“You  do not deliberately obliterate hundreds of billions of dollars of investor money. The financial markets that we have constructed are now so complex, and the speed of transactions so fast, that apparently isolated actions and even minor events can has catastrophic consequences.”—Richard Bookstaber

 

Richard Bookstaber, a former colleague of mine at Morgan Stanley, has written an excellent book, A Demon of our own Design, that highlights the perils in the financial world and the market place. The expected $200 billion in write-downs by institutions across the globe has occurred because institutions have employed tremendous leverage when purchasing “financially engineered” derivative products which they fatally misunderstood.

 

What is a Financial Derivative?

 

Derivatives are financial instruments whose value is derived from the value of something else. They generally take the form of contracts under which the parties agree to payments between them based upon the value of an underlying asset or other data at a particular point in time. The main types of derivatives are futures, forwards, options, and swaps.

 

What is the Main Use of Derivatives?

The main use of derivatives is to reduce risk for one party while offering the potential for a high return (at increased risk) to another. The diverse range of potential underlying assets and payoff alternatives leads to a huge range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) — see inflation derivatives — or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the payoffs.

In essence, as stated above, a derivative is a tool to transfer risk. That is, the purchaser or seller of the derivative tries to take an equal but opposite position in the futures market against the underlying commodity. For example, a farmer will buy/sell futures contracts on a crop from/to a speculator before the harvest since the farmer intends to eventually sell his crop after the harvest. By taking a position in the futures market, the farmer minimizes his risk from price fluctuations. 

 

Ernest Werlin Role in Financial Innovation

In 1986, I created a derivative called the Inverse Floater. This security hedged out the risk of lower income to short term investors when money market rates declined. That is, my Inverse Floater’s coupon went up when short term rates declined.

What happened in the real world with Inverse Floaters?

 

The good news is that trillions of dollars of inverse floaters have been purchased to overcome the negative impact of deflation or falling short term interest rates.

The bad news is that Orange County California declared bankruptcy in the early 1990’s because their treasurer bought on leverage hundreds of millions of inverse floaters outright. The value of these purchases plummeted when short term rates rose rather than declined. The treasurer had stacked his board with unsophisticated people who were “clueless” to the financial risks that he was undertaking.

 

The Devil is in the Details

As Richard Bookstaber points out, in the real world many times derivatives do not perform in the market place the price role that they were theoretically designed for. As a friend of mine point out, if buyers of oil contracts or gold contracts actually took delivery of their “contracted for” oil or gold the system would break down; that is, we do not have the storage capacity for all the oil that is traded on the future exchanges.

 

Using Derivatives to Speculate

Speculators use derivatives when direct ownership of the underlying security is too costly or is prohibited by legal or regulatory restrictions, That is, with relatively small amount of money, a speculator can take huge positions. That is, the cost of the option might be as little as 1% of the underlying cashing security. Thus, small swings in price can lead to tremendous profits or losses.

 

Bookstaber’s Background

 

Rick received a Ph.D in economics from MIT. He has held managing director positions at Salomon Brothers, Morgan Stanley, and Moore Capital for collectively close to thirty years. As a “rocket scientist”, Bookstaber provided an insider’s perspective to the tumultuous management decisions made throughout the financial community. He has designed some of the complex options and derivatives that, combined with the globalization of the world’s markets, and the ever-increasing speed of transactions, allows markets to slide out of control. In essence, Bookstaber argued that many of the financial innovations and regulations that are supposed to level the playing field instead make the markets more dangerous for all players, big and small. In essence, Bookstaber accurately predicted the inevitable financial doomsday that has beset the markets since August 2009. At the time of the writing of this essay, financial firms have written off more than $100 billion dollars, and the red ink continues to flow.

 

Positive or Innovative Responses to the Current Financial Crisis

 

On the positive side, today’s Wall Street Journal, indicated that the Federal Reserve, Foreign Central Banks, and the United States Treasury are “thinking outside the box” to contain the crisis. The Federal Reserve, for example, is allowing institutions to borrow for as long as six weeks and accepting a wide spectrum of collateral. The Federal Reserve is considering lowering the discount rate to the level of the federal funds rates to eliminate the “stigma” associated with borrowing at the Federal Reserve window. The Treasury is working hard to get banks to cooperate with Citicorp to reduce their SIV problem. The Treasury has encouraged lenders to postpone resets on sub-prime mortgages to forestall the expected two million defaults in 2008 from higher borrowing costs on mortgages. The Federal Reserve allowed quickly a foreign institution to take a 4.9% position in Citicorp.

