- Part I: The Ayn Rand twist to the Greenspan plot
- Part II: Brave new world of derivatives
Till roughly 10,000 BC, humans subsisted in small wandering groups that hunted and gathered food for survival. Then, in the Neolithic age, the Sumerian civilisation of West Asia domesticated animals and plants, settled in one place, founded villages and started farming.
A similar evolution is underway in the financial services world. The great financial centres of today's world, New York and London, are probably equivalent of the Sumerian civilisation and are working through the painful transition of the financial services world from the hunter-gatherer era to the farmer era.
Just as the Sumerian farmers had to learn to deal with the domestication of plants and animals (some were useful to man and some were dangerous), we are learning to deal with the world of financial derivatives - how to make them useful and how to curb their dangers.
The enormous pain that the world is going through now may just be the pain of this transition in which we are learning when and how to use derivatives and when and how not to use them.
One of the lessons we have learnt is that derivatives ought not have been used to solve a structural problem that banks face. Banks, Alan Greenspan points out in his memoir, The Age of Turbulence, have historically relied on passive depositors, mainly working and middle class people, who keep their savings in passbook accounts, as the source of funds.
These depositors are happy to leave their money around in banks without worrying too much about the return they are getting from it and accounted for 95 per cent of the banks resources in the 1950s in the United States.
They now account for only 60 per cent, says Greenspan, making banks dependent on the same volatile investors that the securities market depends on.
Such expensive borrowings force banks into two risky moves - investing in mortgage-backed securities and taking on leverage.
For example, when a billion dollars gets a return of only $2 million you need to leverage your trade 20:1 or 30:1 to get a 20-30 per cent return. The risk here is that should the trade go against you and you lose $2-3 million, that effectively wipes out all your capital.
If the word gets around that such an event is likely to happen, crowds may not gather outside bank branches but lenders will instantly demand their money back forcing a bank into bankruptcy.
In other words, banks have to find a long-term solution to their financing problem now that passive, unsophisticated depositors are a fading breed.
While all this was unfolding, Greenspan, inspired by his early contact with Ayn Rand, depended on innovative entrepreneurs and market forces rather than government intervention to find solutions to this explosive use of derivatives.
Not that it's easy to regulate financial entities by treating them as a homogeneous group. Doing that is somewhat like trying to have a single set of traffic rules for cars, trains and commercial airplanes.
The nature of risks that hedge funds - financial entities who are fervent believers in derivatives, for example - deal with are as varied as the risks facing car passengers are different from those facing train passengers as are those facing airplane passengers.
Hedge funds that do options trading face what are called gamma risks; those that do relative value trading face risks with the sizing of trades and the usage of leverage; and hedge funds that deal in distressed debts face event risks specific to the firms they invest in. Having a common set of regulations to deal with all these risks have proven so far to be challenging.
While derivatives are a modern innovation like the microprocessor and antibiotics, we have clearly not learnt all that we need to know about this potent invention. Central to derivatives is that make computers crunch reams of historical data to detect discrepancies in the way prices move across different tradable financial assets.
This has been the classic way to diversify risks. But there are occasions, rare as they may be, when the prices of these assets instead of offsetting each other can all fall steeply and in unison. When that happens, all hell can break loose.
Then there are cases where good intentions can go wrong. One example is sub-prime mortgages, financial instruments whose original purpose was to make home-ownership possible for a class of citizens who were not eligible for home loans because normal lending standards were too high for them to qualify.
The idea was that a higher interest rate would cover the possibility of higher delinquency, a classic free-market way of using price as a way of rationing credit. However, during the last few years, when interest rates dropped and remained low, many homeowners used sub-prime financing to repay their earlier loans and even get some cash released, called cash-out financing.
According to a study published in The Federal Reserve Bank of St Louis Review, "Slightly over one half of sub-prime loan originations have been for cash-out refinancing."
Earlier this week, I went for a stroll by the big, bronze statue of a crouching bull near my office in New York. I could not help wondering whether, in times to come, this bull would spring to life and bring back the good times of the past decade or whether, like the Tower of London, or Qutab Minar, it will merely be a curiosity for tourists, a reminder of the power that Wall Street once was.
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