A Derivative Story

It was a tumultuous week in the financial markets. With credit spreads again widening sharply, all indications continue to point toward a serious financial system dislocation. Currency markets were also unsettled, with a major surge in the yen leaving the dollar about 4% lower for the week against the Japanese currency. In the stock market, the Dow and S&P500 ended the week down about 2%. Strong buying propelled the Transports 3% higher, as the Morgan Stanley Consumer index and the Utilities gained 2%, and the Morgan Stanley Cyclical index posted a small advance. The financial stocks were mixed as the S&P Bank index declined only 1%, while the highflying brokerage stocks came back to earth a bit with the Bloomberg Wall Street index sinking 5%. For the quarter, the AMEX security broker/dealer index gained 20%. Throughout the technology sector, selling turned serious this week. The NASDAQ100 was clipped for 6%, decreasing its gain for the quarter to 19%. The NASDAQ Telecommunications index declined 5%, the Morgan Stanley High Tech index sank 7%, and the Semiconductors 8%. Hardest hit, The Street.com Internet index slid 13%. The small caps suffered as well with the Russell 2000 shedding 6% this week. And illustrating how volatile the marketplace has become, yesterday the NASDAQ100 swung 8% between intra-day highs and lows and today it was 5%.

In a troubled week for credit market, the key 10-year dollar swap spread widened a further 11 basis points to 126. For what was an extraordinary quarter, the 10-year dollar swap surged 47 basis points. For the week, the benchmark Fannie Mae mortgage-back spread rose 14 to 193; this spread rose 57 for the quarter. For Fannie Mae's benchmark 10-year note, spreads rose 14 basis points this week and about 60 for the quarter. For Freddie Mac's 10-year note, spreads surged 17 basis points this week and 59 for the quarter. The Federal Home Loan Bank System saw spreads on its benchmark 10-year debt rise 13 basis points for the week and 45 for the quarter.

Last week's writing discussed the two critical "pegs" that have worked decisively to circumvent market mechanisms, hence stimulating historic credit excess and fostering the US financial and economic bubble. The first is the Federal Reserve's policy of pegging short-term interest rates, and second is the direct and implied government guarantees that have fostered astonishing credit growth by the government-sponsored enterprises and the financial sector generally. There is, however, a key third factor in the three-legged stool that supports the US bubble: derivatives.

Interestingly, the perception is that contemporary derivative markets, made possible with tremendous advancements in computing power and quantitative theory, have played a significant role in our current prosperity. And, actually, we cannot disagree. Greenspan himself has stated "By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives." Greenspan associates the growth in derivatives with prudent risk management: "The reason that growth has continued despite adversity, or perhaps because of it, is that these new financial instruments are an increasingly important vehicle for unbundling risk…In short, the value added of derivatives themselves derives from their ability to enhance the process of wealth creation." We, on the other hand, have always vehemently disagreed with Greenspan's derivative analysis. Instead, we view the proliferation of derivatives as part and parcel to unprecedented credit excess and speculation.

Importantly, the proliferation of derivatives has been a critical factor in the egregious credit excess that has come to promote devastating distortions and imbalances to the US financial system and economy. To help clarify our view of the maligning nature of derivative proliferation, we will resort to a bit of fiction and incorporate a flood insurance analogy.

Imagine a quaint and tranquil town near a pristine river. Throughout history, this river has been prone to the occasional dangerous flood that would completely wipe out the unfortunate homeowners within the flood zone. Demonstrating the prudence that comes from an appreciation of history, few individuals were willing to take the high risk of gambling with Mother Nature. But after several floodless years, and perhaps persuaded by stagnant profits in the property and casualty insurance business, the local insurance company, Morgan Insurance, begins offering limited flood insurance. Cautiously, this initial coverage is only for houses constructed outside of the 100-year flood plane and, as well, only at premium rates. A few of the less risk-averse residents jump at the opportunity of living along the river. Building commences on several structures, including a beautiful mansion constructed for the newly enriched insurer, Mr. Morgan. Word travels quickly that flood insurance is now available, and this fact certainly does not go unnoticed by Goldman Insurance Company.

