Reform of the OTC Derivative Market
By
Henry C.K. Liu
Part I: The Folly of Deregulation
This article appeared in AToL
on December 3, 2009
On October 7, 2009,
the United States House of Representatives Committee on Financial
Services at
long last held a public hearing on Reform of the Over-the-Counter (OTC)
Derivative
Market: Limiting Risk and Ensuring Fairness.
OTC derivatives are contracts executed outside of the
regulated exchange environment whose values depend on (or derive from)
the
values of underlying assets, reference rates or indexes. Market
participants
use these instruments to perform a wide variety of useful risk
management
functions. The Bank of International Settlement (BIS) reports that the
notional
value of all outstanding OTC derivative contracts ending June 2009 was
$49.2
trillion worldwide against a 2009 world GDP of $65.6 trillion.
In the US,
congressional hearings are the
principal formal venue by which committees collect and analyze
information in
the early stages of legislative policymaking. The House
Committee on Financial Services oversees and formulates
policies and develops legislation that govern the entire US financial
services
industry, including the securities, insurance, banking, and housing
industries.
The Committee also oversees the work of the Federal Reserve, the
central bank,
the Department of the Treasury, the Securities and Exchange Commission,
and
other financial services regulators and agencies. As such, its mandate
covers
the OTC derivative market where derivative instruments are traded
directly
between counterparties outside of exchanges. The largely unregulated
OTC
derivative market has been a major source of systemic risk in financial
markets. The Committee is currently chaired by Representative Barney
Frank,
Democrat from Massachusetts,
with
Republican Spencer Bachus from Alabama
as ranking member.
Witnesses initially called by the Committee for the hearing
were all derivative industry representatives. The list included Jon
Hixson, Director of Federal
Government Relations at
Cargill, an international provider of food, agricultural, and risk
management
products and services that relies heavily upon futures and OTC markets.
Cargill
is an extensive end-user of derivative products on both regulated
exchanges and
in the OTC markets. It also actively offers risk management products
and
services to commercial customers and producers in the agriculture and
energy
markets. On the list was also James Hill of Morgan Stanley, appearing
on behalf
of the Securities Industry and Financial Markets Association, Stuart
Kaswell of
the Managed Funds Association which, through one of its lobbyists, has
delivered significant “bundled” donations to Congressman Frank. Another
witness
was Christopher Ferreri of the Wholesale Markets Brokers Association.
All are or
represent beneficiaries of deregulated derivative markets.
Robert A. Johnson, Director of Financial Reform at the
Roosevelt Institute, was added as a witness at the last minute after
protests made
to Chairman Frank by Americans for Financial Reform, an organization of
some
200 citizen groups advocating the interests of consumers, labor unions
and
small businesses. Johnson prepared an opening statement which focused,
among
other concerns, on the “structurally dysfunctional money politics
system” that
allows legislators to be improperly influenced by well-financed
industry
lobbyists and campaign contributions. Johnson’s point was validated by
the fact
that his opening statement was cut short by Congresswoman Melissa Bean,
Democrat from Illinois,
who
chaired the meeting in the absence of Chairman Frank and whom Harpers
Magazine
described as “another industry-funded committee member”. Johnson’s
written
statement was kept off the committee’s website on a manufactured
technicality,
presumably to suppress awkward public exposure of Wall Street financial
support
to Democratic legislators.
The draft of the reform bill fails to call for the
establishment of a special exchange for OTC derivatives as proposed by
some
reformers. It proposes instead to establish a clearinghouse, which is a
weaker
vehicle for tracking OTC derivative transactions. But it also would
allow banks
and their counterparties to be exempted from posting such transactions
to the
clearinghouse if the parties do not wish to, by simply claiming that
their
derivative contracts do not fit into standardized formats enough to
benefit
from centralized clearinghouse practices. An earlier draft of the bill
would
even have exempted transactions designed to hedge risk. Since
practically all
speculative derivative contracts contain elements of risk hedging, it
would mean
that essentially all derivative contracts could be exempted.
In an interview with Democracy Now, Johnson characterizes
the reform bill as “too tepid, too weak, too late … Very industry
influenced.
We had a crisis and they are pandering to the perpetrators.”
All may not be lost. The legislation also has to pass the
House Agriculture Committee, chaired by Congressman Collin C. Peterson,
Democrat from Minnesota,
which is
more likely to include a requirement that derivative contracts be
traded on an
exchange, or at least that banks and companies report their derivative
contracts
to a clearinghouse. “As things stand now, I’d be more inclined to
support the
Ag bill,” says Chairman Frank of the House Committee on Financial
Services.
Robert Johnson, allowed to testify before Senate Agricultural
Committee,
reveals 4 major flaws in
the financial
sector.
Reform towards Deregulation
Finance deregulation took a great leap forward with
securities litigation reform after the Republicans captured the House
of
Representatives in November 1994 in President Clinton’s first mid-term
election
which lost control of Congress to the Republicans. The Private Security
Litigation Reform Act of 1995 (PSLRA) was passed easily by a Republican
controlled Congress and, with Democrat support, even overrode a
perfunctory
presidential veto. The law was signed into law by a deeply wounded
Democrat
president who desperately needed Wall Street financial support to win a
second
term. It is a testimony of Clinton’s
political ingenuity that the orchestrated bipartisan veto allowed him
also to
avoid losing campaign donations from trial lawyers.
PSLRA was ostentatiously directed at aggressive security
litigators, the most successful of whom was Bill Lerache, who had
recovered
billions for shareholders victimized by security fraud committed by
management.
Lerache and other partners in Milberg Weiss later pleaded guilty to
making
“false material declarations under oath” in federal court proceedings,
allegedly intended to conceal $11.3 million in secret payments and
kickbacks
that the firm was said to have paid to named plaintiffs in more than
225 class
actions suit in order to secure the standing to file the class action
suits.
