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Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition


Interview with Satyajit Das



Introduction

Why a Revised Edition?

Before the global financial crisis or great recession, most people had no ideas about the extraordinary and arcane world of “derivative products”. In 2008, AIG almost went bankrupt because of its exposure to one type of derivative — CDS (credit default swaps, a form of credit insurance). Mortgage-backed securities (MBS) and collateralised debt obligations (CDOs) — also cheerily known as Chernobyl Death Obligations — helped to bring the global financial system to the edge of collapse.

The crisis has made people interested in knowing about this gigantic system of commercial bets in financial markets - the total outstanding amount of derivatives adds up to a mere $600 trillion (some 10 times the value of global production).

Given that Traders... was first published in2006 and anticipated some of the problems, it seemed appropriate to update the book and re-launch it.

Did you really predict the Global Financial Crisis?

As the crisis has become larger and the losses have become greater, the number of people who apparently knew this was going to happen has increased exponentially.

I don’t think Traders… said the crisis was going to occur on such and such date. The book anticipated many problems that have become apparent. It exposed the sophistry of derivatives and the structured credit market. It highlighted the moral hazards and distorted incentive structures that posed major threats to market stability.

In a 2006 speech to promote the first edition – ‘The Coming Credit Crash’ – I argued that: “an informed analysis of the structured credit markets shows that risk is not better spread but more leveraged and (arguably) more concentrated amongst hedge funds and a small group of dealers. This does not improve the overall stability and security of the financial system but exposes it to increased risk of a ‘crash’ during a credit downturn.” These problems are now becoming readily apparent. The enormous cost to ordinary investors and taxpayers to fix the problem has also become clear.

What’s new in the Book?

The paperback edition remains largely unchanged from the original text. I felt it would be intellectually dishonest to go back and embellish the original version, which remains a true record of my views as at the time. I have added a new Afterword that deals with the GFC and the role that derivatives and related financial products played in the crisis.

Derivatives & Financial Products

Did derivatives and these arcane products cause the crisis?

Whilst derivatives did not create the GFC, they undoubtedly contributed to and exacerbated many of the problems. They are also going to make resolution of the issues more difficult. Events over the last 2-3 years have only served to confirm my views that the world underestimates the importance of derivatives and their role in finance.

Do you think derivatives have a role in modern economies?

As industry lobbyists say ad nauseum, derivatives are used to hedge and manage risk promoting investment and capital formation. While derivatives can play this role, derivatives are now also used extensively for speculation – manufacturing risk and creating leverage. Over the last two decades, they have become creators of risk.

Derivative volumes are inconsistent with pure risk reduction. Relatively simple derivative products provide ample scope for risk management. Increasingly complex and opaque products are used to increase risk and leverage as well as circumvent investment restrictions, bank capital rules, securities and tax legislation.

Few, self interested industry participants are prepared to admit the unpalatable reality that much of what passes for financial innovation is specifically designed to conceal risk or leverage, obfuscate investors and reduce transparency. The process is entirely deliberate. Efficiency and transparency is not consistent with high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits.

Traders... is full of stories of banks taking unsuspecting businesses and investors for a ride. How did large reputable institutions sanction these deals?

You mean other than the money that the traders, their bosses and the bosses’ bosses made!

The book also shows that the firms and investors weren’t totally blameless. Who’s wrong – the bank or the client?

The bank may understate the risk and overstate the benefits to sell a profitable deal. The clients quietly bank profits but the moment the deal turns sour they suffer amnesia attacks and claim they never understood the transaction and relied on the bank’s “advice”. Declining profit margins in core businesses have meant that companies have become dangerously reliant on financial profits rather than operating profits. Fund managers are also under huge pressure to show high returns for their investors. Until you address that, it will be difficult to stop speculation.

Where did the risk management go wrong?

Risk management is generally a fig leaf behind which management and Boards of Directors hide. Despite the amount of money spent, little serious risk management takes place. It’s like most corporate governance - the triumph of form over substance.

Do you feel bankers or traders who devised these transactions got away easy, almost unpunished?

In Hong Kong, some people who lost their life savings in certain structured deals committed suicide. But very few people will be held accountable. White colour criminals are always treated more lightly and they usually can afford better lawyers. Capital punishment for mis-selling derivatives would probably stop most of the problems but I can’t see that being acceptable.

Do derivatives and finance contribute to the economy in general?

Paul Volcker, former chairman of the Fed, recently said: ““I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth.”  I remain skeptical of any real positive measurable contribution except to the banks and traders.

Can academia and theory contribute to enriching the science of derivatives?

Theory and practice have always been the most occasional of bedfellows on Wall Street. Confucius wrote that: “The superior man understands what is right; the inferior man understand what will sell.” Banks simply want to make money. They are in the business of manufacturing financial products and selling them to clients. Theory merely allows financiers to enter into a dialogue with their clients and then sell them something that they thought they wanted.

