Some Derivative Observations

You have to admire the focused and determined sorts who know, when they’re ten years old or so, exactly what they’re going to be in life, and with amazing single-mindedness become what they said they’d become – a doctor or an architect or whatever. And you know they’re the freaks of nature. The math whiz ends up fronting a third-rate rock band and then becomes an art historian. The jock, the guy who could do anything and charm anyone, becomes a quiet middle-manager at an accounting firm. The gorgeous cheerleader ends up as managing a funeral home.

Think about it. Jerry Rubin – the kid from Cincinnati who was the radical of all radicals – became an investment banker – “wealth creation is the real American revolution” – and died because he was stupidly jaywalking out here on Wilshire Boulevard and got creamed by a big car. None of that was planned.

But planning is an odd activity. Where do you see yourself in five years, in ten, in twenty – and what specific steps in which specific order will assure that that is exactly where you’ll be at those milestones? Now write down those steps and post them on your bathroom mirror, so you see them every morning – and get to work. Maybe you’ve run into a career coach who says such things. But as a rule, no one becomes what they said they’d become. And the exceptions prove the rule, if you can find any. And jaywalking is always a bad idea.

So most people fumble around trying to figure out what they should do with their lives, as they discover their talents, or lack of talent, and discover where their patience ends. For some the critical time comes as the first year of college comes to an end. You have to declare a major and lock yourself into that. And an amazing number of people change majors from the one they intended. Imagine starting college in pre-med chemistry, and in spite of being a math whiz, discovering that calculus makes no sense to you at all, and the thought of solving differential equations bring tears to your eyes, and you don’t much like the chemistry and biology lab work, or the intense geeky people around you. That was uncomfortable. So summer comes and you sit with your father – himself in his third career – and ask him about his work. It might not be bad to be a stockbroker too. The money is good, and the people are interesting.

But then he explains short selling to you, and you just don’t get it. You borrow a hundred dollars worth of stock and, even if you don’t own it, you sell it to someone who wants it – and you put the hundred bucks in your pocket. Then the stock tanks as you hoped it would, or maybe knew it would. And then you buy the same amount of the same stock for forty dollars. And then you return what looks just like the borrowed stock, or actually is the borrowed stock itself, to the guy who let you use it – and say thank you – and keep the sixty bucks left over. The market dropped like a rock, or at least this one stock blew up, and you made a killing – because things went really wrong.

Was that it? People make money when they buy low and sell high, when stock prices rise, but the big money is made when the market drops, when you sell what’s not yours and then buy it back? At that point it seemed best just to decide to major in English. Beowulf, in the original, was easier to understand.

But there was no money in that, of course. And these days short selling is not that simple, as all that had turned into credit default swaps, which are a form of derivatives, or something. Were the old man alive today he’d be giggling at all this, but Andrew Leonard tries to explain that it’s all very simple, or not:

A credit default swap is analogous to an insurance policy written against the possibility of some kind of negative “credit event,” such as, for example, an automaker declaring bankruptcy and defaulting on its bond obligations. Let’s say General Motors issues a bond and I purchase it. But I’m worried that General Motors may collapse, so I buy a credit default swap on my bond from AIG. In return for regular premium payments, AIG promises to reimburse me in full in the event for the value of my bond in the event of a GM bankruptcy. In the parlance of Wall Street, by purchasing the credit default swap I am “hedging” against the chance that my bond will suddenly become worthless.

But what if I don’t own any GM bonds, but I still buy insurance against the possibility of a GM default? In that case, I would be purchasing what is known in the trade as a “naked” credit default swap — akin, say some detractors, to buying fire insurance on a house that you don’t even own. I would be making a bet, plain and simple, on GM’s credit-worthiness.

So the bet wouldn’t pay off unless something bad happened to GM. Fair enough, but one could argue that “naked” credit default swaps – where you don’t own any GM stuff at all – shouldn’t be legal. That just doesn’t seem right. But it has become the norm:

Estimates of the percentage of the overall market for credit default swaps accounted for by “naked” swaps range as high as 80 percent. If you think that sounds like a wild gambling spree you aren’t too wrong. In fact, the Commodity Futures Modernization Act of 2000 that made sure credit default swaps would be largely unregulated specifically exempted such derivatives from anti-gambling laws.

