October 31, 2011

Staff Picks: Halloween, Zombies and the Devil's Derivatives

By: 800-CEO-READ @ 7:20 PM – Filed under: Current Events & Public Affairs

This may be a ghost story. It happened on a dark night mistaken for morning in America, a night that would descend over the entire financial world.

Nicholas Dunbar sets the scene in his book, The Devil's Derivatives:
For most of it's history, our financial system was built by on the stolid, cautious decisions of bankers, the men who hate to lose. This cautious investment mind-set drove the creation of socially useful financial institutions over the last few hundred years. ... People like that did not drive the kind of astronomical growth seen in the last two decades.
So who did create that astronomical growth? Dunbar tells of encountering them one evening while they were "celebrating their annual bacchanal, which is also known as "bonus season.'"
I knew bout some of them: there was the head of the financial institutions derivatives marketing who forgot which of his Italian supercars had been towed off to the car pound. There was the head of credit structuring notorious for preying on female staff and having his corporate credit cards stolen by prostitutes. These young men—and almost all of them were young, some shockingly so—were the avant-garde of the credit derivatives boom, enjoying the first, fifth, or tenth million. ... There are many sobriquets for these young lions, but I like to think of them as the men who love to win.
So the stage is set for a battle between the men who love to win, for whom "any uncertain bet is a chance to become unbelievably happy, and the misery of losing barely merits a moment's consideration," and the men who hate to lose, who "are attached to the idea of certainty and stability" (you can think of them as vampires and werewolves). But the battle never happened. The moon was just right that night.
[T]he love-to-win mindset spread like a virus. With all that pixie dust—or was it filthy lucre?—these bankers sprinkled across London and New York, who could be surprised that their influence spread? First, it infected the traditional bankers (and their hate-to-lose cousins at insurance companies, municipalities, and pension funds). Men and women who had been pillars of the communities from Newcastle-upon-Tyne to Seattle shrugged off their time-honored—boring!—roles of prudently taking deposits and offering loans and started wanting to make "real" money. Regional bankers in turn spread it to consumers, who were encouraged to drop their "antiquated," risk-averse attitudes toward borrowing and home ownership. And thus was born the greatest wealth-generating machine the world had ever seen. It was truly awe inspiring in its raw power and avarice, and truly horrifying when it came crashing down.
Dunbar traces this all to a new emphasis on shareholder value among banks in the late '80s and the rise of new derivatives that would help banks increase that value, sparking "the innovation race between two ways of transferring credit risk: the old-fashioned 'letter of credit' versus a recent invention, the credit default swap." Perhaps it's a good idea to briefly define exactly what a derivative is (to the best of my limited knowledge). A derivative is essentially a forward contract on a future transaction that allows each side to reduce uncertainty and "square up logistics." The largest derivatives market in the world is in interest rates, with the most common being the interest rate swap. The most destructive derivative has been the credit default swap:
Rather than being linked to currency markets, interest rates, stocks, or commodities, these derivatives were linked to unmitigated financial disaster: the default of loans or bonds. I found it hard to imagine who might be interested in buying such a derivative from a bank. The nonfinancial companies whose activities in the globalized economy exposed them to financial uncertainty didn't seem interested. The derivatives that were useful to them—futures, options, and swaps linked to commodities, currencies, and interest rates—had already been invented. It seemed to me as if the credit default swap as an invention searching for a real purpose. As it happened, the kind of companies that found credit default swaps most relevant were those that had lots of default risk on their books: the banks [themselves].
This allowed money to flow much more freely as institutions could make loans they weren't responsible for recovering, loans could be bundled into credit default obligations (CDOs), and you could speculate on that bundle of loans with credit default swaps. It was, essentially, creating money out of thin air, loaning it to whoever would take it and then buying insurance on it just to turn a buck. The problem is that there are a finite number of applicants out there qualified to take out loans the banks could bundle, and invented money is infinite. So they started loaning money to folks who they knew wouldn't be able to pay it back, and this is where the zombies come into the story.
Having flooded the market with seemingly safe investments larded with subprime money, the traders created zombie banks to buy them. Brick-and-mortar banks liked these zombies, because they evaded accounting rules and regulations, and increased profits. Hungry for higher fees, ratings agencies encouraged the growth of this new market and undermined governance. Wall Street saw the zombie structured investment vehicles (SIVs) as ideal "dumb money" customers for buying subprime CDOs and began setting them up specifically for this purpose. But at first whiff of in 2007, investors fled this market, causing the zombies to collapse almost overnight. Banks were forced to bail them out, which increased their subprime problems
And that's when it all came crashing down, when the banks realized that they didn't even know how much risk they were carrying, and when the government stepped in to essentially insure an unknown and bail out the banks.

Well, at least the men who love to win "got theirs" for awhile, even if the rest of us largely lost out when it all came crashing down. But here's my question: Was all that wealth, all those profits they created and moved around during those boom years really, truly growth? Or was it just a ghost?