Tuesday, September 16, 2008

Derivatives: financial W M D

Warren Buffett in 2002 Newsletter to shareholders of insurance company Berkshire Hathaway warned of the dangers of Derivatives:

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

[. . .]

We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Paul Krugman argues that the shadow banking system is now beset by "postmodern bank runs":

To understand the problem, you need to know that the old world of banking, in which institutions housed in big marble buildings accepted deposits and lent the money out to long-term clients, has largely vanished, replaced by what is widely called the “shadow banking system.” Depository banks, the guys in the marble buildings, now play only a minor role in channeling funds from savers to borrowers; most of the business of finance is carried out through complex deals arranged by “nondepository” institutions, institutions like the late lamented Bear Stearns — and Lehman.

The new system was supposed to do a better job of spreading and reducing risk. But in the aftermath of the housing bust and the resulting mortgage crisis, it seems apparent that risk wasn’t so much reduced as hidden: all too many investors had no idea how exposed they were.

And as the unknown unknowns have turned into known unknowns, the system has been experiencing postmodern bank runs. These don’t look like the old-fashioned version: with few exceptions, we’re not talking about mobs of distraught depositors pounding on closed bank doors. Instead, we’re talking about frantic phone calls and mouse clicks, as financial players pull credit lines and try to unwind counterparty risk. But the economic effects — a freezing up of credit, a downward spiral in asset values — are the same as those of the great bank runs of the 1930s.

And here’s the thing: The defenses set up to prevent a return of those bank runs, mainly deposit insurance and access to credit lines with the Federal Reserve, only protect the guys in the marble buildings, who aren’t at the heart of the current crisis. That creates the real possibility that 2008 could be 1931 revisited.

ABC's Economics Correspondent the fabulous Stephen Long today:

ELEANOR HALL: So if the Federal Reserve is that worried why didn't it bail Lehman's out?

STEPHEN LONG: Well I think that there's two reasons that the US government chose not to bailout Lehman's. The first is the sound policy reason that if the government keeps on bailing out failing financial institutions you create a situation where it actually over the longer haul encourages excessive risk taking and unsound borrowing and lending which is at the core of this crisis, a situation known as moral hazard.

And the other thing is that there comes a point where the US government just has to say well we can't afford to keep on bailing out failing institutions. They've effectively nationalised Fannie May and Freddie Mac, half a trillion dollars of mortgages and one in three mortgages in the US are failing at the moment. And so they're underwriting massively the housing market in the States. You've got an irony that a neo-conservative-neo-liberal government is effectively socialising a whole lot of assets and they have huge debt.

ELEANOR HALL: And today we've got President George W. Bush saying he's confident that Wall Street can manage this. But what if that confidence is misplaced? How bad could it get? And for real people?

STEPHEN LONG: Well don't trust anything that politicians are saying at the moment and take even what market participants are saying with a grain of salt because they have clear vested interest in accentuating the positives. How bad could it get? Well it's already really bad. We have every major economy in the Euro zone in the US with subpar growth. You've got a collapsing housing market in the US and in Europe and you've got serious capital problems.

But beyond that you've got this situation where there are tens, hundreds of trillions of dollars in the credit markets in fancy financial products that were designed to mitigate risk, but have come sources of speculation. Credit default swaps which are essentially a form of insurance against companies going bankrupt.

Well there's a real concern in financial markets that if you're having big investment banks going down and they've essentially been selling these products and you're having hedge funds which have bought these products en masse going down, you could get to a situation where you have essentially a nuclear meltdown where people on different sides of trades in these markets can't meet their obligations and you get just an implosion in the financial markets.

ELEANOR HALL: So no money available for businesses?

STEPHEN LONG: Yeah and the irony is that credit derivatives where people invested in stuff that was meant to be an insurance against the risk of a LB event happening and credit default swaps insurance against company collapses could come back and bite them because of the complexity in the financial system.

So much of this opaque, it's a shadow system unregulated. It's not clear what all the exposures are.

ELEANOR HALL: We heard Robert Reich the economic secretary under Clinton speaking earlier in the program about the need for a sort of super regulator; would that solve things?

STEPHEN LONG: Well it won't solve anything immediately, it might help in the next crisis, but it can't solve anything in this crisis. This has to play itself out and I would expect it's going to get a lot worse before it gets better.

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