Why would they do that? The Futures Modernization Act of 2000 was the work of Phil Gramm, the Republican senator from Texas and John McCain’s economic advisor in the last election, and Gramm’s wife was on the board of Enron. Enron was masterful at this sort of thing. And it killed them. In 2008 the “Close the Enron Loophole Act” was enacted into law to regulate “energy trading facilities” a bit more. It was too late.

And Leonard says that in the case of the SEC’s charges of securities fraud against Goldman Sachs, things are just as weird:

Hedge fund manager John Paulson is alleged to have convinced Goldman to put together a synthetic collateralized debt obligation (CDO) – a basket of credit default swaps mimicking the function of real mortgage backed-securities that Paulson had pre-selected as most likely to blow up as the housing market deteriorated. Paulson then turned around and bought naked credit default swaps that would pay off if the synthetic CDO tanked. Many people are wondering, with good reason, what the social utility of such a house of cards might be. It seems highly unlikely, for example, that Paulson would have made the same bets if he had been required to own a piece of the securities that he was certain were doomed to collapse.

But people just don’t think that way:

The stock answer from defenders of derivatives is that allowing speculators to bet as much as they want on the credit-worthiness of everything from GM to Goldman-Sachs to the sovereign debt of Greece to the most fanciful synthetic CDO concoction is that such activity provides “liquidity” to the market that makes it easier for legitimate (that is, non-speculative) hedging to occur. If I want to buy a credit default swap on GE, someone has to be willing to sell one. And if lots and lots of parties are buying and selling at the same time, I’m more likely to be able to find what I need to suit my specific circumstance. Liquid derivative markets therefore, theoretically make it easier for credit to flow in an economy. A bank might be more willing to make a loan if it knew it could easily buy insurance against a default on that loan.

A flourishing market for credit derivatives, we were told, time and again throughout the last decade, was crucial to helping all kinds of actors manage their risk, to make the world a safer place.

That seems unlikely. It seems like a complex interlocking scam, where everyone is guessing at who loses – or it’s a game, like passing around the hot potato, or kind of like musical chairs, when you’d better find a seat when the music stops. As in the children’s game, someone is going to be the pathetic loser, and have to leave the game. And that we’re saying this is good for everyone puzzles Leonard:

I know I’m not alone at being astonished when I hear the same argument being made today, so soon after the world witnessed the greatest collective failure of risk management in living memory. Teasing out the responsibility that credit default swaps, specifically, deserve for the overall crisis is tricky, but I think you have to be willfully obtuse to claim that they played no role at all. Speculators betting negatively on the credit-worthiness of Bear Stearns and Lehman Brothers helped to feed the sense of panic over the prospects of the two firms, and fueled the reluctance of the investment banks’ counterparties to roll over the short-term loans that kept the companies functioning. And of course, AIG’s inability to make good on its credit default obligations required a massive government bailout.

It was a house of cards, and created a negative feedback loop that made anything even remotely shaky sure to fail. What good is that?

But Leonard says you can defend it all, but that puts everything backwards and upside-down:

You can make a good argument that instead of allowing financial institutions to better manage their risk, credit derivatives actually distributed risk from those best able to manage it to those least able to do so. By packaging up mortgage loans into securities and selling them off to others, the banks and lenders whose primary job used to be to evaluate whether a potential mortgage borrower was a good risk offloaded their responsibility to other parties who had little, if any, expertise whatsoever in the American mortgage business. Risk was distributed from those who understood it to those who didn’t.

But maybe that was the whole point – find a sucker. All you have to do is make the process sound good and noble:

Back in 1999, the President’s Working Group in Financial Markets produced a report arguing that an unregulated derivatives market would “reduce systemic risk.” But all the evidence seems to prove that exactly the opposite happened: Systemic risk increased! Among those who signed their names to that report: Larry Summers, Alan Greenspan, and Arthur Levitt, Bill Clinton’s SEC chairman. To this day, I haven’t heard a good answer from any of them to the question whether the increased liquidity made possible by unregulated derivatives markets was worth the devastation that the entire global economy suffered in exchange.

And here we are, ready to start serious debate on the exact language of derivatives regulation, and a flat-out ban of naked credit default swaps isn’t even under discussion. It seems amazing – as if we were simply handing out invitations to an arson party.

