The core cause of the financial crisis of 2008, and again today in 2020, has been the dangerous impact of derivatives markets created by large banks, insurance companies and hedge funds. Speculative trading practices by large banks were outlawed in this country under the Glass-Stegal Act of 1935. But in 1999, at the end of the Clinton Administration, Glass-Stegal was repealed. This repeal, along with passage of the Commodity Futures Modernization Act), during the Bush II administration, opened the door for massive speculative trades in complex derivative instruments.
To be sure, in 2009, the Dodd-Frank Wall Street Reform Act attempted to regulate credit default swaps to a degree. But in response, US banks and hedge funds shifted speculative derivatives trading overseas, and then lobbied congress to limit meaningful regulatory enforcement of Dodd-Frank, the “Volker Rule.” As a result, speculative trading in the global derivatives markets has continued relatively unabated to this day.
In recent years, famed investor Warren Buffett pulled no punches in calling speculative derivatives “weapons of mass destruction.” In his 2017 letter to shareholders, Mr. Buffett explained:
The valuation problem [in derivatives] is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.” I can assure you that the marking errors in the derivatives business have not been symmetrical.
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. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.
Charlie [Munger] and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees… In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.Berkshire Hathaway shareholder letter, Feb. 2017
While Mr. Buffett’s shareholder letter highlights the dangers of trading in speculative derivatives markets for financial firms, insurers and the general economy, it is nevertheless useful to examine how and why these financial instruments are, in Mr. Buffett’s words, “financial weapons of mass destruction.” A brief discussion follows.
Derivatives are essentially contracts that reference an underlying financial instrument–typically a bond or futures contract or a trading index, or a combination of multiple underlying instruments. Derivatives markets and products can be used either for risk management (i.e. for a commodity “hedge”) or for speculation (i.e. making a financial “bet”). This distinction is important.
For example a prudent airline will typically hedge against a rise in fuel prices to manage expected future expenses and thereby properly price airline tickets. This is an example of a commodity option (single-product derivative) used for sound management purposes.
But speculative derivatives are an altogether different animal. To better understand speculative derivatives, a few definitions are helpful:
–Swap. A “swap” is a bet. Just like a bet on a horse race–no different. So an “interest rate swap” is a bet on the direction of an interest rate over a relevant period of time. A “credit default swap” is a bet as to the likelihood a certain company will default or experience an adverse credit event.
–-Product. In derivatives parlance, a “product” is also a bet. So a derivative product is a derivative “bet.”
–-Trade. A derivatives trade is also a bet. Nothing is really traded in the standard usage of that term; rather, bets are paced on a certain outcome, and the “trade” (bet) either pays, or it doesn’t.
–-Structured Product. A “structured” product is a bet on the direction of performance of multiple underlying reference securities in relation to one another. So again, a “structured product” is just a “structured bet” based on the relative movement of various underlying reference securities. Or, if you will, a “pick-six” bet or an “exacta” bet in a horse race. Same basic concept.
—Buying or Selling Protection. The buyer of “protection” is placing a bet that a credit derivative will experience a certain event–usually an adverse event. The seller of protection is taking that bet, at certain odds offered by the seller. So the “seller” in gambling vernacular, is the “bookie,” while the “buyer” is the gambler placing the bet.
As is obvious from this short list of definitions, the derivatives trading (betting) industry uses various euphemisms for the words “bet”, “gambler” and “bookie.” Indeed, today’s world of speculative derivatives trading is nothing but a huge gambling casino where systemically-critical banks and hedge funds place bets, and insurance companies (counter-parties) accept those bets, gambling on on performance of a limitless variation of the performance of financial instruments or economic/geopolitical events–all in an effort to capture higher yield than standard investments can produce.
Derivatives to protect a business or investment against downside catastrophe have been part of the financial system for, literally, centuries, in the form of options. But just as derivatives have been around for centuries, so has derivatives regulation. In the U.S. and U.K., derivatives were regulated primarily by a common-law rule known as the “rule against difference contracts.”
But all that had changed by at least the 1998-2000 time frame. With formal repeal of the Glass-Stegal Act and passage of the Commodity Futures Modernization Act) derivatives have not only been unregulated, they are also the biggest game in town in the global financial business. In an unregulated environment, large banks, like JP Morgan and Citibank, have used derivative trades for speculative purposes to lever up trades with ever-higher leverage. This is how higher investment yields have been captured in an otherwise low-interest-rate environment. But in a nutshell, speculative trading in derivatives markets is a primary contributor to financial destruction–first in 2008, and again today, in 2020.
