The Perfect Financial Storm - Part 9B: The Derivative Time Bomb

Ever since the 1987 stock market crash brought derivative instruments to everyone's attention, the financial system has been buffeted by waves of derivative mishaps. In each case the cauldron has been contained. Experts have concluded these crises were liquidity-driven. They believe that when they erupt, they can be contained by a fresh injection of liquidity from central banks. When these catastrophes occur, the Federal Reserve has moved expeditiously to flood the markets. In each calamity the financial markets have bounced back only to see another crisis erupt elsewhere. The Fed fixed the peso and derivative crisis in 1994. It resurfaced again in Russia and in the U.S. in 1998.

Experts have identified four accelerators that must be restrained in any crisis to keep it from escalating. They are leverage, forced selling, momentum mood swings and a loss of confidence. It is widely believed in financial and government circles that if enough liquidity is applied, the collateral damage to the financial system can be minimized. Up to this point each financial maelstrom has been isolated, contained, and prevented from turning into a worldwide contagion. This has bred widespread confidence in the Fed and complacency by the investment community. At the same time it has created a moral hazard in the marketplace. There is a capricious belief that the Fed and other central bankers are capable of bailing out the U.S. or any other nation out of a disaster. Today, while our financial system stands closer to a precipice, confidence in the efficacy of monetary policy is supreme.

The financial community and the investment public readily believe that monetary policy will fix the stock market and avert a recession in the U.S.. Burgeoning debt burdens held by consumers and corporations, a negative savings rate, and a monstrous trade deficit are shallowly ignored by the media and financial press. Everyone believes in a V-shaped recovery or the so-called "soft landing". The financial bubble is simply ignored. Wall Street believes that an inventory problem is behind our current troubles. Dividend yields of less than 2%, a P/E ratio of 28 for the S&P 500, or a negative P/E for the NASDAQ is irrelevant. There is too much confidence and complacency. That is where the danger lies. When there is this much complacency, it is usually shattered by an unexpected event. I will repeat something that I wrote in Rogue Wave that is relevant to today's smugness.

There will come a day unlike any other day, an event unlike any other event and a crisis unlike any other crisis. It will emerge out of nowhere at a time no one expects. It will be an event that no one anticipates – a crisis that experts didn't foresee. It will be an exogenous event – a rogue wave.

The Fuse Is Burning

Derivative Exposure Increasing

I believe that a rogue wave is lurking somewhere out there in that arcane world of derivatives. (See Rogue Wave for a complete explanation of derivatives.) The notional value of derivative contracts is now widely believed to exceed 0 trillion dollars worldwide. During the fourth quarter of 2000, derivatives in U.S. commercial bank portfolios increased by .2 trillion to .5 trillion. Most of that increase was in interest rate contracts. Credit derivatives increased by billion to 6 billion. Equity, commodity, and other contracts grew by billion to .08 trillion. Like previous quarters, the bulk of these contracts are concentrated in the seven largest banks. The top seven banks account for .9 trillion or 96% of the total notional value of derivatives. One bank, JP Morgan Chase, accounts for 59% of that total.[6]

"Netting" Disguises Reality

The netting of contracts can reduce part of the gross exposure of derivative positions. Close to 70% of these contracts have been netted. (Netting limits the exposure of a bank's obligation, in the event of a default or insolvency of one of the parties, to the net sum of all contracts in the bilateral netting arrangement.) These notional values are a reference value on which contractual payments are derived. The amount of risk in these contracts is related to the bank's aggregate trading position as well as its asset and liability exposure. Total credit exposure for the top seven banks increased to 254% of risk-based capital from 239% in the third quarter. These top seven banks hold 97.5 percent of their contracts for trading purposes. Banks reported revenue of 5 million from trading positions in the fourth quarter.[7]

The problem with derivatives is that the bulk of these contracts (90.2%) are over-the-counter (OTC) contracts. They are preferred because of their customization, but they are less liquid than exchange-traded contracts and expose the banks to greater credit risk. There is always the danger of counter-party risk and the creditworthiness of the parties in each transaction. A bank may take an aggressive position as being long or short in a particular market. In order to mitigate that risk, an opposite hedge may be taken with another party. The problem arises when the institution, which is used to hedge a long or short position, gets into financial difficulties. It may end up defaulting, leaving the other firms long or short position unhedged and naked.

