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Another devil in the financial crisis

Posted by Yogesh on Wednesday, 24 September, 2008

You may not understand derivatives, but you could eventually feel the effects of these arcane investment tools: slower growth, higher interest rates and a weaker dollar.

By Jim Jubak

Bet you haven’t seen this on a bumper sticker lately: “Save the derivatives market.”

Hardly catchy. Especially since almost no one actually knows what a derivative is. And it sure goes against the emotions of the crowd right now.

Along with Christopher Cox, the head of the Securities and Exchange Commission and of a Wall Street culture of greed, derivatives are the villains in the current collapse of the global financial system.

But we’d better stop pointing fingers at these tools and start figuring out how to get this market functioning again if we’re at all interested in ending the financial crisis before it drags all the economies of the world into a decade of stagnation with low growth and high interest rates.

This crisis is no longer about the U.S. housing market or mortgages, or even about failing Wall Street institutions. We’re way beyond that. What’s at stake now is the entire global financial system that has underpinned world economic growth over the past two decades or more.

If we don’t fix that, the cost will be slower economic growth around the world, and especially in the U.S., over the next decade and perhaps longer. Here in the U.S., we’ll be able to measure the cost in higher interest rates and a weaker currency, but the effects will be felt in every economy in the world.

Money in motion

What’s broken is the financial conveyor belt that moved dollars around the world and made global economic growth go.

At the receiving end, this conveyor belt loaded up the dollars that the developed world, and especially the U.S., had paid to the oil economies of the Middle East, Russia, Nigeria and the rest of the gang, and to the global factory economies of China, India, Brazil and the rest of that group. It then delivered those dollars to the great financial recycling centers of New York and London, where they were turned into T-bills, mortgage-backed securities, Fannie Mae (FNM, news, msgs) debt and derivatives such as collateralized debt obligations and credit default swaps. The belt then returned its load of financial products back to the Middle East, Russia and China.

The smooth operation of this conveyor belt meant that the dollars paid for oil and for manufactured goods didn’t just sit in bank vaults in Beijing, Moscow and Riyadh, Saudi Arabia. Instead, they were recycled into houses built in Sacramento, Calif., engineering contracts in Osaka, Japan, and crane orders in Düsseldorf, Germany. That kept the economies of the developed world chugging along, which in turn kept up global demand for oil and other raw materials and for manufactured goods. That demand meant that China would have money to build roads and buy railroad cars, that Russia would be able to hire Schlumberger (SLB, news, msgs) to manage Siberian oil fields and that Saudi Arabia could build chemical plants.

It’s no simple matter to recycle a cash flow that has amounted to $700 billion a year from the U.S. trade deficit alone.

To keep all those dollars rolling down the conveyor belt back to the New York and London financial markets, the Chinese and Russian and Saudi holders of those dollars had to be convinced that the U.S. Treasury bills they were buying wouldn’t be devastated by U.S. inflation or a falling dollar.

They needed to be convinced that the U.S.-dollar-denominated corporate bonds they were buying wouldn’t go down the tubes when a company thousands of miles away failed.

They wanted to know that the bundles of mortgages they were buying in markets that they’d never seen were AAA-rated — and that their money was safe even if that rating turned out to be wrong.

They needed to know that it was safe to invest so much money outside their home market and that their own national cash flows wouldn’t take a huge dive if oil prices or exports plunged.

In good hands?

What they wanted was insurance. And that’s exactly what derivatives promised.

In the derivatives market, you could buy a contract, for a price, that would insure you against the rise in inflation or a rout in the U.S. dollar. You could buy a contract that would insure you against the failure of General Motors (GM, news, msgs) or IBM (IBM, news, msgs) — at very different costs, of course. You could buy a contract that would insure you against a plunge or a spike in oil prices.

In fact, for a price, you could lay off the risk of just about any event — corporate or financial or economic — that you could think of. And the ability to lay off that risk was critical to keeping the global conveyor belt running.

Derivatives were a key lubricant in the system that kept dollars moving around the world.

That lubricant gradually failed over the past year as the financial crisis kept growing deeper. Companies and countries that bought derivatives as insurance discovered that first some, and then many, buyers of derivatives realized their insurance was only as good as the counterparty on the other end of the contract. If the financial company that had sold insurance against a rising dollar or a default by Fannie Mae didn’t have the cash to pay up, then the derivative was worthless as insurance. Better to keep your money at home in your own pockets if you couldn’t trust the derivatives market to deliver on its insurance promises.

The lubricant also failed as the price of insurance went up. If the price of buying a derivative to insure against some unpleasant possibility rose high enough, then it was again better to keep your money at home than to pay the extra premium.

The bankruptcy of Lehman Bros. (LEHMQ, news, msgs) and the near bankruptcy of American International Group (AIG, news, msgs) produced an almost complete breakdown in the lubricant.

Lehman was a party to hundreds of billions in one-off derivatives that covered risks of default, interest rates, equity moves and moves in commodity prices.

The Treasury’s bailout plan is nothing more than a blank check with no accountability and no oversight, Jim Jubak says. Taxpayers will ultimately feel the burden of the recklessness.

AIG was an even bigger player. Its near bankruptcy and then its $85 billion government buyout led the London Stock Exchange to suspend trading in 113 exchange-traded commodity funds run by ETF Securities. All had been backed on matching derivatives from AIG.

Market makers had stopped making prices for the funds because they were worried that trading in the funds would leave them open to risk if AIG went into bankruptcy.

The Lehman bankruptcy shows the London traders were right to worry. Investors are discovering the collateral Lehman posted against its derivative swaps isn’t enough to cover the cost of buying comparable derivative insurance from another company.

