Lessons derived derivatively

With the prospect, though not inevitability, of another Greatish Depression upon us, some are trying to write of the lessons to be learnt from recent events.

The ever-analytical Brits, for instance, at FT.com have this commentary bylined as analysis:

Washington’s waning way: how bail-outs poison a free market recipe for the world

Reluctant liberalisers around the world now have a great deal more ammunition when faced with American visitors saying: “We’re from Wall Street and we’re here to help.”

A model of freewheeling finance the US has pushed around the world, which had already undergone some tactical withdrawals over the past decade, appears in headlong retreat.

That package may have started with advocating lower import tariffs on goods, a policy which commands relatively wide support among orthodox economists. But it has expanded to include more controversial strategies: allowing foreign institutions to buy local banks or set up their own subsidiaries, deregulating domestic financial markets and ending controls on cross-border capital movements.

Jagdish Bhagwati of Columbia University, a leading trade economist, has long warned that this is a dangerous confusion of liberalised financial markets, which are subject to repeated bubbles, panics and crashes, and the international movement of goods and services, which is not. Yet in practical terms the two have often been bundled. Washington has sought, for example, to export its own financial model through its trade deals.

This, Mr Bhagwati says, is the result of a “Treasury-Wall Street nexus” that has an irrevocable attachment to deregulation. “Wall Street tries to exert pressure on US policy in a big way wherever possible,” he says. “It is an ideological commitment. You are made to feel like a socialist freak if you argue against any part of it.”

Yet such liberalisation often still forms an important part of Washington’s international economic diplomacy, embedded as it is in its trade policy. US financial services companies have traditionally been among the more enthusiastic lobbyists for trade deals.

Yes, there is anger in Berlin and Paris at Washington’s refusal – up until after the outbreak of the subprime crisis – to heed European calls for more regulated markets.

“We must civilise financial markets, and not just through moral appeals against excess and speculation.”

Nicolas Sarkozy, the French president, said the world would have to learn the lessons of the financial crisis and rethink the values and practices of globalisation. This would mean shifting the emphasis from speculation to entrepreneurship and restoring a proper balance between the market and the state.

“The market economy is a regulated market, a market that is at the service of development, at the service of society, at the service of all. It is not the law of the jungle,” he said, predicting the end of laisser faire capitalism.

“The lesson is not that there were too many innovations in the US and so we should not innovate at all ... It is wrong to say that all these sophisticated products are just bad things,” says Fang Xinghai, director general of Shanghai’s Financial Services Office. “If we learn the lessons [of the crisis] we may even speed up financial reforms because we will know the kind of precautions we will need.”

Problem is, these "lessons" were already part of the syllabus. It's just that the rowdy boys on Wall Street didn't come in from recess and only attended the rocket science 101 classes, failing to show up for the afternoon session on how not to blow yourself up.

You'd think they'd been to a jihadist madras rather than a business school and never made it past the suicide belt tailoring class.

At the pleasurable risk of saying "I told you so", the writing of these lessons was written on the chalk boards years ago. For instance:

March 16, 2006

Say you're in your garage of a Saturday night, sitting around the card table with your mates, knocking back a few tinnies and playing a bit of cards. Most of the bets are done with coins.

When in walks a very savvy looking kinda bloke, with a big wad of notes and wants in. Do you reckon it would change the character of the game? You betcha it would.

In ways I cannot put together in a coherent, scholarly study, I have noticed a distinct change in the character of the equity markets over the last decade. It is becoming dominated by big, lightning quick money. Oh, the Big Boys have always had a major impact, and in that regard there is nothing new. They've always enjoyed their power to push the market this way or that. They've always enjoyed a clubiness that allowed for information to be shared in ways that didn't quite pass the "insider trading" bright lines. But they usually bought stuff to own it, to manage it, to work it, to put it in thieir trophy room.

But these new guys are not just big bullies; they're bold, cold Matrix-like machines. Just listen to CNBC at the number of times they mention how dominant block trading has become. Do you remember the term "hedge fund" being common parlance more than a decade ago? What about "black box" trading?

A black box is not some fatcat in a pin-striped suit and a big cigar. It is a streak of cyberdata, a stateless, motherless virus hellbent to ambush, arbitrage and retreat faster than a ninja.

And they are everywhere, in to everything. Their bytes permeate every conceivable market, like a monstrous whale seiving the nutirients and little, bottom-of-the-food-chain investors and small players from the oceans of cash that trade the world's goods.