Still, the suits that Lerache successfully brought were themselves of
undisputable legal merit.
PSLRA made security fraud cases more difficult for
plaintiffs to win. It reflected the belief prevalent among those in
charge of
the financial system that the market is the best self-regulating
mechanism
against fraud and abuse out of self interest without the need for added
legal
constraints. Alan Greenspan, former chairman of the Federal Reserve,
Robert
Rubin, former Secretary of the Treasury, and Arthur Levitt, former
Chairman of
the Security Exchange Commission, all were strong believers of the myth
of
market self-regulation and used their considerable influence to help
create a
deregulated regime in structured finance.
Skeptics of Self Regulation
There were skeptics of market self-regulation.
James S Chanos, head of Kynikos Associates, a short-selling hedge fund
with $3 billion under management, was known for being the first to
question Enron on its accounting fraud and for tipping Fortune
magazine reporter Bethany
McLean on it,
testified before the House Committee on Energy and Commerce on February
6, 2002
that PSLRA was responsible for the dramatic increase of fraud from 1995
through
2001 and that the statute “has emboldened dishonest managements to lie
with
impunity by relieving them of concern that those to whom they lie will
have
legal recourse. The Statute also seems to shield underwriters and
accountants
from [legal accountability for] lax performance.” He added that “no
major
financial fraud in the United States
in the last ten years was uncovered by an outside accounting firm.”
Derivative Market propelled by Financial Innovation
Financial innovation propelled the development of derivative
market which in turn became a fertile field for abuses that caused
serial
financial crises around the world since 1994, starting with the Mexico
peso
crisis, the collapse of 233-year-old British firm Barings inn 1995 from
the
billion dollar loss incurred by derivative trader Nick Leeson, the 1997
Asian
financial crisis detonated by the Thai central bank’s inability to
sustain the
fixed exchange rate of the overvalued baht, and the 1998 financial
crises in
Russia and Brazil that froze global markets briefly and subsequently
cause
interconnected markets to crash in locked steps. While
each of these crises had its own
particular roots, the vehicle that caused market failure in all cases
was
derivative trading.
Difference between Exchange-traded derivative and OTC
derivatives
Derivatives tighten the connectivity between markets and
enhance market efficiency. But they do this by increasing systemic risk
globally if left unregulated. Exchange traded derivative contracts are
generally standardized and investors are protected against fraud and
default by
transparency and the financial reserves of the exchange. OTC derivative
contracts are uniquely structured and traded directly between
contracting
parties with full assumption of risk of counterparty default. Many
large
financial institutions, including big banks, generate handsome fee by
acting as
a private clearing houses for OTC derivative contracts. However, OTC
derivatives
traded by large financial institutions that also trade with other large
financial institutions present systemic risk to the whole
interconnected
market.
The Myth of Self Regulation
Yet many policymakers and legislators still do not have a
clear understanding of the nature of financial derivatives or how the
derivative market actually works. While the destructive potentials of
financial
derivatives have been recognized since their invention thirty-six years
ago,
most regulators still lack the full understanding needed to design
effective
regulation for the derivative market, particularly the OTC derivative
market.
As a result, they tend to accept the myth of self regulation as the
best,
albeit still imperfect, solution propagated by influential free market
ideologues.
This is because the innovation-driven workings of the OTC
derivative market are constantly evolving out of the public eye, making
it
difficult for anyone who is not a direct market participant in
bilateral
counterparty contracts to develop effective regulation to protect the
financial
system from derivative-induced systemic meltdown and to protect the
general
public from risks of loss. Yet, bilateral derivative contracts are
hedged
through interconnection throughout the entire market. These contracts
manage
unit risk by transferring it to systemic risk. Thus regulation needs to
be
focused not just on size, but also on the location of strategically
placed fire
breaks to prevent systemic contagion. Such systemic contagion can
travel
without even a direct physical connection. During the 1997 Asian
financial
crisis, speculators sold in strong but highly liquid market in futile
attempts
to save distressed position in illiquid markets, bringing the entire
global
market down.
Individually Benign yet Systemically Dangerous
Derivatives, financial instruments whose values are derived
from underlying assets, are not by themselves toxic financial products
invented
by evil financial wizards. They are rational instruments for unlocking
latent
value in financial transactions through mathematical logic. With
precise
measurement of derived value and immaculate logic in risk management,
full
potential net value can be effectively captured for both the
participating
parties and the economy as a whole that otherwise would be left
untapped in
conventional financial transactions. By definition, value creation is a
positive contribution, but only net value creation after taking into
account risk
of loss can be a positive economic contribution. Creating or capturing
value
via unknown risk is merely gambling with luck. Derivatives, by their
opaque
nature, only hide risk by dispersing it, but not by extinguishing it,
allowing
the risk to stay invisibly in the system, thus creating a false sense
of
safety. Such instrument structurally under-price risk by only hiding
it. (Please
see my May 23, 2002 article: The
Danger of Derivatives)
Synthetic Notional Value
A derivative, being
a financial instrument that derives its value from an underlying asset,
is a
sophisticated vehicle for pricing derived values that are affected by
market
risks. Rather than trading or exchanging the underlying asset itself,
derivative traders enter into contractual agreements to exchange cash
flow, or
assets of equivalent value, over time based on expected future value of
the
underlying assets. A futures contract is an agreement to exchange the
value of an
assumed underlying asset at a future date, but not necessarily the
physical
asset itself. Thus was born the concept of notional value in derivative
structures.
The Use of Leverage
To capture minute change in value, derivatives are routinely
structured with high leverage so that a small movement in the value of
the
underlying asset can cause large changes in the value of the derivative
contract. This leverage, coupled with the astronomical growth of the
OTC
derivative market, has turned many financial institutions that
participate in
this market into “too big to fail” entities, the failure of which can
cause
serious systemic impact, allowing them to expect government bailout by
holding
the financial system hostage in a distressed market to prevent systemic
collapse. Thus the “too-big-to-fail” syndrome leads directly to
heightened
moral hazard. Still, leverage is the music of the derivative market.
