‘As we know, these are the known knowns. There are things we know we know. We also know there are known unknowns. That is to say we know there are some things we do not know. But there are also unknown unknowns, the ones we don’t know we don’t know.’ — Donald Rumsfeld, when he was the US Secretary of Defence
Derivatives are at the heart of most financial crises that have plagued banks and companies all across the world over the last three decades. From small-scale industrialists of Tiruppur to the banks lending to the subprime home loans market in the United States.
“Derivatives business is filled with beautiful lies,” says Satyajit Das, the internationally renowned expert on financial derivatives. He has had a foot in both the sides of the derivatives equation, having worked for banks (the “sell side”) such as the Commonwealth Bank of Australia, Citicorp Investment Bank and Merrill Lynch and, as treasurer of the TNT Group, for clients (the “buy side”). Das has authored several books on derivatives including Traders, Guns & Money — Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT Pearson). He speaks about the arcane world in an interview with Vivek Kaul.
How did financial derivatives become an important part of the financial system worldwide?
Derivatives aren’t new. They evolved out of agricultural futures used for hedging soft commodities for over 100 years. In the 1970s, the concept was extended to financial commodities —- initially interest rates, currencies, equities etc.
The original rationale was hedging —- it’s what banks like to tell regulators and what regulators like to hear. The real impetus to derivatives from the late 1980s onwards was using derivatives to create and assume risk—- fundamentally the opposite of what derivatives originally did. Investors were looking for higher returns. So banks started to manufacture risks using derivative technology.
They have many advantages —-cash settlement (you don’t have to have a position in the underlying asset and volumes are not constrained by available volumes in physical assets) and they are off-balance sheet (leverage). Deregulated banks seeking to grow their product range and profits found derivatives trading to be a new source of revenues. All these factors combined over the last 20 years to help derivatives grow into a $600 trillion market; around 10 times the world GDP.
You say in your book Traders, Guns & Money… that the derivative business is filled with beautiful lies. Could you elaborate?
Beautiful lies are the lies that we like to believe. We know they are not true but everything makes us want to believe them. The derivatives business is filled with ‘beautiful lies’ — for example, even the simple business of hedging can be a beautiful lie.
Why is hedging a true lie?
Take the example of an airline that locks in the price of its jet fuel over the next year. You get the “illusion of certainty”. You can’t hedge without knowing what is going to happen to oil prices. Locking the cost of oil through forward contracts has a cost or a benefit, the difference between the current price and the forward price.
If the oil price is $100/barrel and the forward price is $110/barrel, then the cost of the forward is $10/barrel. The oil price has to rise at least $10/barrel before you gain. Does the forward guarantee certainty? The airline’s cost of oil is fixed. But its problems are not over. Assume the airline hedges but its competitors don’t.
If the oil price falls then our airline’s cost of oil is fixed. But competitors benefit from lower oil prices. What happens if the competitors cut fares? Oops! Our airline is stuck with fixed oil costs so it can’t really afford to cut prices. It can cut fares and bleed to death. It can keep fares high and bleed to death. If it cuts fares then its revenue falls but its costs stay the same. If it doesn’t cut fares, customers fly with competitors with cheaper fares.
Hedging provides certainty —- of death. You assume that the underlying exposure will be there. Suppose the airline gets it routes —- the underlying exposure disappears but your hedge remains. There have been quite a few notable hedging deaths over the years. In the words of a famous surgeon: “The operation was a total success but the patient died”.
You say lack of transparency lies at the heart of derivative sales. Why is that?
The Chicago School and free market theocracy enshrined concepts such as efficient markets, transparency and informational symmetry. A dealer can’t get rich from that. If everybody understands the product and the price is transparent then margins narrow. The game has always been to complicate the structures making them less transparent to take advantage of informational “asymmetry”.
Many clients do not understand the structures or can’t value them. They may end up overpaying for risk. Difficulties in valuation and assessing risk also affect the banks. Traders need to convince risk managers there is no risk and the product controllers that the profits they are showing are correct. In this world, sales people lie to clients.
Traders lie to sales people and to risk managers. Risk managers lie to the people who think they run the place. The people who run the place lie to shareholders and regulators. Investors and corporations generally lie to themselves about their understanding of derivatives and why they are using derivatives. The recent experience of Indian companies using complex currency derivatives to hedge the rupee seems to be consistent with the global experience.
What is the impact so-called ‘quants’ have had in popularising derivatives?
Financial mathematics —- much of which is reasonably trivial — is used for pricing, valuing and risk management of derivatives. Risk quantification is based on the Gaussian distribution used by Markowitz. Nicholas Nassim Taleb in The Black Swan argued that risk quantification based on this approach has problems.
