by Conor McCabe
In 1999, the Clinton administration put pressure on Fannie Mae to ease ‘The credit requirements on loans that it will purchase from banks and other lenders’.10 The government wanted to encourage banks ‘to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans’, and it used Fannie Mae and MBSs to do so. Essentially, Fannie Mae, the main underwriter of home mortgages in the US, was moving into subprime lending. ‘In moving, even tentatively, into this new area of lending,’ wrote The New York Times in 1999, ‘Fannie May is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s.’11 In February 2004, the chairman of the Federal Reserve, Alan Greenspan, explained to The New York Times that the sizes of Fannie Mae and Freddie Mac, and the fact that they were government-sponsored enterprises, made it ‘difficult for Congress to avoid a bailout in the event of a financial calamity’. ‘It’s basically creating an abnormality,’ he said, ‘which the system cannot close around, and the potential of that is a systemic risk sometime in the future, if they continue to increase at the rate at which they are.’12 Greenspan’s concerns were not with MBSs as such, but with the fact that they were concentrated within federal-protected financial institutions. His preferred solution was not the oversight of such potentially risky ventures, but the further deregulation of mortgage securities in order to let the dynamics of the free market – and its invisible hand – set the parameters of risk and, of course, to profit from that risk.
In the late 1990s, new types of MBSs were developed, this time for private banks. They were called private-label mortgage-backed securities. They lacked any form of a government guarantee – implicit or otherwise – and as such they carried greater risk. The absence of a government guarantee also meant that banks relied on private credit-rating agencies to enhance confidence in these new securities and to encourage investors. These were freely given. As one commentator put it:
Debt holders relied on credit rating agencies such as Moody’s, Standard & Poor’s, and Fitch to prescribe the amount of risk associated with private label securities. These private label securities earned great ratings from the credit agencies. In fact, the vast majority of private label debt was rated AAA, the highest rating achievable, second only to debt that was government insured. The appeal to investors was a higher return as to the comparable government insured securities.13
The rise of these private-label mortgage-back securities, coupled with the liberalisation of lending practices in Freddie Mac and Fannie Mae, meant that ‘most subprime lenders were [now] financed by investors on Wall Street’ rather than ‘traditional banks and thrifts, which traditionally financed their loans with deposits’.14 Furthermore, the transactions surrounding these products were highly complex and required a strong degree of mathematical fluency to decipher them, so much so that many of the bank executives and regulators who traded and regulated the securities simply did not understand the mechanics. Such were the wage bonuses and profits generated by these products, however, that there was little desire on the part of the financial markets to question the process. Accordingly, there was an increasing reliance on computer software packages to compensate for the lack of detailed knowledge. In the words of the 2011 Financial Crisis Inquiry Commission Report:
Financial institutions made, bought, and sold mortgage securities they never examined, did not care to examine, or knew to be defective; firms depended on tens of billions of dollars of borrowing that had to be renewed each and every night, secured by subprime mortgage securities; and major firms and investors blindly relied on credit rating agencies as their arbiters of risk.15
Furthermore:
… while the vulnerabilities that created the potential for crisis were years in the making, it was the collapse of the housing bubble – fuelled by low interest rates, easy and available credit, scant regulation, and toxic mortgages – that was the spark that ignited a string of events, which led to a full-blown crisis in the fall of 2008.
Trillions of dollars in risky mortgages had become embedded throughout the financial system, as mortgage-related securities were packaged, repackaged, and sold to investors around the world.
When the bubble burst, hundreds of billions of dollars in losses in mortgages and mortgage-related securities shook markets as well as financial institutions that had significant exposures to those mortgages and had borrowed heavily against them.
This happened not just in the United States but around the world. The losses were magnified by derivatives such as synthetic securities.16
The slowdown in the US housing market in 2006 took place alongside a rise in mortgage defaults. The securitisation of mortgages, however, had become a key element of the world’s financial markets. The route by which bad loans in Chicago ended up on the balance sheets of ILB Deutsche in Düsseldorf was ‘opaque and laden with short-term debt’, and was facilitated by the development of the shadow banking system.17
‘IT WAS KIND OF A FREE RIDE’18
Paul Volcker, former Chairman of the Federal Reserve, 11 October 2010.
