Markets Need Rules

“Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”

Warren Buffett, 2002 Annual Shareholder Letter

 

Albert Einstein famously had the foresight to recognize the dangers that his discoveries in nuclear physics could visit on the planet.  Even while they struggle to scrub the blood from the walls, there is little sign of that kind of thoughtfulness on Wall Street.

Derivatives are another of those boring, intangible subjects that hardly anyone cares about, but affects all of us.  They are almost entirely unregulated and have become by far the largest form of capital investment in the world.  By some estimates the derivatives market is several times the size of the total global economy.   Derivatives brought on the 2008 collapse and after much talk about dealing with them, they remain just as unregulated now as before the crash.  They are busy building force again for the next disaster.

New rules will be emerging soon as regulators work to implement the limited financial reforms Congress enacted this year.  The behind the scenes battle over those rules will determine whether Wall Street will see very modest curbs on its the most dangerous and lucrative financial innovations ever, or none at all.

At its core a derivative is actually a very simple instrument.  It is a gamble based on an unrelated transaction – like when you go to Vegas and bet on the Cowboys game.

When you buy stock or a bond you take at least a distant interest in the success or failure of an enterprise.   When you buy a derivative you have no participation, no stake whatsoever, beyond the bet itself.  You are just multiplying the outcome of a transaction.  That distance removes any limitation on the scale of the bet.  A single bond issue, for example, can be gambled on by derivatives traders to infinity.

Those who defend derivatives argue that they provide a vital financial function by allowing organizations to more accurately assign a price to relatively intangible risks.  Think about that Cowboy game you gambled on.  All those bets tell a story about the predicted outcome.  In principle, derivatives trading is supposed to cushion risk.  And they do create a relatively visible market for risk that allows companies both to hedge their bets on a certain deal and to better weigh the odds.  That’s nice.

The trouble is that along the way they multiply the stakes of a particular bet endlessly.  As a consequence, instead of hedging exposures, they can act as a sort of risk catapult, amplifying damage from a failed transaction outward.

Imagine that A Inc. enters into a deal with B Co. and decides to hedge their risk of loss on the deal by insuring it with a derivative called a credit-default swap.  They pay a third-party, C Partners, $25K for a promise that C will cover their loss if the deal goes bad.  The trouble is that any of the parties, or any unconnected parties, can get into the action too over and over again, offering to swap risk related to that transaction.

C bundles all its derivatives and sells a swap on them to D in which D promises to pay C if it incurs losses.  It can keep going, and going in an extended game of hot-potato.  Before long the modest deal between A & B for $1m has $3m in derivative deals riding on it if it goes bad.  And none of these parties had to put up any meaningful capital because there are no legal requirements. It’s all pure vapor.  That’s what creates the economic fission from the transaction.  That’s how the derivatives market can be larger than the whole global economy.

Cool, huh?  Like watching a plane crash.

What you need in order to turn this process into a mass disaster is a serious miscalculation or a shift in performance of a whole economic sector – like the mortgage market.  One day the first domino falls and the damage rolls through the entire economy like a tsunami.

How often would this happen?  This market has existed on a large scale for about fifteen years and its already brought the Western world to its knees once (along with some other serious shocks along the way, see Long Term Capital Management).  It will happen again, though you can’t hope to predict where it will come from.

How many more chances do we need to give it?  Can’t we at least stop them while we get back off our knees?

It’s that magnifying affect rising from the lack of rules that transforms derivatives from an arcane risk-management device, like insurance, into the economic equivalent of a nuclear bomb.  They’re a great idea, except they will persistently threaten to destroy capitalism until we rein them in.

The Democrats had a brief window in which they could actually have tackled dangerous problems like this and addressed them with some sensible solutions.  Instead, they had a hippie-freakout and devoted all their pathetic political capital to a futile effort to fulfill Lyndon Johnson’s dream of socialized medicine.

By the time they were finished failing in that effort and declaring victory, they had no momentum or consensus to deal with financial regulation.  The bill they passed to tackle the banking collapse was just as toothless and irrelevant as their healthcare catastrophe – and almost as long.

Congress punted on this issue, leaving it to relatively weak regulators to come up with rules that will only impact this market around the margins.  Your bank is making short-term cash in derivatives Vegas while you read this.  Those bets will eventually sour and we will face another crisis.

With the GOP bouncing back will someone flip the safety on this weapon?  Not likely.  Government is finished doing things for a while.  Republicans, greedily clutching  the crack-pipe of self-regulating markets helped make this happen in the first place.  As we stand amid the ashes their message so far has been “You’re Welcome.”  The response from the Tea Party Movement to the crash has been fury that someone had the insolence to rescue civilization.  Don’t look to this version of the GOP for any help.

The only thing this batch of Republicans will do different as the next crisis builds is let it burn with a smile as they search the skies for Jesus.

Keep looking.

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