In the aftermath of the 2008 financial crisis, the Harvard Law School Forum on Corporate Governance and Financial Regulations described trading in speculative derivatives markets like this:
Finance economists and Wall Street traders like to surround derivatives with confusing jargon. Nevertheless, the idea behind a derivative contract is quite simple. Derivatives are not really “products” and they are not really “traded.” They are simple bets on the future—nothing less, and nothing more. Just as you might bet on which horse you expect to win a horse race and call your betting ticket your “derivative contract,” you can bet on whether interest rates on bank deposits will rise or fall by entering an interest rate swap contract, or bet on whether a bond issuer will repay its bonds by entering a credit default swap contract.Harvard Law School Forum on Corporate Governance and Financial Regulation, July 21, 2009
Unregulated Derivative Trades: A Recipe for Disaster
The trigger for the 2008 meltdown was mortgage-backed securities, while the trigger for the current (2020) market crisis seem to have been the corona virus and the repo market meltdown that began Sept. 16, 2019.
But as with any large explosion, the trigger, or detonator, is just the spark that ignites a keg of dynamite, which then explodes. In this analogy, corona virus (2020) or mortgage backed securities (2008) are the trigger (detonator)–while the keg of dynamite are the global base of derivative financial instruments and their complex inter-relationship of counter-party insurers.
This actual underlying cause (speculative trading in derivatives markets) of the 2008 financial collapse was described by the Harvard Forum on Corporate Governance and Financial Regulation as follows:
It was the deregulation of financial derivatives that brought the banking system to its knees. The leading cause of the credit crisis was widespread uncertainty over insurance giant AIG’s losses speculating in credit default swaps (CDS), a kind of derivative bet that particular issuers won’t default on their bond obligations. Because AIG was part of an enormous andId.
poorly-understood web of CDS bets and counter-bets among the world’s largest banks, investment funds, and insurance companies, when AIG collapsed, many of these firms worried they too might soon be bankrupt. Only a massive $180 billion government-funded bailout of AIG prevented the system from imploding.
Notwithstanding the 2008 financial crisis, speculative bets in derivatives markets in the subsequent years have actually accelerated. The global derivatives edifice is larger today than it was in 2008. No one has an accurate estimate of the total size of the global derivative markets, since so many derivatives are traded and insured in private (OTC) transactions away from the view of public markets, but the most understated estimates place the amount of global derivatives at roughly $640 trillion, in “notional” (face value) amount. $640 trillion. Higher estimates place the notional amount at $1.25 quadrillion. Let these numbers sink in, if you can.
As a point of reference to grasp the magnitude of these amounts, in 2019 Global GDP was about $85 trillion. This means that the notional (face) value of derivatives–most of which are speculative bets–in 2019 was anywhere from 7.5x to 14x the total value of goods and services produced in the entire world. Put another way, if the derivatives market had collapsed in 2019 (last year), the goods and services produced by the entire world could be sold, and would still only pay the outstanding derivatives balance at the rate of 7 cents to 13 cents on the dollar. And yet here we are, in 2020, facing a very real possibility that the entire derivatives edifice will, in fact, collapse in the very near future, leaving every economy in the world insolvent and, probably, bankrupt.
Turtles All the Way Down!
The astronomically large, inter-connected edifice of speculative derivatives in our global financial system calls to mind the mythical creation belief (whether humorous or an actual belief is unknown) that the world rests on the back of a giant turtle. When a true believer was asked what was beneath the giant turtle, the response was “another turtle.” When then asked what was beneath that turtle, the response, “of course, another turtle: its turtles all the way down!“
The phrase “turtles all the way down!” has become an expression of the problem of infinite regress. But the analogy seems rather apt for the world of derivatives markets. Our global financial system has morphed into successive, giant layers of financial derivatives that support the entire edifice. Beneath one derivative instrument is another derivative instrument. Beneath that derivative instrument is yet another. Its probably no exaggeration to say of our global financial system, in 2020, that yes, its “derivatives all the way down!” If true, then this is an extremely sobering state of affairs, and it would explain why Wall Street bankers so strongly resist any restraint on their ability to conduct derivative trades, at will, off balance sheet, with virtually no accountability or regulatory supervision.