The authors of the Financial Crisis Inquiry Commission Report found that the US financial system of 2008 bore little resemblance to that of their parents’ generation; ‘The changes in the past three decades alone,’ they concluded, ‘have been remarkable.’19 In 1933, in the wake of the Wall Street Crash and Great Depression, the US legislature passed the Glass-Steagall Act. This established the Federal Deposit Insurance Corporation (FDIC), which was set up in order to avert banks runs and sharp contractions in the finance markets. It meant that ‘if banks were short of cash, they could now borrow from the Federal Reserve, even when they could borrow nowhere else. The Fed, acting as lender of last resort, would ensure that banks would not fail simply from a lack of liquidity.’20 The price of this bank guarantee was regulation. In order to lessen the chances of a bank failure, the Fed insisted on measures to avoid excessive risk. The 1933 and 1935 Banking Acts ‘prohibited the payment of interest on demand deposits and authorized the Federal Reserve to set interest rates on time and savings deposits paid banks and savings and loans associations’ (S&Ls or thrifts).21 Congress moved to limit the competition for deposits, as it felt that ‘competition for deposits not only reduced bank profits by raising interest expenses, but also might cause banks to acquire riskier assets with higher expected returns in attempts to limit the erosion of their profits’.22
The cap on interest rates came under increasing pressure in the late 1960s and early 1970s, as inflation grew and institutions such as ‘Merrill Lynch, Fidelity, Vanguard and others persuaded consumers and businesses to abandon banks and thrifts for higher returns’.23 ‘These firms,’ said the Financial Crisis Inquiry Report:
…created money market mutual funds that invested these depositors’ money in short-term, safe securities such as Treasury bonds and highly rated corporate debt, and the funds paid higher interest rates than banks and thrifts were allowed to pay. The funds functioned like bank accounts, although with a different mechanism: customers bought shares redeemable daily at a stable value. In 1977, Merrill Lynch introduced something even more like a bank account: ‘cash management accounts’ allowed customers to write checks. Other money market mutual funds quickly followed.
These funds differed from bank and thrift deposits in one important respect: they were not protected by FDIC deposit insurance. Nevertheless, consumers liked the higher interest rates, and the stature of the funds’ sponsors reassured them …
Business boomed, and so was born a key player in the shadow banking industry, the less-regulated market for capital that was growing up beside the traditional banking system. Assets in money market mutual funds jumped from $3 billion in 1977 to more than $740 billion in 1995 and $1.8 trillion by 2000.24
The Glass-Steagall Act, along wit
h limiting interest rates, had also ‘strictly limited commercial banks’ participation in the securities markets, in part to end the practices of the 1920s, when banks sold highly speculative securities to depositors’.25 Most of these regulations were phased out in the 1980s and ’90s, with the Gramm-Leach-Bliley Act in 1999 one of the final nails in the regulatory coffin. This Act ‘allowed banks to affiliate for the first time since the New Deal with firms engaged in underwriting or dealing with securities’.26 On 15 December 2000, the US Congress passed the Commodity Futures Modernization Act. This allowed for the deregulation of the Over-The-Counter (OTC) derivatives market. It also extended the 1992 pre-emption of State laws relating to derivatives, ensuring that they could not be declared as illegal or, indeed, as gambling. The Bill’s promoter, Senator Phil Gramm, told Congress that:
[The] enactment of the Commodity Futures Modernization Act of 2000 will be noted as a major achievement by the 106th Congress. Taken together with the Gramm-Leach-Bliley Act, the work of this Congress will be seen as a watershed, where we turned away from the out-moded, Depression-era approach to financial regulation and adopted a framework that will position our financial services industries to be world leaders into the new century.27
The Act ‘shielded OTC derivatives from virtually all regulation or oversight’.28 It led to a boom in the trade of these products, especially credit default swaps. These successful moves towards deregulation ensured that financial markets had such scant supervision as had not been seen since before the Wall Street Crash and Great Depression. In 2011, the Financial Crisis Inquiry Commission concluded that the Commodity Futures Modernization Act of 2000 and the rapid expansion of the derivatives market ‘was a key turning point in the march towards the financial crisis’.29
‘… TURNING THE FINANCIAL MARKETS INTO GAMBLING PARLOURS SO THAT THE CROUPIERS CAN MAKE MORE MONEY …’
Charlie Munger, Vice-Chairman, Berkshire Hathaway Corporation, May 2008.
At its simplest, an OTC derivative is a contract between two parties which involves a transfer of risk. With regard to financial markets, risk is associated with the volatility of prices over time. Currencies change in value, for example, on a daily, hourly, even minute-by-minute basis, and are subject, in times of extreme crisis, to crashes. Similarly, the value of bonds, shares and securities are subject to fluctuations in price and the threat of bankruptcy and default on the part of the issuer. OTC derivatives are used by those who trade in financial products as a way of hedging the risk associated with financial products, of limiting exposure to risk and to the inherent market volatility of financial assets or rates. However, unlike standard derivatives (also known as ‘plain vanilla’ derivatives), OTC derivatives are traded outside of the regulated exchange environment. The contract is between two parties only, and remains that way. The two parties ‘agree on a trade without meeting through an organised exchange’.31 They are ‘neither registered nor systematically reported to the market. Thus the full risk exposure in the system is not known until the crisis hits.’32 OTC derivatives are custom-made to meet the risk-hedging requirements of the customer. They are the haute couture of the securities world – each one unique and mathematically ornate. And the construction and sale of each OTC derivative yields a handsome fee.