Investors are faced with taking a hit if they want to buy the same insurance – because prices are higher — if they can find a counterparty at all now that the derivatives market is shrinking.

Problems in the derivatives market don’t stay confined to that market. In the short run, we’ve already seen the effects at work in the commodities market. AIG was a counterparty to a good part of the $30 billion invested in the Dow Jones AIG Commodity Index ($DJAIGCH), the second-most-popular benchmark for commodity investors.

Commodity prices took a big hit Sept. 17, as market makers pulled away from the market: If you can’t easily get a price for a commodity that you want to sell, your impulse is to sell it anywhere for any price. In addition, CME Group (CME, news, msgs), formerly known as the Chicago Mercantile Exchange and the world’s largest futures exchange, staged an emergency sale of AIG’s agricultural commodity positions with the approval of regulators.

It’s no coincidence that the commodity markets have rallied as AIG has stabilized and as pressure has eased on derivatives markets.

A partial solution

The Federal Reserve and the U.S. Treasury have announced the outline of a plan that would use $500 billion to $1 trillion of taxpayer money to buy toxic investments from banks and other financial companies.

At this point, we don’t know exactly what the government would buy under this plan, but “toxic investments” has become a code word for the billions in busted mortgages and mortgage-backed securities now on banks’ balance sheets. The U.S. government — that’s you and me — would wind up owning a good chunk of the busted mortgages on foreclosed homes in California, Florida and Michigan and who knows what else.

But as big as this buy-up would be and as tough as it would be to structure so that Wall Street wouldn’t make a killing selling broken assets to taxpayers, this plan addresses only part of the financial crisis. It’s going to be a whole lot easier to fix that part of the crisis than it will be to fix the derivatives market that lubricates the global conveyer belt.

For a start, it’s so much harder because the derivatives market is so much bigger. As big as the numbers are being tossed around in discussions of Treasury Secretary Henry Paulson’s plan, it’s even harder to grasp that those huge numbers are still just chicken feed in the global financial system.

The global market for derivatives has a notional value of $455 trillion. The market for a single kind of derivative called credit default swaps (CDS) comes to $62 trillion. A single company, the recently rescued AIG, was counterparty to $422 billion in derivatives. That’s just a tad below the low-end estimate for the government buy-up plan as a whole. For a single company.

But the reasons that it will be harder to fix the derivatives market than the mortgage market don’t stop with size. There are three other very significant obstacles to a fix:

  • There’s no political lobby to throw its might behind fixing the derivatives market. In the mortgage mess, the banks want it fixed, homeowners who are under water want it fixed, and elected officials who want to get re-elected want it fixed. The only dissenting voice comes from the taxpayers who will pay the tab, and we’ll get rolled as usual. On the derivatives side, the financial industry has successfully fought against regulating the derivatives market. In 2000, then-Sen. Phil “Americans Are Whiners” Gramm succeeded in getting the derivatives market declared off-limits to regulatory agencies in the Commodity Futures Modernization Act. When Gramm left the Senate in 2003, he went to work for Swiss bank UBS (UBS, news, msgs). With that kind of cozy history, I don’t expect to see the financial industry take up the call for more regulation of the market.
  • Derivatives are hard to understand. The reforms needed to fix the market are even tougher to grasp. One big problem, for example, is that most derivative contacts aren’t traded on any exchange. They are unique, one-off contracts between an individual buyer and seller. Without a market to act as a clearinghouse, there’s no way to know how many contracts any individual seller has written. Which, of course, turns out to be crucial to figuring out which sellers can stand behind which deals. And without a market, there’s really no way to price these contracts. So when a company such as AIG or Lehman faces a need for capital, there’s really no way to figure out what any nonmarket contracts are worth. Fixing this problem would require negotiating some degree of standardization into derivative contracts so that more of them could be tracked on existing over-the-counter exchanges. That would require tough negotiation by a politician with the smarts to understand the industry and the determination to see it through, although the political reward would likely be slight. You know anybody who fits that bill?
  • And finally, it’s much easier to demonize the derivatives market than to fix it. Derivatives do allow traders to speculate on the direction of just about any price, and the high-profile presence of speculators in the derivatives market is enough to turn general opinion against the market as a whole. Who wants to reform the place when it’s easier to preach against it?

An endangered species

I don’t think we’ll fix the derivatives market. And that will have long-term costs. The world won’t come to an end. The market will gradually pull itself back together into something like its pre-crisis dysfunctional functionality. It will go back to moving money around the world.

But it won’t function as well as it could. It won’t function even as well as it did in the years running up to this crisis. And that will mean higher interest rates, especially in the U.S., as overseas investors with less faith in the insurance offered by derivatives ask for a higher return. It will mean a declining dollar as investors find it costs more to insure against U.S. inflation and a fall in the U.S. currency. And it will mean slower economic growth than would be possible with a reformed derivatives market as the conveyer belt to recycle dollars works a little less efficiently.

The Treasury’s bailout plan is nothing more than a blank check with no accountability and no oversight, Jim Jubak says. Taxpayers will ultimately feel the burden of the recklessness.

The good news, of course, is that the damage will be inflicted so gradually that we quite possibly won’t even notice until we wake up, in a decade, poorer than we could have been.

One final thought: I like tilting at windmills. So I’m willing to pay to have bumper stickers printed up with something like “Save the derivatives market” and then pass those out to readers. If we can come up with a better slogan, that is. Something that mixes rage with humor, I think. Send in your ideas, and if I get a few good ones, I’ll run a poll here to pick the best. Keep those cards and letters coming in. Source MSN

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