Without
access to leverage, the derivative market will have no dancers.
The net capital rule created by the SEC in 1975 required
broker-dealers to limit their debt-to-net-capital ratio to 12-to-1.
After the
rule was exempted in 2004 for five big firms, many hedge funds
increased their
leverage to 40-to-1 to maximize profit by enlarging the risk profile by
trading
with the big five. (Please see my January 22, 2009 AToL article: The
Zero Interest Rate Trap)
Moral Hazard and Too-Big-to-Fail
Moral hazard generated by the “too-big-to-fail” syndrome
distorts the risk management role of derivative structures. It turns
the
hedging function of derivative into profit centers derived from an
under-pricing of risk for unsustainable gains.
The solution to the “too-big-to-fail” dilemma intuitively
lies in preventing institutions from getting too big. Yet because of
interconnection of markets, even failure of small entities in large
numbers can
trigger systemic failure. This gives even larger numbers of small
entities of
similar risk profile, but each not too big to fail individually, the
ability to
cause systemic failure.
In mathematics, the theory of large numbers includes the phenomenon of
unsustainable exponential growth which occurs when the growth rate of a
mathematical function is exponentially proportional to the function’s
escalating value. Such exponential growth is mathematically
unsustainable and
will eventually implode. Malthusian population theory is based on the
un-sustainability of exponential growth.
Multilevel marketing is designed to create a fast growing marketing
taskforce by
compensating not only for sales it generates, but also for the sales of
other
new marketing taskforces introduced to the company by each existing
marketing
taskforce, creating a limitless down-line of distributors and a
hierarchy of
multiple levels of compensation in the form of a pyramid, such as that
employed
by Amway Corporation. The crisis in sub-prime mortgage is caused by
massive
network marketing, even as each subprime mortgage individually is only
a small
contract.
No bank, however big and well capitalized, can withstand the onslaught
of a
systemic breakdown of market-wide counterparty exposure built by
multilevel
marketing of liabilities such as subprime mortgages and their
securitization.
The Need for Firebreaks
Thus the problem of systemic market failure is caused not merely by
unit
bigness, but also by the absence of firebreaks to prevent exponential
growth
and the resultant systemic contagion effect of large number failures
from
chained counterparty reaction. It is hard to understand why
policymakers are
not cognizant of this obvious fact enough to focus on the need for
firebreaks
in interconnected financial markets to both prevent the buildup of risk
chain
reaction and to contain systemic failure contagion.
Options and Hedges
In finance, options
are derivatives
because they derive their value from an underlying asset. An
option
contract is an agreement between a buyer and a seller that gives the
buyer the
right, but not the obligation, to buy or to sell a particular asset on
or
before the option’s expiration date at an agreed price. In return for
granting
the option, the seller collects a payment or a consideration from the
buyer.
Options can be used to speculate for profit or to hedge
risk. The classic model of hedging, originally developed in 1949 by
Alfred
Winslow Jones (1910-1989), takes long and short positions in equities
simultaneously to limit exposures to volatility in the stock market.
Jones, Australian-born, Harvard and Columbia educated
sociologist turned financial journalist, came upon a key insight that
one could
combine two opposing investment positions simultaneously: buying stocks
and
selling short paired stocks, each position by itself being risky and
speculative, but when properly combined would result in a conservative
portfolio that could yield market-neutral outsized gains with high
leverage.
The realization that one could couple opposing speculative plays to
achieve
conservative ends was the most important step in the development of
hedged
funds, a term coined by a 1966 article in Fortune
to describe the fund run by Jones.
The manipulative
power
of options lies in their versatility. Options enable the buying
party to
adapt or adjust its position to handle any future situation that may
arise.
Options can be used speculatively with risk or protectively against
risk to fit
the buyer’s desire. This means an option buyer can do everything from
protecting a position from decline to outright betting on the movement
of a
market or index for gain. Options are therefore merely passive
versatile
financial instruments. The users of options determine their purpose for
their
use.
Why Option Trading
Needs to be
Regulated
Regulating the
options market
has all the controversy of the debate on gun control. Guns do not
kill; only people kill; but guns
make it easier for people to kill. Thus gun control is advisable even
though it
is not a final solution to purposeful or accidental killing. Further,
guns
should definitely be kept away from children who have not developed the
mature faculty
to handle a dangerous weapon properly. Similarly, the trading of
options should
be regulated to protect investors who do not fully understand the
implications of
their investment decisions by the use of options.
To facilitate varying cash flow needs of different
participants in a transaction, payments can take the form of structured
settlements which are agreements to pay a designated party a specific
sum in
periodic payments over an extended period, sometimes for a lifetime
without
definitive end, instead of a lump sum. The risk on the uncertain
aggregate
payout amount is assumed inherently by the design of the structure.
An option is a derivative whose value changes over time in
relation to the performance of the underlying asset such as a stock.
This makes
the precise evaluation of outstanding value of options difficult for
the human
mind to decipher in a timely manner, making risk-managed trading
problematic.
Options and Futures
A more complex version of an option is a futures contract,
where the value varies with the value of an underlying commodity or
security. A futures contract commits a party to
buy or sell a specified commodity of standardized quality at a certain
date in
the future, at a market determined price (the futures price).
The contracts
are traded on a futures exchange and as such they are not
over-the-counter derivatives
that are traded outside of exchanges between counterparties directly.
Futures contracts are derivative instruments. The price is
determined by the instantaneous equilibrium between the forces of
supply and
demand among competing buy and sell orders on the exchange at the time
of the
purchase or sale of the contract.