The Problem With Wall Street’s Current Risk Models
Wall Street traders assume, and are quick to argue to regulators and the public, that the total notional value of a derivative needs to be “netted” out in order to assess risk. This means, for example, that if an underlying bond has a face (notional) value of $1 million; while 100 derivative trades linked to performance of this single underlying bond also have a face (notional) value of $1 million each, then the face values of each instrument over and above the underlying amount ($100 million total in the above example) must be netted out. Wall Street traders firms only count the face value of the underlying instrument in assessing risk.
This netting process may reasonably assess risk in smoothly-functioning capital markets, since the underlying obligation is paid, and counter-party insurers are thereby released from their respective guarantee obligations; the underlying debt just goes away.
But this risk-netting process used and advocated by Wall Street completely breaks down in times of capital market distress. When underlying obligations are not timely paid, demands are thereby made on each respective counter-party; and if enough obligations remain unpaid, the counter-party finds itself in a position of being unable to pay all counter-party claims. This is precisely what happened, infamously, to AIG in 2008, as most people know–and is happening again today (2020).
Too Many Sticks of Dynamite
The problem with Wall Street’s risk-netting process for derivatives is that each new derivative contract is like adding an additional stick of dynamite to a larger pile. During smoothly-functioning capital markets, the first stick of dynamite is increased by 100 more sticks. Without a detonator, the dynamite remains in a safe condition and no harm is done. When the underlying obligation is paid, all 101 sticks of dynamite are removed, and all is well. This is the “latent” state of financial derivatives referenced by Mr. Buffett in the 2017 Berkshire Hathaway shareholder letter, quoted above.
Further, if a single stick of dynamite blows up (say, the underlying instrument goes unpaid), a relatively small problem exists–a problem that can probably be repaired. However, if 100 additional sticks of dynamite are added to the pile, and THEN the underlying obligation goes unpaid…well, then we have a problem: we have a live pile of dynamite sticks in a dangerous condition. And if a trigger (detonator) is added to the mix and we have an explosion of 101 sticks of dynamite–a much bigger problem exists. Indeed, when 101 sticks of dynamite blow up, rather than just a single stick, we have something more akin to a weapon of mass destruction referenced by Mr. Buffett.
Wall Street’s risk-netting model counts only a single stick of dynamite, while assuming the other hundred, or so, sticks simply do not exist. This approach is clearly not working, given the repeated derivatives crises we have experienced in recent years. And in reality, many underlying instruments are referenced by, and linked to, derivative trades with leverage approach 300:1. So continuing the dynamite analogy, we may actually have over 300 sticks of dynamite blow up (derivative payouts fail) if the underlying reference instrument goes unpaid.
In today’s world (circa 2020), by far the greatest risk of non-payment in debt obligations is in the highly-leveraged corporate credit market discussed in Part 1 of this series.This is obviously problematic in business and corporate asset valuations since an implosion of the corporate credit market would leave no company untouched.
Does Wall Street’s risk-netting model make sense? Wall Street’s model only functions in smoothly-functioning capital markets. When capital markets breakdown, an explosive condition exists, that can be triggered by any number of potential detonators. So when markets are in distress, Wall Street’s risk-netting models makes absolutely no sense whatsoever, and are dangerously irresponsible.
And since nowadays financial crises seem to occur with every business cycle, it is the height of irresponsibility to use models that assume financial derivative disruptions are “once-in-a-century” events. This is abjectly not true.
So what should the correct risk-assessment model be for derivatives market? The correct model for risk, according to an emerging science known as complexity theory, is to add all derivative risk, rather than net derivative risk. Using the example above, this means we can only assess risk of market collapse by adding all 101 sticks of dynamite–something Wall Street analysts refuse to recognize.
The Thesis of this Blog Series on Valuation
The primary thesis of this blog series is that asset valuations in 2020 must now account more completely for global economic conditions than ever before, due to Federal Reserve policy and the unavoidable influence of global derivatives trading markets.
In theory, the standard valuation models used in bankruptcy courts and other civil courts will continue to work just fine, even in times of asset value distortions, as long as a correct attention is placed on global economic conditions. This requires courts and valuation experts to account for the impact speculative derivatives may have on the value of an asset and asset class.