 

Trojan Horses in the Land of Derivatives

 

After reading A Demon of our own Design, I have learned about some of the Trojan horses that have been created in recent years. Let me share with you some of the problems. 

 

1. Many of the prices of these “financially engineered” products vary dramatically depending upon changes in volatility or risk assumptions.  Moreover, past price movements do not necessarily ordain future price levels. Henry Ford might have been right when he said “History is Bunk!” 

2. The correlation between the derivative product and the underlying securities can vary. A decline in the derivative product can exaggerate the loss of the underlying stocks. Bookstaber described the 1987 stock market debacle when the S&P declined 21% in one day. In essence, the derivate market opened up earlier than the New York Stock exchange and was significantly more liquid than the stocks which composed the S& P index which traded on the New York Stock Exchange. Thus, when the S&P index cratered, the combination of specialists and Wall Street market makers could not react as quickly to find the appropriate number of buyers for many stocks that made up the index. That is, many of these stocks were comparatively illiquid. In fact, bell weather names like IBM or AT &T lacked the liquidity of the S&P index. Moreover, the posting of trades on the New York Stock exchange was several hours behind; thus, the extent of the debacle was not fully comprehended on a timely basis.

3. The ‘financial engineer” who created the product understands the flaws of the product better than his supervisors. Hence, when the product price deviates from expectations he can hide the real source of the problem, creating huge losses for his firm.

4. The compensation system of Wall Street encourages a speculative fervor because of the opportunity to make out-sized bonuses. That is, for the individual making a $20 million dollar bonus by taking untoward risks outweighs the personal costs of creating huge losses. Stated differently, greed drives the process rather than a feeling of fiduciary responsibility. Moreover, managers such as Stan O’Neal of Merrill Lynch or Chuck Prince of Citicorp wanted to emulate the profits garnered by Goldman, Sachs without having the appropriate risk management tools or experienced traders. Mr. O’Neal fired conservative mortgage-backed managers and replaced them with risk-takers in order to replicate Goldman’s earnings. The eight to twelve billion dollar loss at Merrill from their exposure to sub-prime mortgages highlights Mr. O’Neal’s folly.

5. Nobody or no team of “risk managers” can possibly understand or guestimate accurately the financial risk of all the different strategies that the firm has incurred. Moreover, if many institutions put on the same “bad” trade, their collective unwinding the “bad” trade escalates the loss. Bookstaber discussed one security that required millions of permutations to guestimate its value. Can you imagine the pricing problem from owning billions of different complex securities? When I worked at Steinhardt Management in 1994, the legendary Michael Steinhardt made an outsized bet on the Canadian Government market, and then could not liquidate his position in a timely manner.

6. No strategy can work for ever. That is, subtle changes in the marketplace can undermine the assumptions that originally prompted the trade. Thus, a trade where you borrow let us say in Japan because it has low interest rates and invest in the United States where we have comparatively higher interest rates can back fire if the dollar declines precipitously against the yen. That is, your loss from the decline in the dollar outweighs your “carry profit” from owing U.S. Securities and borrowing in Japan.

7. While theoretically, the likelihood of a negative incident might be one in a hundred, somehow the improbably happens more often that the statistical model would indicate. One contrarian investor said that he would love to make 100 $1000 bets where the odds of his losing are 100 to one. He believes that he can win at least five times.

 

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Wall Street Skillfully Used Madison Avenue Techniques to Peddle their Products.

 

Moreover, Wall Street has employed Madison Avenue techniques to describe some “toxic” waste products in benign terms. Bookstaber talked about naming strategies such as “portfolio insurance”, enhanced money market funds, sub-prime mortgages; secured investment vehicles, etc. in order to encourage investors to embrace these products without understanding their potentially negative fallouts. The dependence upon the rating agencies to determine the true credit rating of a product has led to monumental losses in collateralized mortgage and debt obligations. 2007 has witnessed wholesale downgrades of collateralized securities that is unprecedented in American history.

 

Conclusion

 

In essence, while “financially engineered” products have been implemented because they met real commercial needs, there needs to be caution in how much reliance one should put on a product

 

Over the past few months, we have seen monumental losses at Merrill Lynch, Citicorp, Countrywide Financial, Morgan Stanley, UBS, the State of Florida, and scores of institutions from Great Britain to Iceland to Japan. In essence, Bookstaber points out that globalization, the speed of transactions, and the high level of leverage have created greater instability in the world’s financial system.