It is useful to understand that futures and option contracts
are not market prediction, but market implications that have been
precisely
calculable since 1973. Futures and option contracts are extensively
used to
manage risks involved in holding interest-sensitive stocks of firms
whose
earnings are affected by interest rates changes, such as banks,
insurance
companies, financial companies, utilities or any enterprise that
deploys large
amount of debt.
Black/Scholes/Merton Formula
In their 1973 paper, “The
Pricing of Options and Corporate Liabilities”, Fischer Black and
Myron
Scholes published an option valuation formula which has become the
standard
method of pricing options. Black and Scholes derived a stochastic
partial
differential equation governing the price of an asset on which an
option is
based, and then solved it to obtain their formula for the price of the
option.
Robert C. Merton published a paper expanding the mathematical
understanding of
the options pricing model and coined the term “Black-Scholes” option
pricing
model. Merton and Scholes received the 1997 Noble Prize for Economics
for this
and related work.
Black and Scholes made path-breaking contribution to the growth of the
option
market by providing a mathematical calculation for precise pricing of
an
option, changing it from mysterious intuitive guesses to measurable
rational
implication.
Derivatives based on the yield performance of assets,
interest rates, currency exchange rates and various domestic and
foreign
indices are now routine financial instruments that serve a wide range
of risk
management strategies. A key characteristic of derivatives is their
ability to
exploit leverage, which when used knowledgeably, can enhance returns
for
investors with appropriate appetite for risk, or be highly effective in
hedging
portfolios through the neutralization of risk exposures.
Black/Scholes merely made it possible to mathematically
determine the precise and accurate price of an option, no more, no
less. This simple feat in
real-time
accurate pricing in option markets was equivalent to the invention of
accurate
time keeping in milliseconds in computer science. It opened up the
possibility of
building mathematical models that aim at profiting from managing risk.
A lot of people since Alfred Winslow Jones have known that pairs
of opposite bets can cancel risks. What was lacking was the precision
needed to
identify the true pair opposites. Black/Scholes
made it possible to precisely
price every option trade in real time with a logic that the entire
market
accepts to be as reliable as the formula 2+2=4. But the market for
complex
reasons is never 100% efficient or rational. One reason is the
aggregate
tendency to overcompensate due to the herd instinct. Too many correct
moves
that individually compensates accurately for local errors can lead to a
big
aggregate overcompensation for internally generated systemic error.
Fischer Black and Myron Scholes found a partial solution to accurately
price options
in theory. But it was Robert Merton at Harvard who completed the
mathematical
formula. Merton’s father was a prominent behavioral scientist at
Columbia
who coined the concept of self-fulfilling prophecy. Merton studied
mathematics at
Cal Tech. Being mathematically trained and a gambler by instinct,
(there were
all kinds of stories about his gambling, how he would bet his annual
salary in
the market and live on loans collateralized by his holdings), Merton
focused on
prices in a series of infinitesimally minute time units, a process
which came
to be known as “continuous time finance”.
In the 1970s, one could not read any current literature in
finance without coming across reference to Merton’s influential work.
Merton
translated the yet unpublished theoretical concepts of Black/Scholes by
defining the relationship between an option and its underlying asset
mathematically
and came up with an elegant and easy-to-use formula that any college
grad can
use to trade options. But Merton, as a gentleman scholar, waiting for
Black/Scholes to publish first. At the time of Balck/Scholes’
publication, it
was merely an academic theory, because there was not yet an operating
options
market.
About three weeks before the B/S publication, the Chicago
Board of Options Exchange began to list stock options for trading, but
it was a
very slow process. Not too long later, Texas Instrument came out with a
hand-held calculator that had a Merton /B/S formula built-in. 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.
The derivative market took off. When B/S/Merton won the
Noble prize, young traders without exception were shouting “well
deserved”. No
one could have use the B/S/Merton formula profitably before the advent
of the options
market, and the option market could not have taken off without the TI
calculator with a built-in B/S/Merton formula. Financial innovation,
similar to
scientific and engineering innovation, evolves from a coincidence of
related
breakthroughs.
The Black/Scholes math-based models can sweep the market in seconds and
identify inefficiencies and execute arbitrage trades to exploit market
inefficiency.
Derivative trades at first blossomed to reduce market inefficiency. It
started
as an exercise in portfolio insurance to mitigate risk, but as it
became
possible to mitigate risk, risk management actually allowed market
participants
to take on larger risk with a false sense of safety. Risk management
then soon
became a profit center, leaving the insurance part behind. The profit
advantage
of each trade is often very minute, that is why it takes a huge number
of
trades, with notional values in billion of dollars to made sizable
profit. Soon,
the notional value market became exponentially larger than the physical
market.
Credit Default Swaps
Credit Default Swaps (CDS) are contracts in which the buyer
of the CDS makes a series of
payments to the seller and, in
exchange, receives a payoff if a credit instrument goes into default.
CDS
contracts have been compared with insurance, but it is different in
many
aspects. For one, a buyer of a CDS does not need to own the underlying
security
or other form of credit exposure; in fact the buyer does not even have
to
suffer a loss from the default event. It is in a way similar to buying
insurance on the death of a total stranger, which would be illegal in
insurance.
According to the Bank for International Settlements (BIS),
total outstanding Credit Default Swaps (CDS) at year end 2007 was $43
trillion,
more than half the size of the entire asset base of the global banking
system.
Total derivatives outstanding amounted to over $500 trillion in
notional value,
off the balance sheets of banks into those of Special Investment
Vehicles
(SIVs) with Collateralized Debt Obligations (CDOs) and other conduits
comprising the highly leveraged shadow banking system. July 2007 was
the month
the credit market imploded globally. US
GDP was only $14 trillion in 2008. It will take the US
36 years to produce $500 trillion in GDP.
Notional Value
Granted notional values are not the amount at risk. It is
only a value on which derivative contracts calculate winning or losses.