LTCM – A Case in Point

This default danger is amplified as we have seen in the case of Long Term Capital Management. LTCM's counterparties in their derivative transactions were supposed to be protected by their collateral. However, in reality, as the fund failed, it forced a liquidation of contracts thereby driving down price and evaporating collateral in the process. Long Term's collapse left the counterparties to their swaps naked and unhedged by the event of LTCM's bankruptcy. In the end, the extent and magnitude of Long Term's positions not only put the hedge fund in danger, but it also put Wall Street on the hook as well. Long Term's failure nearly caused a run on Wall Street. In its final days it was leveraged by more than 100 to 1. All of the big banks and brokerage firms had a stake in LTCM. It took Fed intervention and fourteen banks chipping in to cauterize LTCM's problems and prevent them from turning into a contagion.

Explosion in Today's Derivatives

Once again the growth of derivatives is exploding. The figures listed above do not contain the position of major Wall Street investment houses. The very size of these contracts is staggering. The derivative market dwarfs the actual financial markets. This table only includes the top seven banks. It doesn't include investment banks or derivative holdings worldwide. The total notional value of derivatives worldwide is estimated to be in the range of 0 trillion. Clearly, the markets are leveraged as never before and the size and scope of derivatives have turned our banking system into a large casino. The bulk of these contracts are used for trading purposes and therefore these contracts have become instruments of speculation.

The most frightening aspect of this market is that it continues to expand on top of mishaps such as LTCM. What happened to Long Term is not an isolated event. It came after a decade of misadventures: S&L crisis, Mexico, Asia, and Russia. In spite of each one of these crises, the Fed has taken a laissez faire attitude towards derivatives. It has thwarted efforts to regulate or require fuller disclosure. It continues to allow the banking system to build up its exposure in this market taking the view of intervention rather than prevention. It has, in effect, created a moral hazard by shielding these large institutional investors from the consequences of their mistakes. The result is that the derivative markets continue to mushroom and thereby emboldens investors to make even bigger bets.

The chart on the left is based on values as of 12/31/00. It depicts the U.S. market's largest company, GE, with 5 billion in market cap, to the ever-expanding "Tower of Babel" in derivative assets. The sheer size of comparison should send warning signs worldwide.

The Rhetoric Against Concern

The main argument in support of this speculative market is that LTCM and other derivative calamities are merely isolated cases. They can be avoided by better modeling. If problems erupt to jar the financial system, they can be contained by immediate injections of liquidity. We have experienced these problems before from the stock market crash in 1987 to more recently LTCM and Russia in 1998. In each case, Fed action has contained them. This has given way to complacency and invincibility. Despite each crisis, the derivative market grows larger and more concentrated. This begs the question, At what point does the market become too large and too concentrated where intervention cannot succeed? I believe we are rapidly approaching that point.

The Lure of Leverage in Derivatives

The huge amount of leverage inherent in derivatives allows speculators to magnify their returns. In the case of LTCM, it turned a cash-on-cash return of 1% into a hefty 59% return - all because of leverage. Derivatives give speculators enormous power to enlarge their positions. It gave George Soros the ability to take on the Bank of England and force the country to devalue its currency. It can, as is the case of the precious metals markets, distort the market laws of supply and demand. Silver and gold have been running large supply deficits for many years. Despite silver and gold production deficits over the last decade, the price of both metals has declined. The world of derivatives has allowed large price distortions to occur. It is also been employed in currencies, stock markets, interest rates, and precious metals. The danger derivatives represent can best be illustrated by two examples.

