"How did you go bankrupt?"
"Two Ways. Gradually, and then suddenly."
--Ernest Hemingway, The Sun Also Rises
I recently debated an economist from the University of Chicago on the economic value of exotic derivatives. "They add liquidity," he insisted, repeating the standard wisdom. But recent events have shown that such instruments indeed create liquidity -- until suddenly they destroy it.
For example, a credit default swap is an insurance contract against a bond defaulting. Many of the bonds thus insured were themselves derivatives, in this case bonds backed by sub-prime mortgages.
There are about $2 trillion dollars of subprime bonds in the marketplace -- but $62 trillion dollars of different kinds of "swaps" making bets for or against the failure of those bonds. This kind of leverage is why derivatives create a house of cards.
Supposedly, these derivatives on top of derivatives "spread risk," but in truth they spread risk the way an epidemic spreads diphtheria. Mainly, they created financial pyramids that hid risk, allowing ever thinner ratios of capital-to-debt with each added layer.
One bad bet on swaps by a tiny unit of A.I.G., the world's largest insurance conglomerate, took down the whole company. Though ordinary insurance is well regulated, with required reserves against insurance losses, regulation of this particular exotic insurance was nobody's responsibility. And just before the Federal Reserve acted to nationalize A.I.G, the New York State insurance commissioner had drafted an order permitting A.I.G to tap some $20 billion in strictly segregated insurance reserves to bail out its ailing swaps unit in London. Just as one credit default infects another, so regulatory lapses feed on one another.
With credit default swaps, investors were spared the need to perform the most basic of capitalist roles -- to have a close look at what they were buying. Swaps were moral hazard on stilts.
Why, after all, do people and financial systems go bankrupt "gradually, and then suddenly?" Because as their real situation worsens, they stave off the day of ruin by borrowing. Bankruptcy comes with terrible suddenness when creditors stop lending. The more exotic and opaque the security, the higher the tower of possible debt and the more devastating the eventual crash.
Here is the radical implication of these interconnected collapses: The next financial system, rebuilt by governments on the ruins of the old one, needs to be plain vanilla. The banking system should be restored to its basic role of supplying credit to the real economy, with as few complications as possible.
We need a system in which commercial banks take in deposits and make loans; and where investment banks underwrite securities such as ordinary stocks and bonds. This kind of system is transparent to regulators. They can measure the value of assets, and require banks to put aside reserves against non-performing loans. Without complex derivatives that have no trading market and hence no valuation, it again becomes possible for regulators to assure capital adequacy and limit the disguised layers of pyramiding. Investors can once again make informed decisions.
If financial engineering did all that its enthusiasts claim for it by way of improving the efficiency of capital markets, we would have seen the results in improved GDP. But growth was far higher in the era of plain vanilla finance.
The Chinese, have grown at about ten percent a year for two decades, with only the most rudimentary of financial systems. Banks take in deposits and underwrite industrial expansion. The system simply prohibits collateralized debt obligations. There are many unsavory aspects of China's political system, but its financial system gets the job done.
It is fashionable to argue that financial engineers will always innovate around regulators, but until deregulation became the norm in the Thatcher-Reagan era, regulators did well. For the first two decades of the postwar era, entire categories of transactions were simply proscribed.
Lately, the regulatory problem has been less technical than political. In 1994 the U.S. Congress, then controlled by Democrats, passed a law prohibiting subprime mortgage underwriting. But Alan Greenspan, then Fed Chairman, refused to issue the necessary regulations. In 1995, Republicans took over Congress and no one held Greenspan's feet to the fire.
Democrats also come in for their share of blame. When Brooksley Born, then the head of the Commodity Futures Trading Commission, proposed to regulate derivatives, the entire bipartisan political establishment came down on her -- Robert Rubin, Alan Greenspan, and other financial regulators. The allegation was that her proposal would "disrupt" financial markets. All it would have disrupted were exorbitant profits that built pyramids of risk.
In 2000, then Senator Phil Gramm, now an adviser to John McCain, got a law enacted for the benefit of Enron, effectively prohibiting the regulation of credit default swaps entirely. Had these two forms of regulation not been politically aborted, the current financial collapse would have been avoided. So the challenge of prohibiting the most dangerous of financial exotics is not technical, but political.
