambling frenzy ensued. Bankers bet that the Housing Bubble would never end.
And there you have it, the Brave New World of 2009. What Zabel does not emphasize is that bets on the possibility of highly correlated credit events were also highly leveraged—10:1, 20:1, or even 40:1. We’ve all seen a movie where a guy places a bet on a basketball game, he’s getting 9 points, it’s a can’t-miss lock, he can’t lose. He makes a $10,000 bet but he’s only got a ten-spot. An impossible basketball event occurs, he loses, he can’t pay up, he’s on the run, and the bookies send the heavies around to “collect” what he owes. It was Wall Street making these irresponsible bets in the real world. Unlike in our movie, Wall Street has two rich uncles named Mr. Treasury and Mr. Central Bank to bail him out.
Investing In Productive Works
So should we salvage AIG? And Citi and other banks? Or should we save General Motors? My assumption is that we can’t save everybody who needs saving. Otherwise 1) the Fed will have to print so much money that you’ll need to carry $5000 to the store to buy a loaf of bread; or 2) the Treasury will create deficits so large over and above our entitlements debt—assuming the Chinese, Japanese, and Saudis continue to buy that debt—that your great-great-great grandchildren will still not be able to pay it off.
General Motors, as incompetent and unethical as their leadership has been, actually manufactures things of value, or at least they could. I’m not talking about the clowns who introduced the Hummer, although people are still buying them. And I’m not talking about manufacturing in general, which does not make the crucial distinction shown in Figure 2.
Figure 2 — Two manufactured items. On the left we have a granite counter-top, which beautifies the home (which is often a McMansion miles from nowhere). On the right we have a prototype of the Chevy Volt, a plug-in electric hybrid vehicle which potentially lessens our dependence on oil.
Capital expenditures put toward manufacturing Chevy Volts is an investment in productive works, as opposed to spending money on making granite counter-tops or, God Forbid, issuing credit default swaps. This is such a simple point that I am almost embarrassed to make it.
I say “almost” because there is now so much confusion in a world that has been dominated by Finance, Insurance, and Real Estate for the last 30 years that few seem able to grasp the crucial distinction between a mortgage-backed collateralized debt obligation and a fuel-efficient battery-driven car.
Worst yet, economic theories of value provide no help. These basically amount to “give the people what they want” where value is reduced to price, e.g. “in neoclassical economics, the value of an object or service is often seen as nothing but the price it would bring in an open and competitive market.” We can no longer afford to live in a society that knows the price of everything and the value of nothing.
If you tell people what they should want over and over again, that is what they will want. All we’ve made for 30 years is gas-guzzling cars & trucks, houses, shopping malls, and roads to hook them all up. That’s what people were told mattered. Look where that got us.
Let’s end where we started. It was the London Banker who quoted Mr. John Mills on “unproductive works” at the top. He expressed his misgivings last July.
I have been both a central banker and a market regulator. I now find myself questioning whether my early career, largely devoted to liberalizing and deregulating banking and financial markets, was misguided. In short, I wonder whether I contributed – along with a countless others in regulation, banking, academia and politics – to a great misallocation of capital, distortion of markets and the impairment of the real economy. We permitted the banks to betray capital into “hopelessly unproductive works”, promoting their efforts with monetary laxity, regulatory forbearance and government tax incentives that marginalized investment in “productive works”. We permitted markets to become so fragmented by off-exchange trading and derivatives that they no longer perform the economically critical functions of capital/resource allocation and price discovery efficiently or transparently. The results have been serial bubbles – debt-financed speculative frenzy in real estate, investments and commodities.
Although plug-in electric hybrids are a weak measure for reducing our oil consumption over the next decade, they form one wedge in an array of programs that must be implemented. Thus a domestically made Chevy Volt is among the “productive works” we require to reverse 30 years of financial engineering that created a credit/debt bubble and exorbitant bonuses on Wall Street. Through a bankruptcy and restructuring, we must save General Motors.
Contact the author at dave.aspo@gmail.com