The Global Derivatives Casino

Tom Lane, April 2009

The headline in The Irish Times of March 31^st reads, "Ireland is downgraded by leading credit rating agency". The article tells how Standard & Poor's lowered Ireland's rating from AAA to AA+, with a "negative" outlook. As a result, the cost borrowing for the Irish Government has risen. And the price of a Credit Default Swap on Irish Government Debt has also risen sharply.

What the Irish Times article does not state is that these credit rating agencies were contributors (through overrating securities) to the financial crisis. That despite this they still have the power to rate Government debt. That Credit Default Swaps are one of the prime causes of the meltdown. And that despite this, these swaps are still being used to bet on our Government's ability to pay!

Standard & Poor's (S&P) is one of the main private credit rating agencies, whose function is supposed to be to provide an independent rating of credit-worthiness. The highest rating is termed AAA, with the lowest being termed 'junk'. The higher the credit-worthiness rating, the lower the risk of default, which means that the borrower can borrow funds at a lower interest rate. A Credit Default Swap (CDS) is a bet that somebody is going to default on their debt. For example, if I decided to buy Irish Government Bonds (i.e. lend money to the Irish Government), I could also purchase a CDS on Irish Government Debt as an insurance policy in case the Irish Government was unable to repay its loans. I would sign a contract with somebody willing to sell me a CDS (called a counterparty). I then pay the counterparty a monthly sum (like a normal insurance policy) and the counterparty pays me the value of the loan outstanding in the case of default. The higher the credit rating of the Irish Government the cheaper the CDS would be, since the risk is lower.

Now there are two things that make a CDS different to a normal insurance policy. Firstly, I can buy a CDS on any debt I like, not just one affecting me personally. It's like being able to buy insurance on somebody else's home. If their house goes on fire, I collect the insured amount. Secondly, the CDS market is completely unregulated. A normal insurance company has to comply with regulations to ensure that they don't behave recklessly so they will be more likely to be able to pay out on insurance claims. Governments back many insurance companies in case the insurer gets into financial trouble. Not so with a CDS. As purchaser, I decide if the counterparty has the ability to pay. This can obviously be risky. The whole system is dependent on trust. When trust breaks down the whole system can break down with it.

A CDS is a type of derivative, and derivatives are at the heart of the financial crisis. A derivative is a device for betting, or for hedging your bets. Hedging means to reduce ones risk of loss on a bet by making a compensating bet on the other side. A derivative is mechanism that allows you to bet on the future direction of the market in an asset that is to be exchanged, but without actually owning the asset to be exchanged. There are various classes of derivatives, called options, futures and swaps. The one we've being discussing is an example of a swap.

Derivatives were originally used to hedge against uncertainty in the future prices of commodities. For example, a farmer (theoretically) could buy a future contract to sell wheat at an agreed price in six months time. This would allow some amount of predictability and a limited level of insurance against price fluctuations due to different harvest yields. Or an airline company could buy an option to buy oil at a specific price in a year's time, thus somewhat insulating them against sharp rises in the price of oil. And because they have bought an option, if the price of oil falls, then they can decide not to exercise the option and just buy the oil in the market. Of course options cost money, but the price of the option is very small compared to the potential losses incurred if the price of oil increases dramatically.

Initially trading in financial derivatives was considered as gambling by authorities and was banned in many countries. But after intense lobbying, the laws were relaxed and in 1971 the first derivatives exchange, the Chicago Board of Trade Option Exchange, was officially sanctioned. [1] Since then the derivatives market has exploded from being insignificant to the largest market in the world. It is dominated by investors and hedge funds whose only interest is to make money from derivatives speculation. The picture below gives an estimate of the relative size of the derivatives market.

Source: The Market Oracle

The CDS portion of the derivatives time bomb in the above diagram is estimated at over $50 trillion, equal to the total world GDP. If just 10% of CDS actually default, somewhere in the financial system there will be $5 trillion in losses.

Derivatives have been called "Financial weapons of Mass Destruction", by investor Warren Buffet. The Mexican financial crisis of 1994 and East Asian financial crisis of 1997 were both greatly exacerbated, and may even have been caused, by using derivatives to speculate on their currencies.

They have also been responsible for a number of major financial losses in the past twenty years, including: 1994 Metallgesellshaft loses $1.5 billion, 1995 Barings Bank collapses, 1998 Long Term Capital Management loses $3.5 billion, 2001 Enron goes Bankrupt, 2002 AIB loses $750 million, 2006 Amaranth Advisors loses $6 billion, January 2008 Societe Generale loses $4.9 billion, 2008-2009 AIG loses $180 billion (to date).