But a 3%
net loss on a notional value of $500 trillion will wipe out the entire
GDP in
2009. The fact that much of this frenzy
speculation was financed by debt made available by the loose monetary
policy of
the Greenspan Fed was of course a key contributing factor that fueled
the
derivative market.
Theory of Heterogeneous Expectation and Efficient Market
Hypothesis
What ever else they were, Merton/Scholes were not
charlatans. They were in fact astute philosophers of a finance
technology
revolution, managing risk by turning volatility against it, with the
advantage
of the law of large numbers within the context of the “Efficient Market
Hypothesis”, the central idea of modern finance and globalization.
The Theory of Heterogeneous Expectation asserts that asset
prices can be affected by investor expectations to create market
inefficiency
and peculiarity. False expectation leads to price bubbles because the
market
for longing an asset is generally easier to make inside an exchange
than a
market for shorting it. This gives rise to the OTC market where both
long and
short plays can be constructed at will.
The Upward Bias of Exchange-Traded Transactions
Legal and exchange rules limitation on shorting gives
exchange traded prices an upward bias, allowing price bubbles long
periods to
build by negating the efficient market hypothesis. Also, the
development of
executive compensation through stock options rather than actual stocks
meant,
in addition to potential dilution of stocks, that executive
compensation is
aligned with stockholder interest only when stock prices rise, but not
when
stock prices fall. Management began to enjoy the security of a separate
lifeboat from risk than shareholders. When
the down side of risk is removed from
management, risk will be
taken by management.
Proprietary Trading
Every hedge fund uses its own proprietary models to exploit
market inefficiency, but they are all based on the same logic of market
efficiency hypothesis. Derivative
traders at first earned money only from incentive fees earned from
trading
profits hedging risks for clients. Soon traders became not satisfied
with only
the return they made from incentive fees from hedging for clients
alone. They
began taking proprietary speculative positions by entering into
leverage
funding agreements with banks and in time led banks to set up their own
proprietary trading operations with off-balance-sheet risk exposure
outside of
their capital requirements.
The Problem of Large, Complex Banking Organizations
In my May 2002 AToL article: BIS vs
National Banks,
I warned:
“…
assessment of
risks is
complicated by recent structural financial developments in the advanced
nations’ financial systems, including increasing global market power
concentration in large, complex banking organizations (LCBOs), the
growing
reliance on over-the-counter (OTC) derivatives and structural changes
in
government securities markets. Despite all the talk of the need for
increased
transparency, these structural changes have reduced transparency about
the
distribution of financial risks in the global financial system,
rendering
market discipline and official oversight impotent.
Even blue-chip global giants such
as GE, JP Morgan/Chase and CitiGroup have overhanging dark clouds of
undisclosed off-balance-sheet risk exposure. Ironically, banks in
emerging
markets are penalized with disproportionate risk premiums when they
fail to
meet arbitrary BIS Basel Accord capital requirements, while LCBOs with
astronomical risk exposures in derivatives enjoy exemption from
commensurate
risk premiums.”
(The auto giants were not mentioned
because even in 2002, they were no longer considered as blue-chip
companies.)
The Bank for International Settlements, which sets capital
reserve requirements for banks, instead of focusing on balancing risk,
developed
Basel II to impose capital reserve on LCBOs against capital losses from
high
risk derivative transactions.
Under Basel II, a bank needs to provide an estimate of the
exposure amount for each transaction, commonly referred to as Exposure
at
Default (EAD), in the bank’s internal systems. All these loss estimates
should
seek to fully capture the risks of an underlying exposure. In general,
EAD can
be seen as an estimation of the extent to which a bank may be exposed
in the
event and at the time of a counterparty default. It is a measure of
potential
exposure as calculated by a Basel Credit Risk Model for the period of
one year
or until maturity whichever is sooner. Based on Basel Guidelines, EAD
for loan
commitments measures the amount of the facility that is likely to be
drawn if a
default occurs. The contagion effect of a chain of EAD is a key
component that
makes loss estimates difficult to pin down. (Please see my May 13, 2009
article: Stress Tests for Banks)
Banks used to set up derivative trades as a service to clients for a
nominal fee.
Then their bond trading department began doing “proprietary” trading
with the
banks funds, exposing banks to risks of huge profits and losses. By
2007, all
banks have gotten into the derivative game up to their necks, as did
all investment
banks and even commercial banks. The profit potential of 40% return
annually was
simply irresistible. Several central banks were also playing this game,
some
even today. The Bank of China was an investor in Long Term Capital
Management
(LTCM) and was the Central Bank of Italy.
Both lost huge sums when LTCM collapsed in 1998.
The Rise and Fall of LTCM
No financial system can sustain returns of 40% perpetually.
Such returns can only be produced by speculation. Thus the systemic
risk was
built into the system when derivatives were used to produce profit
rather than
to mitigate risk of loss. But immediate risk in the OTC derivative
market is
counterparty default. Counterparty risk could turn virtual winnings
into actual
losses, since it is a zero sum game. Further, counterparty default can
be
highly contagious to detonate systemic consequences. That is the main
reason the
Fed was forced to bail out LTCM, because LTCM was the counterparty to
many of
the banks’ trades, in addition to being a big borrower. It was all very
financially
incestuous.
LTCM was founded in 1994 by John Meriwether, the former vice-chairman
and head
of bond trading at Salomon Brothers. LTCM board directors included
Scholes and
Merton. It accepted investments from 80 investors who put up a minimum
of $10
million each. The initial equity capitalization of the firm was $1.3
billion.