Academics may have been after some elusive truth but basically they are the piano players in the whorehouse, without control over what really was going on.  The smarter ones just cut themselves a share of the action.

Most financial crisis that banks and companies have faced over the last 25 years, have their origins in derivatives. Given this why do people time and again, keep going back to derivatives and not learn from their mistakes?

Derivatives are a tool. It is the misuse that has become problematic. The problem is exacerbated by the lack of knowledge of many participants, the adverse incentive structures (a “head I win, tails you lose” culture) and the fact that all the games are played with other people’s money. As for repeating the errors, that is a general human trait. As Giuseppe di Lampedusa (author of “The Leopard”) observed: “everything must change so that everything can stay the same”.

Does the current crisis mark the death of derivatives, particularly the market for exotic products?

To paraphrase Mark Twain “the news of the death of derivatives has been much exaggerated”. Warren Buffet once described bankers in the following terms: “Wall Street never voluntarily abandons a highly profitable field. Years ago… a fellow down on Wall Street…was talking about the evils of drugs…he ranted on for 15 or 20 minutes to a small crowd…then…he said: “Do you have any questions?” One bright investment banking type said to him: “yeah, who makes the needles? Derivatives and debt are the needles of finance and the best and the brightest bankers will continue to supply them as long as there is money to be made in the trade.

Global Financial Crisis

Is the crisis over?

The global economy is currently taking the “botox” cure. A flood of money from central banks and governments – “financial botox” - has temporarily covered up unresolved and deep-seated problems.

What about the ‘green shoots’?

There may be confusion between ‘stabilisation’ and ‘recovery’. It is useful to remember Winston Churchill’s observation after the British expeditionary force’s escape from Dunkirk: “[Britain] must be very careful not to assign to this deliverance the attributes of a victory”.

The ‘green shoots’ theory is based on a slowdown in the rate of decline in key economic indicators, improvements in the financial system, unprecedented government support for the banking system, near-zero interest rates and large fiscal stimulus packages. The recovery of emerging markets also underpins hopes of a swift return to growth.

On 14 June 2009, Wolfgang Münchau writing in the Financial Times (“Optimism is not enough for a global recovery”) eloquently summed up the recovery: “Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world.

What is driving the ‘recovery’?

Low or zero interest rate policy (“ZIRP”) of major central banks helped increase asset prices. Very low returns on cash or near cash assets forced investors to switch to riskier assets in search of return. Low interest rates acted like amphetamine as investors re-risked their investment portfolios. 

Capital injections, central bank purchases of “toxic” assets and explicit government support for deposits and debt issues helped stabilise the financial system. Changes in accounting rules deferred write-downs of potentially bad assets. Despite these actions, the global financial system remains fragile. There may be further losses to come.

The real economy remains vulnerable. Government actions, such as fiscal stimulus and special industry support schemes (cash for clunkers; investment incentives, trade credit subsidies), have boosted demand and industrial activity in the short term. As Wells Fargo CEO John Stumpf told the Wall Street Journal on 19 September 2009:  “If it’s not a government program, it’s basically not getting done.” Private demand remains somnolent. The problem remains as government incentives encourage current consumption and investment but ultimately “steal” from future demand.

In reality, the global economy has, in all probability, entered a period of stability after a fairly big decline. Market sentiment seems to be shaped less by facts than the Doors’ song: “I've been down for so long, it feels like up to me.

Can China help turn around the world economy?

The phoenix-like recovery in emerging markets and China is primarily driven by panicked government spending and loose monetary policies increasing available credit. Estimates suggest that around 6% of China’s growth in 2009 of around 8% is attributable to government spending and increased bank lending.

In the absence of real end demand for products, the increase in production may result in a rapid build up in inventory with surplus being dumped into export markets causing price deflation. The availability of credit is also fuelling speculation in stocks, property and commodities.

A cursory look at the respective economies also highlights the difficulties. Consumption’s contribution to GDP in the U.S. is 71% while in China it is 37%. Given that the GDP of China is around $4-5 trillion versus $15 trillion for the U.S. and average income in China is around 10-15% of U.S. earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.

Additionally, over the last 25 years, Chinese consumption has declined from around 50% to it current levels of 37%. During that same period, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American buyer, lower U.S. growth and declining consumption creates significant challenges for China.

How long the governments continue to spend to maintain the recovery?

Much of recovery has been underwritten by massive government spending. As one anonymous saying states: “Never in the history of the world has there been a situation so bad that the government can't make it worse.

A key risk remains the ability of governments to finance their burgeoning government deficits. A wretched combination of declining tax revenues, increased government spending to cushion the economy from recession and bailout packages for banks and other ‘worthies’ means that many countries face large and continuing budget deficits.

A key issue over the coming months is the continued demand for increased sovereign debt issues. China, Japan and Europe historically have been major buyers of U.S. Treasury bonds. The ability of these investors to absorb the increased supply is unclear.