Derivatives as financial instruments date back centuries, but the market for them was small until 1971, when interest and currency exchange rates became highly volatile in the wake of the Nixon administration’s decision to end its association with the Bretton Woods system. This system had been established in 1944, when the major industrial countries of the world agreed to adopt a common monetary policy. Each major currency maintained a fixed exchange rate with the US dollar, which acted as a reserve currency and which itself was fixed to a gold standard rate. The International Monetary Fund and World Bank were created under this system to help countries bridge temporary balances of payments. The decision in 1971, known as the ‘Nixon Shock’, soon saw significant fluctuations in the exchange rates between currencies – a costly and damaging process for multinational companies who dealt with multiple currencies on a daily basis. These unpredictable fluctuations in exchange rates affected costs and profits. In 1972, the Chicago Mercantile Exchange began trading futures contracts on currencies, as a way of companies limiting their exposure to the market volatility of currency prices over time. The volatility generated by the Nixon Shock offered new opportunities. ‘Money could be made out of that instability using financial derivatives,’ writes Dr Jan Toporowsaki of the University of London, ‘and no one has yet invented a foolproof way to prevent people with money from using it to make even more money no matter how ruinous the consequences may be for society.’33
The sale of these contracts was given a boost in 1973, when Fisher Black of the University of Chicago and Myron Scholes of MIT published a paper in the Journal of Political Economy entitled ‘The Pricing of Options and Corporate Liabilities’. They had developed an algorithm which advanced the way traders could price futures options in a way that limited risk exposure. It assumed ‘ideal conditions’ in the market for the stock and the option, and concluded that under these assumptions, ‘it is possible to take a hedged position on the option, whose value will not depend on the price of the stock, but will depend only on time and the values of known constants’.34 The algorithm was further advanced by the economist Robert C. Merton in his 1973 article ‘Theory of Rational Option Pricing’.35 This modified formula became known as the Black-Merton-Scholes model, for which Merton and Scholes received the Nobel Memorial Prize in Economic Sciences in 1997 (Black had died in 1995, and the award is not awarded posthumously).
The effect of the Black-Merton-Scholes model was to give mathematical security to risk-hedging. One way to eliminate risk is to make two bets: one that covers you if the outcome is favourable and one that covers you if the outcome is unfavourable. The trick is to work out the correct pricing so that the winning bet covers the loss of the losing bet. Black-Merton-Scholes allowed traders to perform this task. ‘Almost immediately,’ wrote the economist René M. Stulz, ‘[the model] was found useful to price, evaluate the risk of and hedge most derivatives, plain vanilla or exotic. Financial engineers could even invent new instruments and find their value with the Black-Merton-Scholes pricing method.’36
In 1974, Texas Instruments brought out a calculator that used the Black-Merton-Scholes model. ‘Soon, every young trader, many as second-year college drop-outs fresh from their first finance classes, was using a handheld TI calculator to trade options and was making more profit in a day than the college professors made a year.’37 The development of computers in the 1970s, and the exponential growth in speed, power and programming, made it easier not only to use Black-Merton-Scholes to price derivatives, but also to develop new and ever-more complex financial products, even to adapt them for individual clients. All of this was done with one purpose in mind: both the buyer and seller of OTC derivatives were trying to beat the market. They were trying to eliminate risk. The growth of the derivatives market also turned derivatives into financial assets in themselves. The sale of a derivative generates revenue. ‘The contracts can be traded, further limiting risk but also increasing the number of parties exposed if problems occur.’38 Furthermore, ‘losses suffered because of price movements can be recouped through gains on the derivatives contract’.39 Instead of helping to limit risk, however, ‘The models were used to justify a bigger appetite for risk’.40
Writing in 2002, the economist Henry C.K. Liu said that although the trade in derivatives ‘grew up alongside new forms of capital flows as part of an effort to better manage the risks of global investing’, it also facilitated new compositions of capital flows ‘by unbundling risk and redistributing it in commensurate return/risk ratios to a broad market’.41 In other words, derivatives, particularly OTC derivatives, not only added a level of insurance to existing financial products, they facilitated the creation and expansion of new financial products by enabling risk, seemingl
y, to disappear. Liu continued:
At the same time, derivatives create new systemic risks that are potentially destabilizing for both developing and advanced economies. While the risk shifting function of derivatives initially served the useful role of hedging and thereby facilitating fund flows, the prevalence of derivatives is now threatening the stability of the global economy as a whole.
This is because:
Derivatives are unlike securities and other assets because no principle or title is exchanged. In their essence, nothing is owned but pure price exposure based on ‘notional’ values. They are merely pricing contracts. Their price is derived from an underlying commodity, asset, rate, index or event, and this malleability allows them to be used to create leverage and to change the appearance of transactions [my emphasis]. Derivatives can be used to restructure transactions so that positions can be moved off balance sheet, floating rates can be changed into fixed rates (and vice versa), currency denominations can be changed, interest or dividend income can become capital gains (and vice versa), liability can be turned into assets or revenue, payments can be moved into different periods in order to manipulate tax liabilities and earnings reports, and high-yield securities can be made to look like convention AAA investments.