Within days Mr. Goldman's firm offers flood insurance and, seeing extraordinary profit potential, provides for flood insurance within the 100-year flood plane. Not surprisingly, this product is quite popular and construction soon commences on a group of homes near the river, including the largest house in town, a castle built by Mr. Goldman. An economic boom takes hold throughout the community, for the homebuilders, the carpet weavers, cabinet-makers and real estate agents, not to mention the local banks absolutely ecstatic that loan growth is rising rapidly and lending profits are skyrocketing. The insurance companies also prosper mightily with flood insurance premiums soaring as new homes pop up all along the river. Soon, writing flood insurance becomes the most profitable business in town, especially after many years of drought. Mr. Morgan and Mr. Goldman, collecting enormous insurance premiums without ever facing payment for flood damage, are wealthy and, of course, revered as geniuses. Young children aspire to sell flood insurance.

Soon, insurance companies are moving in from out of town to set up shops to write flood policies. The local banks, enamored by the extraordinary profits being garnered, begin peddling flood insurance as well. An active market develops in reinsurance, as some of the writers of insurance look to shift some of their growing exposure. Even the residents who have built homes along the river catch the flood insurance bug, investing in flood insurance companies as well as dabbling in the reinsurance market, pocketing some extra cash by accepting some risk of a catastrophic flood. The price and ease of availability of flood insurance incites an unprecedented building boom along the river. All agree that flood insurance and the ability to mitigate risk is the greatest thing that has ever happened to the community. Everyone extrapolates recent wealth increases far into the future, while the local economy prospers like never before. After all, each year the houses get larger and more extravagant, and the profits from writing and trading flood insurance grow exponentially.

Each spring new building commences on more grandiose homesteads located closer to the river's bank, as the increasingly wealthy and optimistic are willing to absorb the higher premiums to be near the water. Soon, "anyone who is anyone" desires to live along the river. The greatest status belongs, of course, to those occupying the most beautiful mansions only yards away from the rushing river. With lenders ensuring that money is easy to come by, home prices near the water surge, stoking confidence as well as providing homeowners additional equity to use as collateral. The local bankers, enthralled with mounting profits from the combination of a lending and the flood insurance boom, aggressively market home equity loans in a battle against a plethora of out of town banks that had recently opened local branches. Lending margins are contracting steadily, but the exuberant lenders are happy to make it up on volume. The local BMW dealer sells new cars like never before, as does the local importer of luxury goods. It also becomes popular to purchase the initial modest homes constructed near the river, demolish the structures, and replace them with much larger residences a few feet closer to the water. Any home built more than 100 yards from the river is referred to as a "doom-and-gloomer" and is likely to be demolished.

Over time, the local economy comes to revolve around the activities of writing flood insurance, lending and financial services, home building, foreign car dealerships, retail and luxury goods and, importantly, the active trading of reinsurance contracts. And as these "new economy" enterprises flourish during the boom, the community loses interest in "old economy" businesses. With bankers and financiers allocating funding to homebuilding, financial services, and "new economy" startups, many previous stalwart "old economy" businesses wither and die. Previous successful machinists and craftsmen close down their shops, some taking sales jobs at the new malls and restaurants. Others set up digs in one of several flashy new office buildings. There they become employees of the many rapidly expanding companies that are in some manner seeking to profit from escalating prices for homes and other assets, as well as from the boom in insurance contract trading. Many quit their jobs to trade contracts in the booming flood reinsurance market. Trading becomes commonplace in the thriving community that has developed along the river.