Examples of Danger: LTCM & Metallgesellscaft

Most readers are familiar with the LTCM story since it nearly brought down our financial markets. But the lessons of LTCM have been forgotten. In fact its main principal, John Meriwether, was back in business fifteen months after the collapse of his hedge fund. Meriwether raised 0 million from his former investors and is busy managing another hedge fund. I'm sure that he is convinced he has better models that will keep him out of danger this time around. The mathematical models developed by his former associate, Myron Scholes, defined risk in terms of volatility. Volatility has replaced leverage as risk. In the process, it has become The Holy Grail of the derivatives market.

The Bell-Shaped Curve Rationale

The models that run derivatives are based on volatility around the mean. They are based on predictable patterns. Patterns emerge in the financial markets and models are developed around them. It is expected that the patterns will remain in force. They should fall under the bell of the bell shaped curve. Markets are expected to remain under this curve with only an occasional deviation. Most models predict that patterns will fall within one or two standard deviations of the curve. If there are abnormalities, they will eventually revert to the mean over time. For the markets to depart from the norm is considered a seismic anomaly.

Blind Faith in "Reversion to the Mean"

Meriwether's investment strategy was based on the fact that patterns always revert to their mean. Therefore any abnormality in the market would, over time, revert to normal. Thus patterns or events are predictable. This instilled in Meriwether an investment stratagem of riding out losses until they turned into gains. It was blind faith in the concept of reversion to the mean. But markets are never certain. In real life they are always in a state of flux. The trading patterns that make up today's universe of certainty may change. How do you know what the next pattern will be? The probability of each new trading pattern is independent of the other. One doesn't remember the other. He believed that mathematics could make an uncertain world certain. Wall Street is completely blind to this fact.

Mathematical models, the certainty of trading patterns within various markets, and the reversion to the mean have become a religion on the Street. Its adherents follow it with blind faith to this day. In the case of LTCM, it eventually led to its demise. The professors and traders at LTCM became convinced of the invincibility of their models. Their bets became bigger and as a result less liquid. For example, in the case of an arbitrage bet on Royal Dutch and Shell Transport, their positions were so large that they became the market, which made them even more vulnerable. Their models didn't take into account or make allowances for what lies at either end of the tail of the curve. In a short period of time, events at the tail of the curve would overwhelm them. In the fall of 1998, a series of events took place that shook the financial markets. It began with Russia's debt default which widened credit spreads on debt - something the traders at LTCM hadn't envisioned. It was followed by conflict with Iraq over weapons inspections. There were rumors that China might devalue exasperating an already fragile situation in Asia, and in Washington the public was introduced to a White House intern named Monica.

As investors fled the Asian and Russian markets, they piled into treasuries and in the process, widened the spread between Treasuries and other debt instruments. Investors were looking for safety. No one wanted risk. While the credit markets tightened, LTCM moved in and loaded up on Russian bonds. They figured that the widening credit spreads would eventually narrow and revert back to the mean. It was a game they had played all too often and won. This time, however, time wasn't on their side. The Asian crisis in 1997 and Russia in 1998 changed the trading pattern. Investors wanted out of risk. Swap spreads in the credit markets went through the roof. LTCM was fully loaded hoping to make a fortune. Their models gave them no cause for alarm. However, instead of reverting to the mean, credit spreads kept widening. LTCM's portfolio began to hemorrhage profusely. Losses went from million a day to 3 million on one particular day. The fund began selling out its portfolio, which further exacerbated their losses. Their positions were so large it became too difficult to unwind them. There wasn't enough liquidity in the market to absorb it.

In the end, the fund would fold, falling victim to the arrogance and hubris of its partners. By ignoring leverage in their models, the fund strictly focused on volatility in its definition of risk. The mathematical models predicted certainty in an uncertain world. To the partners everything fell within one or two standard deviations of the curve. What lay at either end of the tails was a chaotic world the partners chose to ignore. It became their Achilles Heel.

Metallgesellschaft's Mistake

The German firm, Metallgesellschaft, had repeated many of the same mistakes of LTCM. Back in 1993 a subsidiary of the firm, MGRM in the U.S., made an aggressive move to become a major player in the U.S. oil market. They sold long-term oil contracts to independent dealers at fixed prices. MGRM hoped to make money through arbitrage between the spot oil market and the long-term market for oil. The firm sold contracts of oil to independent dealers at fixed prices going out ten years. These financial maneuvers resulted in a mismatch between supply and demand, making the firm vulnerable to the vicissitudes of the market. MGRM's customers went long while the firm went short. MGRM covered its position by buying near-term contracts in the futures market and rolling them over each month. This was their undoing.

