Critical Mass: The Mispricing of Derivatives Risk And How the Financial World Ends

Jim Sinclair does a good job of explaining the difference between the notional and real value of derivatives, and how that real value comes to bear on the financial system in the event of a default. You can read this here for a review of the basic concept if you do not understand it.

Within my own view of money, uncollateralized financial instruments like derivatives are credits, or potential money. When an event triggers them so that they become real, with a significant presence on the balance sheet and the income statement, then they become money.

In the financial world we see the extraordinary growth of derivatives in notional value, to almost unbelievable proportions. This mass of derivatives facilitates the withdrawal of money from the real economy in the form of wealth transferal, such as bonuses and commissions for example. But they do not become actual money themselves until some trigger event. To perhaps stretch our analogy to the physical world, it could be described as the withdrawal of the ocean, as money is siphoned from the real economy by the financial world, in advance of the arrival of a tsunami as derivatives start hitting the balance sheets and are transformed into ‘real money.’

This could be the cause of a hyperinflationary policy error which I have been alluding to for the past several years.  The policy error is not in the simple setting interest rates, but the Fed’s failure to regulate the banking system and manage its risks.   In this the Fed, particularly under Greenspan, was an abysmal failure, and improvement has not been forthcoming.

The explosion of the realization of derivatives would create enormous fortunes and unpayable debts. Depending on how the monetary authorities deal with it, the potential for a Weimer experience is there. Nationalizing the banks and canceling the transactions is one way out. Attempting to sustain these mythical financial structures will take the existing currency system down. That is the limit of the Fed’s power.

Most theories and models are tested at the extremes of their limits, and I suggest that the coming financial crisis will wash many of the current economic and monetary models away, scouring the detritus of years of conflicting interests and fanciful adornments down to their foundations.   But the responsible parties will all sit back and say, “We did not know.”    But of course they did.  They just did not care, as long as it paid them handsomely.

Taking this discussion of derivatives an important step further, the most significant elements of concern in derivatives are the same as they are in all financial schemes: unsustainable leverage and the mispricing of risk.

In derivatives the unsustainable leverage arises from the fact that the impact or risk magnitude of the derivatives, which are often uncollateralized, are artificially reduced by the assumed effects of ‘netting.’ And the risk is mispriced, not only in the terms of the agreement itself, but in the failure to properly account for counterparty risk as the instrument plays out in a larger risk portfolio. There is individual contract risk, and then there is the cascading risk of a highly compacted financial system.

We see situations today in which a single bank may have a hundred or more trillion dollars of notional value in derivatives on their books, against much less than a trillion in assets.

But the risk in such a large position is allowed because the banks can show that they have supposedly ‘netted out’ the risk by making other derivative arrangements that offset their own risk, in the manner of a hedge. As the amounts of derivative netting grows larger and more intertwining, the secondary effects of counterparty risk become tightly compressed.

What if a counterparty fails? Then all its own agreements fail, many of which may be hedges that also fail, and a cascading failure of these financial instruments in a tightly compressed and overleveraged system becomes catastrophic.

In 2002 Warren Buffett famously referred to derivatives as ‘financial weapons of mass destruction.’ But beyond that headline, few in the media took the time to actually communicate what Buffett was really saying, and the risks that the unregulated derivatives markets posed to the banking system.

The collapse of Lehman Brothers threatened to trigger a financial meltdown. A panicked leadership of the country was able to stop it, but at the cost of many trillions of dollars, and a distortion in the real economy that still goes largely unmeasured. And this was by intent, because the leaders feared a loss of confidence in the system. And so while the meltdown was averted, a credibility trap was created that is the epitome of moral hazard.

The influence and knowledge, call it soft blackmail of mutually assured destruction if you will, that the ‘Too Big To Fail’ banks obtained in this coverup of the depths of the fraud and mispricing of risk in the financial system has given them enormous power over the political process. It would have been more effective to have nationalized the banks and cut the risk out at the source, but the new president Obama was badly advised to say the least, by advisors he himself appointed, who were in fact long time insiders in the creation of the risk situation itself.

The global financial system is like a nuclear bomb. At its center are at most ten banks whose financial posture is overleveraged and interdependent not only amongst themselves but also with their national economies. It is not a question of ‘if’ they fail, but ‘when,’ and what is done about it.