With prosperity "as far as the eye can see," residents cheerfully borrow against rising home equity, using these funds to buy goods and services and, of course, to trade flood insurance contracts. The perception is of endless wealth, and to not play is tantamount to admitting a character flaw. A boom-time "new era" mentality grows pervasive for bankers, businessmen, the flood insurance industry and townspeople generally. Their actions seem perfectly rational, as the entire system has evolved to seductively capture the hopes and dreams of individuals throughout the community. In the past, some townspeople worried about floods, especially the older generation that lived through the Great Flood. Yet, it has been years since a major flood and with the current drought having lasted for so many years, most are now convinced that it's different this time with weather patterns having been altered permanently. The insurance companies are major media advertisers, constantly reinforcing how wonderful the drought has been and espousing continued optimism. The running joke in the upscale river bank community is about the "Chicken Littles" that remain living in "old town" and senselessly mutter, "I think there's a big storm coming, I think there's a big storm coming…"

And after years of drought, the aggressive insurance companies have come to dominate almost all financial and economic aspects of the community. They determine which industries and companies have access to capital, and they ensure that their closest friends and clients get in on the best deals. The conservative banks that in the past guarded carefully against excess were either taken over or went out of business. Some of the surviving "old community" banks, having struggled to profit in an increasingly competitive lending market, are now the largest providers of flood insurance and active traders in reinsurance contracts. Hubris runs very high, and the financial sector becomes increasingly aggressive, much to the delight of the now manic community. Not only do the insurers write unprecedented and staggering volumes of new flood policies, they also reduce the amount of reserves they hold for potential losses, choosing instead to pay themselves big salaries and build mansions on the river. All the major insurance companies now employ the presumably most brilliant weatherpersons. Virtually all, curiously, believing that there has been a permanent change in weather patterns. The faith in the "new era" takes firm hold, with nothing but blue skies ahead. After all, why worry when the most aggressive insurance companies now employ the best and brightest young mathematicians. These "rocket scientists" have developed sophisticated models and strategies that call for active buying in the re-insurance marketplace in the unlikely event of a significant change in atmospheric pressure, one that should signal the possibility of changing weather patterns.

Over the years there were a few close calls. There were scary moments when a few storms blew through town, leading to significant dislocations in the reinsurance market. As the crowd would scurry to transfer risk, a few aggressive players were caught in the crossfire and went broke. Fortunately, the storms passed quickly before the citizens of the community got wind of the near accidents. In the most serious dislocation, the market temporarily froze and the insurance trading market nearly collapsed after a devastating flood wiped out another community. However, the chief local bank and insurance regulator quickly intervened to protect the market, emboldening the insurers and townsfolk alike. And although the chief regulator assumed the close call would lead to more prudence and a tempering of the boom, soon the community was borrowing, spending and speculating like never before. But, then again, that's why they are referred to as bubbles. Importantly, over time those trading flood insurance contracts were conditioned to believe that only fools cut losses during these occasional bouts of market panic.

I will conclude this chapter of a derivative story with news of an ominous climate change recognized by only the most astute and sophisticated traders in the flood insurance marketplace. As the savvy “in the know” players begin to unwind positions, strange happenings overwhelm the insurance market. Mysteriously, the price of reinsurance rises abruptly to levels never before experienced, while, at the same time, market liquidity disappears. Interestingly, the vast majority of the speculators, having pocketed “free money” flood insurance premiums on a monthly basis for some time, remain oblivious that the game has changed. At the same time, they are bewildered by the sudden and inexplicable losses that seem to mount by the day. Yet so conditioned, the vast majority of the players are choosing to hold firm with their flood insurance contracts while taking comfort from the numerous weather forecasters ensuring only clear skies. Interestingly, the community’s leading pension trustee, astute, seasoned and conservative by nature, begins taking aggressive measures to reduce his exposure to all but the safest investments, recognizing clearly the impending credit problems for the community as a whole after years of egregious excess. At the same time, a few within the community begin to ponder who has the resources to pay for what will be massive losses come the inevitable flood.

Most unfortunately, the flood insurance and reinsurance markets have regressed to little more than a game of musical chairs. When the music finally stops, there will scant true capital or wherewithal available to satisfy the insurance obligations created in the marketplace. One thing for sure, after years of excessive risk taking and an endemic misallocation of resources, risks have grown exponentially. A flood that not many years before would have caused relatively moderate damage now holds undeniable potential for catastrophe.