Their strategy worked as long as the markets remained in normal backwardation. The firm was selling long-term contracts at higher prices while hedging with short-term prices. However, in 1993, the oil markets reversed into contango. (See graph for visual explanation.) The firm made money as long as the markets remained in normal backwardation. The moment they went into contango, the firm began to lose money. MGRM's traders were betting that the market structure would remain stable and that prices would follow historical patterns. They were also counting on maintaining their hedging practice. The problem arose because in futures markets, losses and gains are immediate. A firm must mark its positions to market. Losses require cash payments to maintain margin. However, gains or losses on delivery contracts appear only at the time of delivery.

The problem for MGRM was that they were covering their long-term commitments with short-term hedges. Their traders made a sophisticated bet that markets in oil would remain in a constant pattern. In other words, the markets they were betting on would fall within the normal probability of the existing state of the market or backwardation. As long as these conditions remained, MGRM made money from the spreads between the expectations of the long and short end of the market.

However, the markets didn't remain the same. In fact, because MGRM's short-term hedges were so large, they in effect contributed to the contango. At one point, they made up close to 20% of all open interest outstanding on the NYMEX. By taking such a large position and having to roll it over each month, the firm created its own death warrant. The firm's position was so large, it began to work against itself. Like vultures swarming to the bloodbath, traders took advantage of MGRM vulnerability. By November of the following year, the firm's trading losses mounted to .75 billion wiping out all of its capital. By February, those losses grew to .2 billion. The parent company pulled the plug. Ironically, had the firm enough capital to weather the storm, the markets eventually went back into normal backwardation.

MGRM became a victim of its own circumstances. A large long position contributes to backwardation of the markets. A large net-short position turns the markets into contango. The very size and nature of its position flipped the markets from the position they were betting on into a position that was bet against them. Like LTCM that would come after it, the traders at MGRM were relying on predictable patterns. When exogenous events surface, markets turn upside down, patterns change, and large bets are turned into large losses.

Four Lessons From LTCM & Metallgesellschaft

Lesson #1 Investment Versus Speculation

The first lesson is found where sound investment strategies turn into speculation. Had MGRM matched its long-term commitments with long-term hedges, it would not have gotten into trouble. By offering its dealers long-term contracts on oil at a fixed price for ten years, MGRM's traders became speculators. To make a commitment as long as ten years for a commodity like oil, without covering, was an unsound business practice. As dynamic as the commodity markets are, they are prone to exogenous events like weather and geopolitical events. To assume that oil prices would remain in permanent backwardation seems incredulous today. Another lesson on investing versus speculation deals with the size of positions. Both MGRM and LTCM backed themselves into a corner by taking oversized positions within a market. In essence, they became the market. The size of their positions made them illiquid and vulnerable.

Lesson #2 Leverage Can Be Lethal

The two-sided nature of leverage is an old lesson. It can magnify returns on the upside, but on the downside, it can be lethal. The size of most derivative contracts allows investors or commercials to leverage their position by commanding a much larger position. That in itself is a form of leverage. When you add debt into the equation, the position of leverage is further magnified. In the case of LTCM, it was leveraged close to 100:1 towards the end. A position this leveraged allows no room for mistakes. Just as that leverage turned a 1% gain into a 59% return, it also magnified losses on the downside. In its final days, Long Term Capital would lose half a billion dollars – a loss of 20% of its equity base – in a single day. When you aren't in debt, you can't be forced to sell. You can afford to hold your position long-term. The partners' view that all markets eventually revert to the mean was meaningless when large amounts of leverage were involved. Leverage makes you vulnerable. It can force you to sell when you don't want to. It removes the element of time out of the equation. LTCM's mistake was defining risk as a function of volatility. Not enough consideration was given to leverage. Leverage by its very nature implies risk. To ignore the role leverage plays within the derivative market is perilous.