The bailouts become geometrically larger given the size and interwoven complexity of the bets. The only feasible solution is to nationalize the banks, keep the real parts of the economy whole, and restart the system in a more sustainable manner. This is essentially what Franklin Roosevelt did in 1933, and to a more limited extent what J.P. Morgan did with the NY banks in 1907. In both instances they dictated terms and made the banks sign to preserve the system.

In the case of the 2008-9 crisis, Bush-Obama failed to dictate terms, and essentially allowed the banks to do whatever they wished to keep going without reforming the system, taking huge sums of money and paying off their bets while maintaining their bonuses and most of their positions. And this was a monumental political failure indeed, and history will probably not be kind.

When the next crisis occurs, there are still a variety of responses. The monied interests will wish to promote another bailout, with harsh terms being dictated to the public, rather than to the banks. This is what is happening in Greece. The terms will be so draconian and unsustainable that state fascism is the most likely longer term outcome. Germany is struggling with that decision today, in light of  bad results in their last two experiences along those lines.

I am not hopeful that the leaders of the political world will have the resolve to do what it takes to bring the banks back under control, given the power that big money has obtained over our worldly leaders.
Following are edited excerpts from the Berkshire Hathaway annual report for 2002.

I view derivatives as time bombs, both for the parties that deal in them and the economic system.

Basically these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. For example, if you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction, with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration, running sometimes to 20 or more years, and their value is often tied to several variables.

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counter-parties to them.

But before a contract is settled, the counter-parties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands. Reported earnings on derivatives are often wildly overstated. That’s because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

The errors usually reflect the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid, in whole or part, on “earnings” calculated by mark-to-market accounting. But often there is no real market, and “mark-to-model” is utilized. This substitution can bring on large-scale mischief.

As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counter-parties to use fanciful assumptions. The two parties to the contract might well use differing models allowing both to show substantial profits for many years.

In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counter-parties. Imagine then that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company.

The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counter-parties tend to build up over time. A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. However under certain circumstances, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z.

In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. (Such as in the case of AIG for example – Jesse) In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.

Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. (This is the Greenspan argument for example, but he and others went further in fighting any sort of regulation in this area. – Jesse)

On a micro level, what they say is often true. I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.

On top of that, these dealers are owed huge amounts by non-dealer counter-parties. Some of these counter-parties, are linked in ways that could cause them to run into a problem because of a single event, such as the implosion of the telecom industry. Linkage, when it suddenly surfaces, can trigger serious systemic problems.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so  far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

As an endnote, it appears that the money in derivatives was too good for even Mr. Warren Buffett to pass up. Berkshire Profit Falls 30% On Insurance, Derivatives.

Here is a fairly simple financial industry explanation of ‘netting.’

“Rather than execute a disastrously complicated web of transactions, swap dealers, and ordinary banks, use clearing houses to do exactly what we just did above, but on a gigantic scale. Obviously, this is done by an algorithm, and not by hand. Banks, and swap dealers, prefer to strip down the number of transactions so that they only part with their cash when absolutely necessary. There are all kinds of things that can go wrong while your money spins around the globe, and banks and swap dealers would prefer, quite reasonably, to minimize those risks.  (Presumably by assuming them away, as in the case of Black-Scholes. Except the assumptions made in netting as compared to the risk handwave in Black-Scholes seem like planet killer class ordnance compared to conventional bunker busters. – Jesse)

An Engine Of Misunderstanding

As you can see from the transactions above, the total amount of outstanding debts is completely meaningless. That complex web of relationships between A, B, and C, reduced to 1 transaction worth $1. Yet, the media would have certainly reported a cataclysmic 2 + 3 + 4 + 5 + 2 + 6 = $22 in total debts.  (But borrowing from Sinclair’s description, if a major counterparty in this daisy chain fails, the notional netting can become ‘cataclysmic,’ and enormous losses can be realized, especially if there are linkages to the commercial credit and banking systems. And this is where ‘mark-to-myth’ and bailouts come in. – Jesse)

Charles Davi, Netting Demystified

Here is a visual representation of what a Lehman size failure would look like in today’s financial markets.

Jesse’s Café Américain