Initially enormously successful with annualized returns of
over 40% after fees in its early years, LTCM’s enormously leveraged
arbitrage
plays involving more than $1 trillion dollars went bad in 1998,
resulting in a
$1.9 billion loss in one month, and a $4.6 billion loss in less than
four
months following the Russian sovereign bond default. The final loss was
$5.85
billion, a record at the time. But six year later, in 2006, Amanranth
Advisors
lost $6.7 billion in gas futures placed by a star trader (Brian Hunter)
and in
2008, Société Général lost $7.1 billion
from trading fraud by a young trader (Jérome Kerviel) in
European Index futures. The trend suggests that no lessons have been
learned
about the failure of market self regulation.
LTCM’s extensive derivative contracts with banks and other
institutional investors worldwide threatened a global market seizure if
it
should default on its obligations, which prompted the Federal Reserve
Bank of New York to step
in to organize a bailout with the
affected major banks. The fund folded in early 2000, but the real
damage was an
increase of moral hazard in the finance industry.
Meriwether had assembled an all star-team beyond theoretical
gurus at the founding of LTCM, including David Mullins, a Vice Chairman
of the Federal
Reserve and expert on financial crises, who wrote the White House
Report on the
1987 crash, blaming it on derivatives, also served as Assistant
Secretary of
the Treasury for Domestic Finance in the George HW Bush administration.
When
disaster hit, Mullins through his old connections brought in the Fed
for a
quick bailout.
Merton and Scholes were not actually doing the trading for
LTCM. They only provided the theoretical strategy. They did not see
LTCM as a
mere hedge fund, but as a state of the art “financial intermediary”, a
new
generation of shadow banking. Unlike old fashion banks who deal with
clients
they personally know, LTCM remotely matched liabilities with assets
globally in
a virtual market, rather than locally as banks used to do as pillars of
their
communities. LTCM borrowed by selling one bond and lent by buying
another bond,
often foreign bonds with different fundamentals, and profited from the
spread
in both interest rates and currency exchange rates. Most of the time
LTCM
traders did not know, or did not care, who were the final sellers or
buyers as
long as the trades were channeled through acceptable broker/dealers and
properly hedged. LTCM was in the highly profitable business of
enhancing global
market efficiency and of providing liquidity to the market. It had no
loyalty
to any particular nation or community, working solely on the principle
of survival
of the fittest. At the end, LTCM was brought down by an irrationally
inefficient market when Russia
defaulted on her sovereign bonds because Washington
refused to come to her aid and by a mega liquidity crunch that LTCM
itself
could not provide.
LTCM employed complex mathematical models to take advantage
of fixed income arbitrage deals through a strategy of convergence
trades of G7
sovereign bonds. Government bonds are “fixed-term debt obligations”
because
they will pay a fixed amount at a specified time in the future.
Differences in
the present value of different bonds are minimal, as according to
equilibrium
theory any difference in price will soon be eliminated by arbitrage.
Unlike
differences in share prices of two companies, which could reflect
different
underlying fundamentals, price differences between a new 30 year
Treasury bond
and a 29-and-three-quarter-year-old Treasury bond should be minimal, as
both
will see a fixed payment roughly 30 years in the future. However, small
discrepancies can arise between the two bonds because of a difference
in
liquidity. By a series of financial transactions, essentially amounting
to
buying the cheaper “off-the-run” bond (the 29-and-
three-quarter-year-old bond)
and shorting the more expensive, but more liquid, “on-the-run” bond
(the 30
year bond just issued by the Treasury), it would be possible to make a
profit
as the spread in the value of the bonds narrowed when another new bond
is
issued. On this principle, LTCM scored huge profits with high
off-balance-sheet
leverage achieved with sophisticate and complex hedges. It also
invested in long
positions in emerging markets sovereigns, hedged back to dollars.
As LTCM scored enviable returns, its capital base grew
beyond the market for profitable bond-arbitrage trades. To maintain
market
expectation of high return on asset under management, LTCM was
pressured to
undertake more aggressive trading strategies. Although these trading
strategies
were non-market directional, i.e. they were not dependent on overall
interest
rates or stock prices going up or down, meaning they were market
neutral, they
were no longer strictly pure convergence trades, but convergence trades
subject
to exogenous impacts.
By 1998, LTCM had very large positions in areas such as
merger arbitrage and S&P 500 options (net short long-term S&P
volatility). LTCM had also become a major supplier of S&P 500 vega
which measures sensitivity to
volatility. Vega is the derivative of
the option value with respect to the volatility of the underlying
asset, and
was in demand by companies seeking to essentially insure equities held
against
future declines.
Because these differences in value were minute—especially
for the convergence trades—LTCM needed to take highly-leveraged
positions to
make profit of consequence. At the beginning of 1998, the firm had
equity of
$4.72 billion and had borrowed over $124.5 billion to acquire assets of
around
$129 billion, for a debt-equity ratio of about 25 to 1. It had
off-balance-sheet derivative positions with a notional value of
approximately
$1.25 trillion, most of which were in interest rate derivatives such as
interest rate swaps, equal to 5% of the entire global market.
LTCM also invested in other derivatives such
as equity options.
After two years of returns running close to 40%, the fund
has some $7 billion under management. But by the end of 1997, LTCM was
achieving only a 27% return — comparable with the return on US equities
that
year. LTCM returned $2.7 billion of the fund’s capital back to
investors citing
as reason “investment opportunities were not large and attractive
enough.” This was a strategic error, as
the reduction
of capital adversely affected LTCM’s ability to withstand a liquidity
crisis a
few months later.
Trouble at LTCM began in May and June 1998 when net returns
fell to minus 6.42% and minus 10.14% respectively, reducing LTCM’s
capital by
$461 million. This was further aggravated by the distressed exit of
Salomon
Brothers from the arbitrage business in July 1998. There were sign that
these losses
could not be explained by temporary volatility.
LTCM’s trading strategy finally unraveled in August and
September 1998 when the Russian government defaulted on its sovereign
bonds (GKOs).
Panicked investors sold Japanese and European bonds to buy US Treasury
bonds.