Lesson #3 Corporate Governance & Accountability

The role of corporate governance, both within organizations and outside them through governmental bodies, establishes the ground rules. In the case of LTCM, there wasn't any governance. There were no independent risk managers watching over the traders. The partners monitored themselves and were accountable to no one. The same lack of supervision was also apparent in the case of MGRM. In most of the derivative mishaps like MGRM, LTCM, Orange County, Bankers Trust, Sumitomo Bank, and Barings Bank an institution healthy one day would appear insolvent the next day. There have been too many instances were a corporate parent would suddenly discover one of its traders or an affiliate had amassed enormous losses. A lone rogue trader or small band of traders had put the firms' capital at risk in all of these cases.

Derivatives are complex instruments. They need constant monitoring. The fact that most of them are over the counter (OTC) makes them less liquid and more prone to credit risk. The fact that regulators allow this market to continue to expand without some form of supervision or prevention means we will have more LTCMs. The occurrence of losses is what discourages imprudent risk taking. Essentially, the actions of regulators have done just the opposite. They have indirectly encouraged more risk taking. By bailing out one firm after another, they have introduced a moral hazard in the marketplace. By its intervention, the Fed shielded well-heeled speculators from their mistakes. This only serves to encourage more risk-taking. A case in point: after the LTCM bailout, Meriwether was back in business fifteen months later.

Under Greenspan, the Fed has joined forces with the big banks in fighting against proposals for tougher disclosure. Instead of acting as sheriff, the Fed has worked to encourage and enlarge the market. Banks have been allowed to run up their exposure without regard to their long-term consequences, knowing "Big Brother" waits in the shadows to bail them out. While government supervision and disclosure requirements have served the securities market well, it is sadly absent in derivatives market. The current disclosure and monitoring rules in the securities industry were brought about by the lessons learned from the stock market crash of 1929. Perhaps it will take another tragic event to awaken regulators from their slumber. The current misguided view is that intervention rather than prevention can solve any crisis. Maybe the Fed also believes that markets will always revert to the mean.

Lesson #4 Rogue Waves Exist

The final lesson is the occurrence of rogue waves. These exogenous events happen more frequently than mathematicians would like. In the world of derivatives, they lie at the tail end of the curve. These remote and improbable occurrences wreck havoc on the models of certainty. If there is one lesson to be learned in investment markets, it is that change is a constant. Patterns emerge, become dominant, and then are abruptly replaced by other patterns. Each pattern is independent of the other.

Rogue waves are events that nobody foresees. An archduke is shot. Bombs are dropped at Pearl Harbor. North Korean troops cross the 38^th parallel. Saddam's tanks roll into Kuwait. In the twinkling of an eye, the world changes suddenly. A crisis is born and markets are disrupted. Only in the computer-lighted rooms on Wall Street are such events considered to be a statistical aberration. They are non-events or acts of God outside the scope of reality. It is funny how often God has a way of showing up. There usually comes a day when, without warning, that rogue wave appears. On that day, random events turn into chaotic disorder. Investment patterns go off the charts. Money is made and money is lost. The difference in successfully riding the wave is one of anticipation.

The real danger in the derivatives market is that the models used to drive it are based on mathematical certainty when in fact the markets are inherently uncertain. How does one anticipate a country suddenly defaulting on its bonds, a reemerging OPEC, the mind of a dictator, a madman, or a terrorist? You can't. Markets will continue to remain uncertain. The fallacy lies in thinking they are certain. Models fail because they are based on the past. They continue to work until events change them. They fail at moments when they are needed most – when a rogue wave appears. In cash markets, rogue waves aren't a problem. When there is no leverage, you can ride them out. You have the luxury of time to revert you back to the mean. When leverage is introduced or when positions are outsized in markets, rogue waves present problems. At its own peril, these are the lessons that Wall Street continues to ignore.

References

[6] OCC Bank Derivatives Report, Fourth Quarter 2000
[7] OCC Bank Derivatives Report, Fourth Quarter 2000