But he notes that Treasury Secretary Timothy Geithner has already explained his own opposition to a ban:

“My own sense is that banning naked swaps is not necessary and wouldn’t help fundamentally,” Geithner told lawmakers on March 26, 2009. “It’s too hard to distinguish what is a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome.”

And he says Ravi Nagarajan explained what Geithner was getting at:

For example, let’s say that someone has an ongoing business relationship, such as a supplier relationship, with a company that is in some financial trouble. In such a situation, the purchaser of a [credit default swap] CDS may be hedging against the collectability of trade receivables. On paper, this purchaser would not own the underlying security protected by the CDS, but the CDS may in fact be a legitimate “proxy” to hedge the exposure of the trade receivables. There are obviously many other examples like this.

But Leonard remains unconvinced:

Those who are inclined at this late date to be charitable might be able to see Geithner’s point. Attempting to distinguish, in written law, between what is an acceptable hedge – legitimate risk management – and what is out of bounds speculation, would be a challenge for any regulator. There are too many possible permutations. Would it be wrong for an investment bank with lots of real estate holdings to try to protect itself against a housing downturn by betting against the performance of the kind of CDO’s that John Paulson orchestrated?

A better or more workable answer might be to make the cost of speculating a little higher. If the sellers of protection were required to keep more capital in reserve to protect against the possibility of large future payouts, they might not be so willing to sell credit default swaps to every speculator who came knocking, or they would at least charge higher premiums, which would make speculation less profitable. Other measures, such as moving credit default swaps and other derivatives into centralized clearinghouses could increase transparency and reduce the opportunity for easy profits by encouraging more price competition.

That might happen, and Leonard notes that we are going to hear a lot about regulating derivatives in the days ahead:

But if anyone starts repeating the mantra of yesteryear – that unregulated derivatives decrease the chances for systemic risk, they should be laughed right off the floor of Congress.

They won’t be. This stuff is complicated, and most members of Congress have taken massive campaign contributions from Goldman Sachs and the other such firms, and some of them worked for Goldman Sachs or have staffers who did, and will work for them again.

Something is fishy here. It’s like the summer just after the first year of college, listening to that explanation of short selling. The words make sense, and the logic of the thing can be worked out. But is seems counterintuitive, and kind of nasty.

But it’s just business, and as William Astore argues, the business of America is kleptocracy:

Kleptocracy – now, there’s a word I was taught to associate with corrupt and exploitative governments that steal ruthlessly and relentlessly from the people. It’s a word, in fact, that’s usually applied to flawed or failed governments in Africa, Latin America, or the nether regions of Asia. Such governments are typically led by autocratic strong men who shower themselves and their cronies with all the fruits of extracted wealth, whether stolen from the people or squeezed from their country’s natural resources. It’s not a word you’re likely to see associated with a mature republic like the United States led by disinterested public servants and regulated by more-or-less transparent principles and processes.

And most folks don’t get what’s going on:

In fact, when Americans today wish to critique or condemn their government, the typical epithets used are “socialism” or “fascism.” When my conservative friends are upset, they send me emails with links to material about “ObamaCare” and the like. These generally warn of a future socialist takeover of the private realm by an intrusive, power-hungry government. When my progressive friends are upset, they send me emails with links pointing to an incipient fascist takeover of our public and private realms, led by that same intrusive, power-hungry government (and, I admit it, I’m hardly innocent when it comes to such “what if” scenarios).

What if, however, instead of looking at where our government might be headed, we took a closer look at where we are – at the power-brokers who run or influence our government, at those who are profiting and prospering from it? These are, after all, the “winners” in our American world in terms of the power they wield and the wealth they acquire. And shouldn’t we be looking as well at those Americans who are losing –their jobs, their money, their homes, their healthcare, their access to a better way of life – and asking why?

If we were to take an honest look at America’s blasted landscape of “losers” and the far shinier, spiffier world of “winners,” we’d have to admit that it wasn’t signs of onrushing socialism or fascism that stood out, but of staggeringly self-aggrandizing greed and theft right in the here and now. We’d notice our public coffers being emptied to benefit major corporations and financial institutions working in close alliance with, and passing on remarkable sums of money to, the representatives of “the people.” We’d see, in a word, kleptocracy on a scale to dazzle.