The profits that were supposed to occur as the value of these bonds
converged
became huge losses as the value of the bonds diverged from sudden
market
aversion of risk. By the end of August, LTCM had lost $1.85 billion in
capital.
The company, which had been providing annual returns of almost 40% up
to this
point, experienced a sudden and massive “flight to liquidity” by its
investors.
The investors in LTCM were all sophisticated professionals: individuals
who had
made hundreds of millions themselves and sophisticated institutions who
were
major market players, including central banks. Central banks as a rule
do not
invest in hedge funds, but LTCM was not simply another hedge fund, but
a market
leader in a new financial market. Barclays was also an investor as well
as a
big proprietary trader with its own account. In fact, when swap
spreads, the
basic thermometer of the credit market, rose in late August, 1998,
Barclay
traders were ordered by top management to unload short positions in UK
swaps, even though the Barclay traders, like those at LTCM, thought the
higher
spread could not hold and convergence would soon return. But Barclay
had enough
of risk and its decision on Thursday August 20, pushed the spread even
higher,
and the next day the run started all over the world, and LTCM was
facing
imminent collapse.
LTCM had counterparty trades with nearly every institution
of importance in the world, including all 15 largest commercial and
investment
banks. As LTCM teetered, Wall Street feared that its failure could
cause a
chain reaction counterparty default in interconnected markets around
the world,
causing catastrophic losses throughout the global financial system. As
LTCM
attempted desperately to raise needed cash on its own to honor its
extensive
commitments, it became clear to the market that a default was imminent.
The fear was that there would be a chain reaction as the
firm liquidated its positions to cover its debt, leading to a sharp
drop in
prices, which would force other firms to liquidate their own debt
creating a vicious
cycle of fire sale.
On September 23, under the auspices of the NY Federal
Reserve Bank, a group including Goldman Sachs, AIG, and Warren Buffet’s
Berkshire Hathaway offered to buy out LTCM partners for $250 million
and to
inject $3.75 billion to take over LTCM and fold it into Goldman’s own
trading
division. The offer was stunningly low as at the start of the year,
LTCM
partners positions were worth $4.7 billion. Buffet gave Meriwether less
than
one hour to accept the deal. As it happened, the time period lapsed
without a
deal.
If LTCM had not returned $2.7 billion of its capital to
investors, it might have been able to withstand the crisis.
Seeing no market options left, the New York Fed organized a
bailout of $3.625 billion by 14 of the 15 LTCM major creditors to avoid
a wider
collapse in the financial markets: $300 million each from Bankers
Trust,
Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman
Sachs,
Merrill Lynch, JP Morgan, Morgan Stanley, Solomon Smith Barney, and
UBS; $125
million from Société Générale; $100 million
each from Lehman Brothers and Paribas;
while Bear Stearns alone declined to participate.
This refusal to play ball on the part of Bear Stearns would
come back to haunt it in 2008 when Bear Stearns needed help to avoid
collapse.
Bear Stearns pioneered the securitization and asset-backed securities
markets,
and as investor losses mounted in those markets in 2006 and 2007, the
company
actually increased its exposure, especially the mortgage-backed assets
that
were central to the subprime mortgage crisis. The Hail Mary bet failed.
In
March 2008, the New York Fed had to provide an emergency loan to Bear
Stearns
to try to avert a sudden collapse, but the firm could not be saved. The
New
Yrok Fed then arranged for JPMorgan Chase to acquire Bear Stearns, with
a Fed
guarantee, for as low as $10 per share, far below the 52-week high of
$133.20
per share before the crisis, although not as low as the $2 per share
originally
agreed upon by Bear Stearns and JP Morgan Chase without a Fed
guarantee.
In return for bailing out LTCM, the participating banks
received 90% of LTCM shares and a promise that a supervisory board
would be
established. LTCM’s partners received a 10% stake, still worth about
$400
million, but this money was completely consumed by their debts. The
partners
once had $1.9 billion of their own money reinvested in LTCM, all of
which was
wiped out.
LTCM’s total losses added up to $4.6 billion. The losses by
major investment categories were: $1.6 billion in swaps, $1.3 billion
in equity
volatility, $430 million in Russia and other emerging markets, $371
million in
directional trades in developed countries, $286 million in equity pairs
(such
as VW, Shell), $215 million in yield curve arbitrage, $203 million in
S&P
500 stocks, $100 million in junk bond arbitrage and no substantial
losses in merger
arbitrage.
After the bailout, when the panic abated, the positions
formerly held by LTCM were eventually liquidated at a small profit to
the
bailers. But the real damage was a sharp rise in moral hazard in the
financial
market that contributed to the crisis of 2007.
The profits from the LTCM trading strategies were generally
not correlated with each other and thus normally LTCM’s highly
leveraged
portfolio would be protected by diversification. However, the general
flight to
liquidity in late summer of 1998 led to a market-wide re-pricing of all
risks
and these separately leveraged positions all moved in the same
direction,
neutralizing the effect of balance in diversified portfolios. As the
unanticipated correlation of LTCM’s positions increased, the
diversified
benefits of LTCM’s portfolio vanished and large losses to its equity
value
accumulated exponentially.
Value at Risk as a Risk Management Tool
Thus the primary lesson of the 1998 crisis and the collapse
of LTCM for Value at Risk (VaR) users is not one of liquidity, but more
fundamentally that the underlying covariance matrix used in VaR
analysis is not
static but dynamic over time. LTCM was a victim of a massive “VaR
break”.
In financial mathematics and risk management, VaR is
a widely used risk
measure of the risk of loss on a specific portfolio of financial assets
in
terms of probability and time horizon. VaR is a threshold value of the
probability that the mark-to-market loss in a portfolio over the given
time
horizon.
