Thursday, March 01, 2007

Franken-derivative: It's alive!

written with tongue firmly clenched in cheek, sort of

Losing control of man's creations is one of the recurring themes in literature of all ages. From Frankenstein to the Terminator to the Matrix the fear that man will become a slave to his creations resonates with people, perhaps not unjustifiably.

When I consider the recent about face from ex-Fed Chairman Greenspan on the possibility but not probability of a recession in the US the notion that we have become, in a sense, slaves to the ever growing derivatives market, comes into shape in my mind. Is Greenspan afraid his comments (as opposed to his actions as Fed Chair) will spook the markets? It isn't as if his track record on these things, at least given his public statements, is particularly good.

More to the point, however, I've been thinking about the fearful way the news of an equity market correction was reported in the regular media. The tight linkage between China's stock market and that of the US was asserted as a given, and I even heard mention of the Yen carry trade and the, terribly negative, expected effects of its unwinding. It is as if the derivatives monster has taken on a life of its and warning us humans that it means business- it will wreak havoc on our world if we don't supply it with its food, liquidity, and the means to get more, open capital markets. Even investment bankers like the guys at Dresdner Kleinwort fear the wrath of this beast, which they have called the Great Unwind.

Some of the reasons cited for the 9% decline in the Chinese markets were fears that the government would try to reduce the leverage (raise margin requirements) used to trade stocks and/or restrict foreign participation in their market. Apparently a 5% decline in the Chinese markets a few weeks prior, which was also blamed on similar fears, was insufficient to get the attention of policy makers who were apparently trying to starve the beast. So, as many do in this age of mass media, the derivatives monster made sure it got on TV. Shocking events get the attention of the media, the media broadcast your message to the world; Donald Trump, eat your heart out.

I've stretched this metaphor to an extreme by speaking of it as if it was a sentient being, which it is not. Yet, if it isn't a sentient being why do so many apparently heed its pleas? Finance is but one of many industries necessary to modern life. If we can bleed the manufacturing economy in the US, why can we not bleed the financial economy? particularly when it forces us to live with a nagging fear of impending doom. The fear of the Pope excommunicating a nation which modern man now finds so silly has been replaced, it seems, by fear that the new priests of high finance will crash our markets or cut off our access to capital.

I agree with Warren Buffett, derivatives are financial weapons of mass destruction so why do we not disarm them? Why do we want to let this creation of ours continue to lead us to misdirect capital, wasting vast amounts of valuable human time in the process? Why would we want to let this creature continue to concentrate capital in fewer and fewer hands, which, in the past, has almost always given rise to class warfare?

How long will it be before some clever terrorist decides to put down his guns and bombs and opens up a hedge fund instead? Rather than suicide bombers we could get suicide portfolios. How many LTCM type blow ups would it take, given the carnage in the sub prime mortgage market, to cause the major markets to seize up? Death by disintermediation.

When Communist Russia began to collapse, justifiable fears arose over its nuclear weapons falling into the wrong hands. What if the leadership of a country with a large financial portfolio, and these have multiplied over the past decade, fell prey to a coup? Should we not also be concerned that in that event the derivatives monster instead of a nuclear holocaust, would be unleashed on the world?

But, it seems we have grown accustomed to the financial sword of Damocles hanging over our heads, perhaps like those who live near volcanoes and don't leave when the ground starts rumbling. Some cultures, for instance like those in Bali who worship the volcanoes, are considered backward because they try to propitiate their gods and thus avoid disaster. This week, when we heard the ground rumble, we too propitiated our gods, convincing ourselves that by so doing, we avoid disaster- but all the while we know it is coming.


STS said...

How bad is the derivatives monster, really? The lack of transparency -- or the paths the falling dominoes would take in a major "credit event" -- is the most worrying thing. But a lot of little quakes should serve to teach risk managers to respond.

Is the incentive system the biggest risk? (Eg. Rajan risk --

Or is it that risk management doesn't have the tools or leverage to detect and correct bad behavior by traders?

Dude said...

How bad is it...bad in the sense that the great unwind will likely lead to a period of disintermediation as a few banks will likely go under, but, I believe, ultimately for the good.

The problem with them, in my view, is that they are, in extremis, unhedgable and unhedgable leverage is a recipie for disaster. In other words, the models themselves are based on the fallacy that markets continually offer smooth continuous pricing.

TallIndian said...

Have you seen that portfolio insurance (especially in securitized deals with credit derivatives) is making a comeback?

Also, many investment banks now seem to believe that that mean reversion is a reality in that any extreme move in one direction will be offset within some reasonable time frame.

Reasonable people actually discuss doubling a position to recover losses after an adverse move as a serious strategy. Google 'CPDO' and see how the ratings agencies reward 'double down gamblers ruin' trade with a AAA rating

Dude said...

Ashes to ashes, dust to dust is the ultimate mean reversion. Those who believe "mean reversion" only forecasts that undesired changes will be reversed are restricting their theory a bit too much, methinks.