The whole item is worth a look, but this is his point:

Consider this: America is not now, nor has it often been, a hotbed of political radicalism. We have no substantial socialist or workers’ party. (Unless you’re deluded, please don’t count the corporate-friendly “Democrat” party here.) We have no substantial fascist party. (Unless you’re deluded, please don’t count the cartoonish “tea partiers” here; these predominantly white, graying, and fairly affluent Americans seem most worried that the jackbooted thugs will be coming for them.)

What drives America today is, in fact, business – just as was true in the days of Calvin Coolidge. But it’s not the fair-minded “free enterprise” system touted in those freshly revised Texas guidelines for American history textbooks; rather, it’s a rigged system of crony capitalism that increasingly ends in what, if we were looking at some other country, we would recognize as an unabashed kleptocracy.

Recall, if you care to, those pallets stacked with hundreds of millions of dollars that the Bush administration sent to Iraq and which, Houdini-like, simply disappeared. Think of the ever-rising cost of our wars in Iraq and Afghanistan, now in excess of a trillion dollars, and just whose pockets are full, thanks to them.

Yep, it’s a bit of a left-side rant, but facts are facts:

Certainly, major corporations, which now enjoy a kind of political citizenship and the largesse of a federal government eager to rescue them from their financial mistakes, especially when they’re judged “too big to fail.” In raiding the U.S. Treasury, big banks and investment firms, shamelessly ready to jack up executive pay and bonuses even after accepting billions in taxpayer-funded bailouts, arguably outgun militarized multinationals in the conquest of the public realm and the extraction of our wealth for their benefit.

Such kleptocratic outfits are, of course, abetted by thousands of lobbyists and by politicians who thrive off corporate campaign contributions. Indeed, many of our more prominent public servants have proved expert at spinning through the revolving door into the private sector. Even ex-politicians who prefer to be seen as sympathetic to the little guy like former House Majority Leader Dick Gephardt eagerly cash in.

So you get this:

A spirit of shared sacrifice, dismissed as hopelessly naïve, has been replaced by a form of tribalized privatization in which insiders find ways to profit no matter what.

So I can buy fire insurance on a house that I don’t even own, or many houses, and make a whole lot of money when they burn down, which I know they will – because I’ve assembled a portfolio of these firetraps, paid a rating agency to rate this portfolio as a super-duper super-safe risk-free AAA investment, and found a sucker to buy the portfolio, a sucker who will never know that I was the one who selected this particular array of firetraps to be certain they’d burn to the ground. And yes, they’re not my houses, but then I’m not the one with the match, starting the fire. I’m just off to the side, making incredible sums of money managing risk, as a general concept. And helping the economy in a way, by keeping all sorts of money flowing this way and that – liquidity is a good thing in the economy.

And there’s Goldman Sachs Chief Executive Lloyd Blankfein:

Is it possible to make too much money? “Is it possible to have too much ambition? Is it possible to be too successful?” Blankfein shoots back. “I don’t want people in this firm to think that they have accomplished as much for themselves as they can and go on vacation. As the guardian of the interests of the shareholders and, by the way, for the purposes of society, I’d like them to continue to do what they are doing. I don’t want to put a cap on their ambition. It’s hard for me to argue for a cap on their compensation.”

So, it’s business as usual, then, regardless of whether it makes most people howl at the moon with rage? Goldman Sachs, this pillar of the free market, breeder of super-citizens, object of envy and awe will go on raking it in, getting richer than God? An impish grin spreads across Blankfein’s face. Call him a fat cat who mocks the public. Call him wicked. Call him what you will. He is, he says, just a banker “doing God’s work”

And would you also like to buy a bridge?

As they say, there ought to be a law. But there isn’t. And thus are English majors born.

About Alan

The editor is a former systems manager for a large California-based HMO, and a former senior systems manager for Northrop, Hughes-Raytheon, Computer Sciences Corporation, Perot Systems and other such organizations. One position was managing the financial and payroll systems for a large hospital chain. And somewhere in there was a two-year stint in Canada running the systems shop at a General Motors locomotive factory - in London, Ontario. That explains Canadian matters scattered through these pages. Otherwise, think large-scale HR, payroll, financial and manufacturing systems. A résumé is available if you wish. The editor has a graduate degree in Eighteenth-Century British Literature from Duke University where he was a National Woodrow Wilson Fellow, and taught English and music in upstate New York in the seventies, and then in the early eighties moved to California and left teaching. The editor currently resides in Hollywood California, a block north of the Sunset Strip.
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