For example, a portfolio of stocks with a one-day 5% VaR of
$1 million has a 5% probability that the portfolio will fall in value
by $1
million over a one trading day period, assuming markets operate
normally and there
is no compensating trading by the portfolio. Operationally, a loss of
$1
million on this portfolio can be expected on 1 day in 20. The portfolio
is
considered risk managed if over the 20-day period, the gain is over $1
million
to cover the possible loss of $1 million. A loss which exceeds the VaR
threshold is termed a “VaR break.”
LTCM had a VaR of between $3-5 million for any given day. In
August 1998, its VaR rose 100 times to $300-500 million for any given
day. In the end, the basic convergence
model used
by LTCM remained operative in that the values of government bonds did
eventually converge but only after the company had been wiped out.
Based on the derivative side of its books, LTCM had an
astoundingly high debt-to-capital ratio. According to transcripts of
the
September 29, 1998 meeting, a desperate Peter Fisher, Executive Vice
President
of the NY Fed and account manager of the Fed Open Market Committee,
told
Chairman Greenspan and other Fed governors: “The off-balance sheet
leverage was
100 to 1 or 200 to 1 -- I don’t know how to calculate it.”
Fisher went on to become Under Secretary for Domestic
Finance of the Clinton Treasury in 2001, and later in 2004 a BlackRock
Managing
Director and a member of the firm’s Management Committee with primary
responsibility for expanding the firm’s balance sheet advisory
services.
BlackRock is one of the world's largest publicly traded
investment management firms with employees in 21 countries throughout
the Americas, Europe and Asia
Pacific. As of 30 September 2009,
BlackRock’s assets under management total US$1.435 trillion across
equity,
fixed income, cash management, alternative investment and real estate
strategies, offering risk management, strategic advisory and enterprise
investment system services to a broad base of clients with portfolios
totaling approximately US$7.25 trillion, almost half of US GDP.
The Sharpe Ratio
The Sharpe ratio,
developed by William Forsyth Sharpe, (or reward-to-variability
ratio) is a measure of the excess return (or
Risk Premium) per unit of risk in an investment asset or a trading
strategy.
The return on a benchmark asset, such as the risk free rate of return
is the
expected value of the excess of the asset return over the benchmark
return. The
standard deviation of the asset excess return is a constant risk free
return
throughout the period.
The Sharpe ratio is used to characterize how well the return
of an asset compensates the investor for the risk taken. When comparing
two
assets each with the expected return against the same benchmark risk
free
return, the asset with the higher Sharpe ratio gives more return for
the same
risk. Investors are often advised to pick investments with high Sharpe
ratios.
However like any other mathematical model, it relies on the data being
correct.
Pyramid schemes with a long duration of operation would typically
provide a
high Sharpe ratio when derived from reported returns, but the inputs
are false.
When examining the investment performance of assets with
smoothing of returns the Sharpe ratio should be derived from the
performance of
the underlying assets rather than the fund’s returns. Sharpe ratios are
often
used to rank the performance of portfolio or mutual fund managers.
The Sharpe ratio has as its principal advantage that it is
directly computable from any observed series of returns without need
for
additional information surrounding the source of profitability.
Unfortunately,
some users are carelessly drawn to refer to the ratio as giving the
level of
‘risk adjusted returns’ when the ratio gives only the volatility of
adjusted
returns when interpreted properly.
Given that a hedge fund manager typically aims for a Sharpe
ratio of greater than 1.0, a Commodity Trading Advisor (CTA) manager
with a
Sharpe ratio of .19 would do poorly under this criterion. A Sharpe
ratio of 1.0
would suggest that the relevant percentage of return and risk is about
even. A
Sharpe ration of 2.0 is excellent but probably cannot be sustained for
long. But
the Sharpe ratio has its own set of difficulties as a performance
measure. In
September 1996, after 31 months of operation, Long Term Capital
Management (LTCM)
reportedly had a Sharpe ratio of 4.35 (after fees). With the benefit of
hindsight, we can say that LTCM’s realized Sharpe ratio after two and a
half
years of operation did not give a meaningful indication of how to
evaluate its
investments.
LTCM started with $1.3 billion in initial assets and
focused on bond trading. The trading strategy of the fund was
to make
convergence trades, which involve taking advantage
of arbitrage between securities that are incorrectly
priced
relative to each other. Due to the small spread in arbitrage
opportunities, the fund had to leverage itself highly to make
money. At
its height in 1998, the fund had $5 billion in capital, controlled
over $100 billion of assets and had positions whose total
worth was
over a $1 trillion in notional value. Soon, it had to cut its capital
down by
more than half ($2.7 billion) without correspondingly reducing to risk
exposure
in an increasingly risk adverse market in order to maintain accustomed
high
return. All it did was to increase its Sharpe ratio.
Due to its highly leveraged nature and a financial crisis in Russia
related to the default of sovereign bonds which led to a flight to
quality, LTCM sustained massive losses and was in danger of
defaulting on its extensive financial commitments. The size and breath
of its
positions made it difficult for LTCM to cut its losses
in its positions without also wiping out still profitable
positions. LTCM
held huge positions in the market, totaling roughly 5% of the
total
global fixed-income market. LTCM had borrowed massive amounts of
money to
finance its leveraged trades. Had LTCM gone into default, it would
have
triggered a global market seizure and financial
crisis, caused by the
massive write-offs its creditors would have had to
make. In September
1998, LTCM, which continued to sustain losses, was bailed out with the
help of
the Federal Reserve which brokered a creditor takeover. A
systematic
meltdown of the market was thus prevented at the last moment, with
significant
rise in moral hazard.
Volatility tends to come in lumps, as volatility tends to
breed more volatility. The LTCM near collapse and the Russian debt
crisis
showed that high volatility would stay with the markets for extended
time
periods even after the precipitating events had subsided. Some market
observers
believe major volatility events tend to occur every four years inherent
in the
structural dynamics of deregulated financial markets.
Next: The Courageous
Brooksley Born
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