I was confused when I first learned of the extent of the CDS market. How could it become so big? For a number of reasons:

Firstly, you don't have to own an asset to trade in derivatives based on it. So all sorts of bets can be made on any asset that can be measured. You can make bets on the future price of a currency, or stock exchange index, for example. Traders sold the same credit risk multiple times to multiple parties, increasing their bonuses substantially, but also increasing the credit risk of the entire system many times. For example, mortgages to the amount of $10 million could be expanded into $100 million of risk through the use of multiple CDS contracts. Secondly, you don't actually need to have the money to back up your bets. All you need is counterparty willing to deal with you. You can borrow the money (called leverage) in order to make your bets. And this is what happened. For every dollar speculators spent betting on derivatives, approximately 95 cents of that money was leveraged. The system got completely out of control, with multiple bets and cross bets across multiple parties in the financial sector. Some of the derivatives being sold were highly complex and understood by only a small number of technical people. As long as most people were paying off their debts then the system worked nicely, with everybody seemingly making a lot of money. But the whole system has become so complex that nobody actually knows the ramifications of particular credit defaults, making it almost impossible to quantify the value of the contracts one holds [2] .

Thirdly, the banks got more and more out of the banking business and into the speculation business. They found a way, called securitisation, in which they could greatly increase the volumes of money they were lending, and therefore the amount of profit they made. Here's an example of how it works. A bank opens a subsidiary (sometimes called a Special Purpose Vehicle or SPV, which is legally independent but controlled by the bank) in a tax haven like the Cayman Islands. It sells on the mortgages it owns to the SPV. The subsidiary creates a number of derivative products based on these mortgage risks. One such derivative is called a Collateralised Debt Obligation (CDO). A CDO is a package made up of debt from different mortgages, called tranches. Some of the mortgages are considered safe, some medium risk, and some 'sub prime' (called "nuclear waste" in financial jargon). The subsidiary gets a credit rating agency (e.g. Standard & Poor's) to give a rating to each tranch. The tranches are sold off, based on their credit rating, to various investors, such as hedge funds and pension funds. What an investor gets from buying the CDO [3] is the actual monthly repayments from the bank's borrowers. In return he pays the value of the debt, but he still makes a profit if the monthly repayments exceed the amount of interest he would have gotten if he had put his money into a bank. So everybody is happy, as long as there are not too many defaults.

The bank obtains a number of advantages from securitisation. It can use this mechanism to circumvent banking regulations that limit the amount of money it can lend. Banks make money by making loans [4] , so this is very attractive. It also (theoretically, but in practice it hasn't worked out that way) reduces the bank's risk of default, because it has sold on the risk, through the subsidiary, to other investors. This encourages it to become more reckless in lending to people who cannot afford the loans ("liars loans") because somebody else down the line (through a derivative contract) will pay up if the borrower cannot pay.

People who patently could not afford a mortgage were seduced into buying homes, based on "teaser rates" (i.e. low interest rates for the first year or so that were just about affordable at the special-offer rate). Everybody assumed, in a gold-rush mentality, that property prices would continue to rise [5] indefinitely. Even if the 'sub prime' people couldn't pay, the banks could just foreclose on them and be left with an asset worth more than the loan. But when people started to default and property prices also fell, the derivative time bomb went off. The CDS and CDO contract obligations cannot be fulfilled, because the amount of money bet is larger than the global GDP! The insurance company AIG has so far received $180 billion from the U.S taxpayer to pay off bets it lost on derivatives to banks and hedge funds. And nobody knows how much more will be needed in the future to shore up AIG.

Derivatives like CDOs and CDSs were advertised as spreading the risk across the system. And they did exactly that; they passed on and multiplied the risk throughout the system. Investors, such as pension funds, thought they were buying AAA securities, but bundled with these securities were risks of which they were completely unaware. But the credit ratings agencies had given them the AAA ratings. Unfortunately, the securities that they were rating sometimes belonged to their most lucrative customers, creating a conflict of interest in which they were naturally inclined to be more favourable towards these securities when making their ratings.

The truth is that nobody knows how exposed each bank or hedge fund is to these derivative contracts. And nobody is telling the truth about their own exposure. Trust has completely broken down in the system with each bank hoarding money in order to avoid being the next victim of the crisis. Banks are unwilling to lend to each other because they are afraid they will not be repaid. Banks are unwilling to lend to business, resulting in a shortage of money in the economy, which is responsible for the economic depression. Many banks are now technically insolvent (their liabilities exceed their assets). Even banks that are solvent fear they will fall victim to speculators who try to make money through 'short selling' [6] their shares and drive them out of business in the process.

A whole industry of hedge funds, private equity firms, deposit banks morphed into investment banks, has grown up over the past thirty years and has become an unregulated "shadow banking system". This is what has caused the financial crisis. It is a global casino in which the loser, as always, is mainly the uninformed and the ordinary people who bear none of the responsibility for the crisis.

To date, the main response of most governments has been to funnel trillions of dollars to the banks in the hope that 'confidence' will be restored to the system, and that the speculation bubble begin in earnest again. There has been no serious attempt made to regulate derivatives or the players involved. And some people are making billions of dollars out of the public bailouts intended to get the banks lending again.

The credit rating agencies contributed to the financial crisis that caused the banking system to fail, leading to the Government bailing out the banks; the fiasco that caused the economy to crash, that is draining the government's finances. And the same credit rating agencies are now downgrading the government debt! And CDS contracts, which were at the heart of the meltdown, are still being used, without any regulation, to bet on our government's ability to pay!