They derive their gains from diverse derivatives of incalculable numbers and varieties, trading the shadows of what used to be a currency or a commodity or a stock or a bond, but now come under the most obtuse and arcane of names that only financial rocket scientists can understand. Their trade is in ideas and concepts and notions and algorithms, not things and companies.

And, importantly, these new guys push around greater wads of money than the old fashioned pin-striped broker because they don't have to use as much (if any) of their own money, and the "products" they deal in control vastly greater amounts of the "real" underlying stuff than that stuff would cost in its own markets.

May 08, 2006

Mr. Li is a Stanford professor widely credited with developing a computerized model that helped turn credit derivatives into the fastest-growing segment of a $270 trillion global market. Ms. El Karoui is a French mathematics professor whose courses have become, as the Journal noted, "an incubator for experts in the field."

Both have warned that some of those who buy and sell these complex instruments don't fully understand the risks involved. Instead of reducing their exposure to unwanted perils, they may well be adding to it.

Making matters more difficult, however, is the fact that the value of certain complex varieties, such as options, asset-backed securities, and credit-default swaps, depends on many inputs. That often necessitates the use of complicated formulas and high-powered computers, especially when portfolios of derivatives are involved.

Yet the mathematical certitude this conveys is misplaced. In truth, pricing often depends on fickle or otherwise fast-changing financial relationships, less-than-adequate histories of how certain markets will perform under a wide range of scenarios and guesstimates about how volatile conditions will be in future.

That means a major financial institution with significant derivative exposure could easily find itself hit with a very expensive and potentially destabilizing loss if even one of its assumptions is wrong

A lack of transparency and inadequate regulation, particularly where OTC derivatives are concerned, make it difficult to identify where the dangers lie. Historically, banks, Wall Street firms and hedge funds have been left to their own devices, on the assumption they were sophisticated operators who would act appropriately.

The fear is not derivatives, but the misuse of derivatives via too much leverage.

The take-away here, from my point of view, is that someone's misuse of the product, which is likely to happen, has a very low probability of triggering a widespread meltdown.

the notional value of derivatives outstanding is approaching the $300 trillion mark.

[Guambat here notes, for those who think the current demand for $0.7 trillion dollars to be used by the US Treasury to "stabilize" the US financial system may be way, way too much, might consider the possibility that it is way, way too little.]

At the same time, risk has become more concentrated with respect to firms, markets and "events." In 1997, for example, the 10 largest banks controlled less than 34% of industry assets; by 2005, it was 44%. At the end of last year, the top five banks accounted for more than 96% of outstanding derivatives contracts versus 83% in 1998. And reportedly, there are more than $200 billion of credit default swaps riding on the financial health of General Motors alone.

Moreover, increasing sophistication and an aggressive hunt for higher returns have spurred hedge funds and proprietary trading desks to exploit a growing array of intermarket arbitrage opportunities, which frequently depend on derivatives to circumvent structural and operational hurdles.

More important, perhaps, is the fact that despite their differences, the one thing many synthetic securities have in common, as Roger seems to have alluded to earlier, is an inherent leverage component. In that respect, he may have made a more salient point. Maybe derivatives won't be the trigger for financial disaster. Maybe they represent just one small part of a far greater threat: too much debt.

Now that is a problem that has led to financial Armageddon--again and again throughout history.

May 03, 2006

COPPER users have threatened to turn their backs on the London Metal Exchange, alleging hedge funds are driving copper prices to speculative extremes that no longer reflect supply and demand.

In a letter to the LME and the Financial Services Authority, the International Wrought Copper Council said that its members faced severe difficulties financing deliveries.

"This market, where speculators can buy what does not exist, is doing serious damage to our industry

"This is a feeding frenzy driven by hedge fund speculation. This would not be happening if the price was left purely to industrial supply and demand.

May 08, 2006

excess begets more excess. It is not momentum anymore; it is a game of chicken.

Commenting on the commodities market in general, Buffett said: "What the wise man does at beginning, the fool does in the end... any asset that has a big move based on fundamentals will attract speculators..."

"At the start of the party, the punch is flowing, everything's going well, but you know at midnight it's all going to turn into pumpkins and mice," he said.

"The problem is that, in commodities there are no clocks on the wall," he added. Buffett said Berkshire didn't make any money on his silver investment because he "bought it very early and sold it very early. Other than that, everything I did was perfect."