In the current crisis people are talking about “one in ten thousand year events”! These seem to occur every year. The concept of dynamic hedging that underlies the Black-Scholes-Merton option-pricing framework allowed banks to trade complex derivatives in the belief that they were hedged.
The models assume efficient markets, no liquidity constraints and no jumps in asset prices. In practice, markets don’t behave that way particularly in periods of stress. Long Term Capital Management (where both Nobel Prize-winning economists Robert Merton and Myron Scholes were partners) used both techniques with highly unsatisfactory results.
Merton ironically articulated the problems of quant models: “At times we can lose sight of the ultimate purpose of the models when their mathematics become too interesting. The mathematics of models can be applied precisely, but the models are not at all precise in their application to the complex real world. Their accuracy as useful approximations to that world varies significantly across time and place. The models should be applied in practice only tentatively, with careful assessment of their limitations in each approximation.” The speech was less than a year before the collapse of Long Term Capital Management.
Keynes (John Maynard, the economist) was right when he observed: “Too large a proportion of recent mathematical economics are concoctions, as imprecise as the initial assumption they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.”
You have said fashion models and financial models are similar. Can you explain?
Fashion models and financial models bear a similar relationship to the everyday world. Fashion models are idealised concepts of male and female beauty. Financial models are idealised representations of the real world. Neither is real. Models don’t quite work in the way that the real world works. There is celebrity in both worlds. In the end, there is the same inevitable disappointment.
Do you see credit default swaps unravelling? What are the kinds of problems you foresee there?
CDS contracts are economically similar to credit insurance. The buyer of protection (typically a bank) transfers the risk of default of a borrower (the reference entity) to a protection seller who for a fee indemnifies the protection buyer against credit losses.
CDS contracts and the structured credit market were originally predicated on hedging or transferring credit risk. Over time the market changed focus —- in Mae West’s words: “I used to be Snow White, but I drifted.” The ability to short credit, leverage positions and trade credit unrestricted by the size of the underlying debt market have become the dominant drivers of growth in the market for these instruments.
Documentation and counterparty risk means that the market may not function as participants and regulators hope if actual defaults occur. A significant proportion of protection sellers is financial guarantors (monoline insurers) and hedge funds. As the credit crisis deepens, the level of defaults will increase. The CDS market will be tested. While there have been a few defaults, the market has not had to cope with a large number of defaults at the same time. CDS contracts may experience problems and may be found wanting. When default occurs the hedgers might find them “naked” and “unhedged”.
The intricacies of the CDS contract and its operation are not well understood by users. Credit derivative dealers talk about their market in much the same way spotty teenagers talk about sex. A lot of people profess to be accomplished experts, but when it really boils down to it, most of them are still fumbling in the dark. CDS contracts may not actually improve the overall stability and security of the financial system but create additional risks.
How did the current sub-prime mess in the US start?
Sub-prime is just one example of a global problem of excessive lending against overvalued assets to borrowers who don’t have the means to service that debt. The problem was caused, in part, by the build-up of savings in the world looking for high quality debt (AAA or AA) to buy. Banks were encouraged to lend to people they probably never should have lent to on overambitious terms.
The dodgy debt was converted into high-quality debt using structured finance techniques and rated by rating agencies using models whose assumptions proved to be incorrect. AAA-rated debt based on portfolio of poor quality loans made a lot of people a lot of money in the short run but the chickens are coming home to roost.
Basically, a pig with lipstick is still a pig. The same business model was used in private equity loans, commercial property and infrastructure and it is all going to have to be unwound.
Where do you think the sub-prime mess will end?
The high levels of global leverage have to be reduced. The financial system is de-leveraging. Credit creation and lending is pretty much at a standstill. This will, in turn, force companies and consumers to de-leverage by selling assets or deferring investment and consumption to reduce borrowing levels.
The process will be a slow one taking years. The amount of money lost (current estimates are in the range of $1-2 trillion) will beggar belief. It may also hamper global growth rates for an extended period. The Goldilocks economy is over — the bears have well and truly returned home.
Most financial crises over the last 25 years have their origins in derivatives. Given this, why do people go back to it, not learn from mistakes?
Derivatives are a tool. It is the misuse that has become problematic. Using derivatives to manage risk provided you understand what you are doing is fine. Increasingly derivatives have been used to create leverage and amplify risks.
The problem is exacerbated by the lack of knowledge of many participants, the adverse incentive structures (a “heads I win, tails you lose” culture) and the fact that all the games are played with other people’s money. As for repeating the errors, that is a general human trait. As Giuseppe di Lampedusa (author of The Leopard) observed: “Everything must change so that everything can stay the same.”