Friday, August 16, 2013

DERIVATIVES EXPLAINED, PART II ... The Financial Commodity Tidal Wave

In my previous post I explained, in very general terms, how we should understand derivatives. Simply stated if a wheat farmer decides to sell his entire crop for $500,000 to a dealer six months before the crop is ready we have a derivative contract (it's a futures contract too). The contract derives its value from the farmers promise to produce wheat and the dealers promise to pay an agreed amount for the wheat.

Derivative contracts can be tied to commodities like corn, lumber, and cotton and, conceptually speaking, have existed as long as markets have existed.

The question for us today is how in the world did derivative markets, which were once primarily associated with agriculture commodities like corn, wheat, and cotton, come to be dominated by today's financial commodities that are built around debt?

Put another way, how did America's economy, which functioned well when derivative contracts focused on agriculture goods, become enslaved to debt-drenched financial instruments that collapsed our economy in 2008?

This is a big question. The answer lies in understanding the role of deregulation and its relation to something we call our shadow banking system.

THE BIRTH OF OUR SHADOW BANKING SYSTEM (the Backbone of Financial Derivatives)
Beginning in the 1980s the United States went on a deregulation binge. This was great for people who had money because it would eventually encourage market players to operate outside of the regulatory framework created for banks and our financial system after World War II.

By the beginning of the 21st century most market players with money would operate in the shadows of of our regulated financial system. Hence the "shadow banking" system. These market players would become the new Banker Gods in America.

The reason for the deregulation binge was quite simple.

Competition from abroad, the turmoil of the 1960s, plus the debt and OPEC-induced inflation in the 1970s created a period of economic uncertainty. Unfortunately, rather than look at the reasons for the competition (the success of the Bretton Woods system) or trying to understand the events of the 1960s and 1970s (Vietnam, debt, and short sighted policies) an emphasis was placed on going after regulations, lowering taxes, and even more deficit spending.

For our purposes here I will focus on the push for deregulation, which was relentless in the 1980s and 1990s.

In the financial sector deregulation would enable wealthy market players to lend money to middle-class America (through loan "brokers"). Borrowers liked the new environment because they didn't have to deal with stingy bankers, who had the audacity to check and see if borrowers could actually pay their bills. Bankers had to follow the rules because it was the law. Perhaps most important, if you didn't pay your bills the bank who originated the loan was on the hook for the losses.

In the new deregulated environment all of this changed.

* New unregulated market players entered the scene as lenders.  
* Banks and new market players could now sell the loans they originated. Others would have to deal with the payments, and the consequences.  
* Loans that were sold could be bundled up by the thousands, and then sold to other market players as cash producing securities.

Best of all for the borrowers they just had to satisfy "lending brokers," who were more than happy to turn a blind eye to the red flags in a borrowers financial history. As long as they got a commission the brokers were more than happy to make the loan. And why not? The loan was going to be sold off and bundled up anyways. The broker could care less if the loan was ever repaid.

Cue the financial derivative explosion.

It's at this point that the agriculture derivatives market takes a back seat to the financial derivatives market. Because many find this market confusing, I'm going to over generalize below.

Because deregulation had made lending and borrowing money so easy, selling and bundling up loan (debt) contracts became the name of the game. Derivative contracts based on debt - which could be car loans, credit card debt, home mortgages, etc. - became the new hot "commodity" in financial markets.

Derivative contracts based on agriculture commodities would take a back seat to the new financial toy on Wall Street.

There are many and very specific categories for each family of bundled up loans that become derivative products. I won't go over those here (but I do so in my book). The important thing to keep in mind is that the majority of these bundled contracts are generally called collateralized debt obligations (CDOs). A clumsy way to understand the term is to see CDOs as debts that others are obligated to pay, with the payments serving as the collateral for market players who purchase the CDOs.

I know, I know ... "CDO" is a clumsy way of saying "debt payments are my source of income" but this is how Wall Street wants it. If you think "bundled up debt," CDO, and "derivative markets" sound complex and mysterious you will be less inclined to challenge the logic behind putting more and more people in debt with credit cards, new home loans, and refinance specials. The name of the game is to get more people to borrow money.

In any case, and in plain speak, deregulation laid the groundwork for debt to become a commodity on Wall Street.

Because debt drenched derivatives were new, and so complex, market players in America gobbled them up like hot cakes. No one likes to look stupid on a hot commodity, even if it's all based on heavily indebted consumers keeping their jobs after refinancing or purchasing items they really couldn't afford. Besides, payment rules built around bankruptcy reform in 2005 and student loan regulations, among others, helped create the facade that debt would become Wall Street's cash cow (another topic for another day).

The shadow bankers and other market players had a field day in this environment.

They created and sold loans to feed the new commodity boom that, again - when we cut through the market speak - really rested on creating more debt in America. What started off as a trickle in the 1980s and 1990s would explode with even more deregulation during the aughts (or when President Bush was in office).

Today, with the U.S. economy is slated to produce about $16 trillion in goods and services, the countries biggest traders in derivatives - JP Morgan Chase, Bank of America, and Citi Group - have made derivative trade bets on about $175 trillion in assets (not just debt laden derivatives).

Today, about 90% of all derivative trading in the U.S. is done by the four largest banks, while the notional value (asset base) of all the derivative trading done around the world hovers around $700 trillion (with one group placing the value at $1.14 quadrillion).

At the same time that trading in derivative products shot through the roof market players busied themselves finding insurance for their new commodity products. They needed the insurance because they wanted desperately to believe that if their bundled up financial instruments failed they would still get their money. I will discuss these insurance instruments in my next post on derivatives.

Still, one thing is clear after the 1980s. Deregulated shadow bankers had a field day. As the author of The Trillion Dollar Meltdown noted, by 2006 only about a 25% of all lending in America was done by traditional, and strictly regulated, banking institutions - down from about 80% just twenty years earlier.

Free marketeers rejoiced at this development because, as Alan Greenspan gushed at the time, with unregulated financial players providing new cash "a new paradigm of active credit management" had been created in America. Happy Days were here again.

Then 2008 happened.

I will discuss this, and more, in my next post on this topic, Derivatives Explained, Part III ... Why Financial Derivatives Are Still Dangerous.

- Mark

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