Are Derivatives Weapons of Mass Destruction? (Part 2 of 3)

By: Siyanda Pali

It comes as no surprise that derivatives have undergone several iterations over time. The gap between the ‘pre-payment bills’ used in Osaka and the Collateralised Debt Obligations which took centre stage in recent times is astronomical. A CDO is a security backed by receivables on loans, bonds and other debt. Returns on CDO’s are paid in tranches, with an associated level of risk attached to each.

In hindsight, the comments made by Buffet in his 2002 letter to Berkshire shareholders seem timely. Almost 5 years to the day later, the global financial system went into free-fall. He, together with a few other mavericks, foresaw the impending doom for many investors as well as society.

It is therefore worth investigating how such a crash occurred. The Global Financial crisis of 07/08 was not as a result of one single reason, but a myriad of reasons working together to create the catastrophe we came to know.

The preceding years to the crisis were years of negligible growth rates in both Europe and the US, which provided incentive for Investment Banks, Hedge Funds as well as other investors to develop a higher risk tolerance.

The financiers at the time adopted a laissez-faire approach to mortgage lending in the US. Sub-prime mortgages, extremely popular among the financiers, were being rolled out to consumers with little to no ability to repay such loans. The mortgages were then given to Financial Engineers, who were tasked with restructuring the risk metrics, making them supposedly more attractive by pooling them together. The argument for this approach was that housing prices in US cities would rise and fall independently. However, because the risk of these mortgage securities was correlated, pooling in this instance proved to be futile, resulting in a depressed housing market in 2006.

Custodians of impartiality such as Moody’s, Fitch as well as Standard & Poor’s all fell asleep at the wheel. The pooled mortgages referenced above were used to finance Collateralized Debt Obligations. Because investors trusted the appraisal of the rating agencies (Triple A credit ratings etc), they bought what they perceived to be safer tranche CDO’s. Tragically, the likes of Moody’s and Fitch all proved to be highly inaccurate in their assessment.

The Basel Committee, a committee which comprises of Central Bankers and supervisors from around the world, has been meeting periodically since 1988. The committee negotiates international banking rules which serve as a marker for, amongst other things, the minimum capital amount banks must possess relative to their assets. However, the oversight to not give strict definitions of capital allowed banks to use forms of debt which had an inferior ability to absorb loss as compared to equity.

As illustrated thus far, derivatives have been in existence for centuries. However, also of great significance is the fact that their existence has been coupled with centuries of regulation. The UK and US derivative markets in particular have been regulated by a common-law rule known as the “Rule against difference contracts.” It never discriminated as to what could be wagered. All one had to do in order to have their wager enforced was to convince a judge that indeed, one of the parties had an economic interest in the underlying asset and was using the derivative contract as a hedge against risk to such an interest.

By now, we know that wagers can be used as a hedge against risk. If, for example, you own a R1 million home, you can hedge against the risk of your home being decimated by an earthquake by purchasing a Home Insurance policy to this effect, with the insurance company liable to pay R1 million in the event that the above occurs. This is a good illustration of derivatives being used for hedging, which performs a very noble social purpose by reducing the risk of the homeowner.

Not all participants in the derivative market do so for hedging purposes, but also, as displayed by Thales, for pure speculation. Speculation, according to Paul Hastings Professor of Corporate and Security Law at UCLA, Lynn Stout, is “the attempt to profit not from producing something, or even from providing investment funds to someone else who is producing something, but from predicting the future better than others predict it”. A speculator might seek to profit from a company’s success by buying Credit Default Swaps on the company’s bonds without buying the bonds themselves. Unlike hedging, which limits risk, speculation, on the other hand, enhances it. Markets which contain a great deal of speculation are consequently associated with ills such as asset price bubbles and price manipulation.

It is not surprising then, that Common-Law judges have looked upon speculation with suspicion. The rule against difference contracts as well as its compliment, the requirement of “insurable interest” meant that derivative contracts which could not be proved to hedge an economic interest in the underlying were deemed legally unenforceable wagers.

Following the above, derivatives could still be used to speculate. However, the rule against difference contracts forced speculators to devise means to ensure that counterparties honoured their contracts. The solution came in the form of private exchanges with membership, margin, netting as well as other requirements to ensure that, despite being legally invalid, speculative traders honoured their speculative contracts. This meant that exchanges kept speculation in check, while the rule against difference contracts did likewise with “Over the Counter” contracts.

This was the case until the rule was abolished. The excessive liberalization began when the United Kingdom passed its Financial Services Act of 1986, “modernizing” the UK’s financial laws by pulverizing the age old rule against difference contracts, making financial derivatives, both for speculation and hedging purposes , legally enforceable. US regulators, not to be outdone by their City rivals, leaped at the opportunity to ensure that Wall Street would’nt miss out on a new attractive market with potential for massive growth by beginning in 1990, to create ad hoc regulatory exemptions for particular types of financial derivatives like Currency Forward Contracts and Interest Rate Swaps. Not before long, the US also adopted a Wild West style by passing the Commodity Futures Modernization Act in 2000.

The CFMA led to a two prong effect on financial derivatives: it exempted them from Commodity Futures Trading Commission (CTFC) and Securities Exchange Commission (SEC) oversight. It also deemed them legally enforceable.This has had a profound impact not only for derivatives in the UK or the US, but also for emerging market and developed economies all over the world.

References

1. Farlex Financial Dictionary (2012). [Online] Available from: http://financial-dictionary.thefreedictionary.com/Collateralized+Debt+Obligation. [Accessed 15 November 2014]
2. Stout, Lynn A. (2009), "How Deregulating Derivatives Led to Disaster, and Why Re-Regulating Them Can Prevent Another". Cornell Law Faculty Publications. Paper 723. [Online] Available from: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1432654. [Accessed 15 October 2014]
3. Stout, Lynn A. (1997), Irrational Expectations, 3 Legal Theory 227 (discussing theories of speculation). [Online] Available from: http://ourfinancialsecurity.org/blogs/wp-content/ourfinancialsecurity.org/uploads/2012/05/LYNN-STOUT-PAPER.pdf. [Accessed 5 December 2014]
4. The Economist (7 September 2013) The Origins of the Financial Crisis. [Online] Available from: http://www.economist.com/news/schoolsbrief/21584534-effects-financial-crisis-are-still-being-felt-five-years-article. [Accessed 15 October 2014]