In the best case the government debt issuance programs is accommodated but squeezes out other borrowers. In the worst case, governments find themselves unable to finance their deficits setting off a new stage of the crisis.

What are the steps that are needed in order to create a sustainable recovery?

Firstly, the financial system must be stabilised. This requires reducing the level of overall debt, recapitalising the banking system and getting the flow of credit to a sustainable level. Secondly, the real economy must stabilise. This includes stabilisation of asset (e.g. U.S. housing) prices, arresting falls in demand, consumption, investment and a recovery of employment levels. Thirdly, global trade and capital flows need to stabilise and fundamental global imbalances must be addressed.

Is there progress on these issues?

Governments and central banks have dealt with symptoms but not addressed the underlying causes of the GFC.

The need to reduce the overall level of debt in certain economies has not been fully addressed. Public debt has been substituted for private debt. Despite some regulatory initiatives, many of the excesses of the financial system remain. Few, if any, lessons have been learned, especially by bankers.

Policies assume that the problems relate to temporary liquidity constraints resulting from non-functioning markets for some financial assets. They fail to acknowledge the severity of the problems and the extent to which the previous high prices of some assets reflected excessive liquidity that overstated their true value. Policy makers assume that liberal application of liquidity – financial botox – represents a permanent cure. In Albert Einstein’s words: “You can never solve a problem with the thinking that created it”.

The markets ability to avoid consideration of these issues reflects Mark Twain’s observation that: “Ignorance more frequently begets confidence than does knowledge”.

What are the three biggest lessons that economists and economies can learn from the financial crisis?

Firstly, the strong growth that the global economy has enjoyed has been driven by unsustainable levels of borrowing, unsustainable levels of emissions and pollution and accelerating consumption of scarce resources such as oil. Secondly, the ability of governments and central banks to control and “fine tune” the economy with a judicial mixture of monetary and fiscal policy is an illusion. We do not necessarily understand the workings and interactions of the global economy as well as we think. Thirdly, that there is always a day of reckoning and that we have to pay for everything at some stage of the cycle. We can’t defer this forever. This means we have to change our expectations and behaviours significantly going forward.

Interestingly, I don’t think any of these lessons have been learnt or even acknowledged. Actions to stabilise the global economy seem only to have created ‘new’ bubbles – in government debt and emerging markets. Government actions seem to be primarily designed to ensuring continuation of the ponzi game. The only lesson learned is that no ponzi game can ever be allowed to stop.

In the words of David Bowers of Absolute Strategy Research: “It’s the last game of pass the parcel. When the tech bubble burst, balance sheet problems were passed to the household sector [through mortgages]. This time they are being passed to the public sector [through governments’ assumption of banks’ debts]. There’s nobody left to pass it to in the future.

Other

Looking back, why did you write Traders…?

People should know about what was going on with their money in this curious world. It’s all done with OPM (other people’s money) – your pension money, the money you deposit with banks, the money of companies whose shares you own. It will help ordinary people understand what your money is sometimes used for. This is a world that few people know about and fewer understand. It’s a world where a small group of gifted, if rapacious, individuals parlay their knowledge of financial products into wealth, leaving shareholders, clients, regulators, and the tax-paying ordinary public to bear most of the risk.

Traders … tells a little of the truth of what really does go on. It may help explain why, in the words of Groucho Marx “You worked yourself up from nothing to a state of extreme poverty.”

Has the world of finance become too complex?

The maze of international finance is almost beyond understanding. In 1988, the Mexican Finance Minister mused how he could explain to a Mexican housewife that her mortgage repayments were going to rise as a result of Russia defaulting of its international debt.

Governments throughout the world have forced people to take more and more responsibility for their own finances. For example, the company pension plan (based on final salary) has given way to schemes where you save personally and rely on your savings and investment earnings to finance your retirement. The general trend from regulators is to force sellers of products to disclose risks. Most people are not equipped to make these choices.

The trend is heavily influenced by self-interest. The cheerleaders – fund managers and banks – are huge beneficiaries of the privatisation of retirement savings and pension arrangements. For examples, in Australia (where I live) compulsory pension savings have created the 4th largest investment market in the world (completely out of proportion to Australia’s population) and created a massive and lucrative investment management industry.

Are you planning a follow-up book?

I would like to do one more book if the opportunity presents itself– the working title is ‘Extreme Money – The Masters of the Universe and the Cult of Risk.’ The idea is to show how it has become possible to make vast fortunes not from producing real goods and services but from money itself.

It focuses on the “Masters of the Universe” – elite financiers – who invented and continue to invent a whole range of extreme money games that have allowed them to generate extraordinary returns for themselves (some hedge fund managers earn in excess of $1 billion) and for their backers. I would like to explore how the culture of risk and extreme money games has changed our world in ways that few fully comprehend.

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