Fools’ Gold Book Review

Fool-s-Gold-9781400142835

Gillian Tett’s Fool’s Gold is about how the JP Morgan derivatives team conjured up the idea of credit derivatives. It follows the history of the credit derivatives into its perversion and how the corrupted idea helped fuel the recent credit crisis. For anyone in the field of finance, it is a must read. If you are interested in derivatives and how they affect the economy and your bottom line, I highly recommend this book. Below is my analysis of some of the parts of the book that I found interesting:

 

1. General Overview of Derivatives

A derivative is a “contract whose value derives from some other asset, such as a bond, stock, or quantity of gold”. Buyers and sellers of these instruments are making a bet on the future value of the underlying asset. Investors can use derivatives for hedging thus protecting themselves from a certain event or make “high-stakes bets on price swings for what might be huge payoffs”. (Tett 9)

 

The protection aspect of derivatives is very useful to companies as it shifts risk from companies unable or unwilling to bear it to companies that are able and willing to bear it. For example, suppose you are a medium sized, multi-national corporation that can be hurt by significant foreign currency fluctuations. You would rather lock into a fixed, known rate rather than be burdened with the risk a quick, unpredictable flux in rates that could drastically affect your net income. As a result, speculators who think the rates will move in their favor for a profit will be willing to give you a fixed rate for a variable one. They have potential for a profit while you can feel safe with a locked in rate.

 

However, the speculator is truly gambling on the future. As a result, derivatives have also created a high-stakes Casino in the financial world as unbelievable losses can pile up very quickly. For example, a bank can extend a credit (loans and derivative transactions) to a foreign company. The company has strong cash flows and is performing very well. However, due to foreign exchange swaps, it can find itself all of a sudden with a $1 billion liability and not enough cash to pay off. With the trillions of dollars currently at stake in derivatives, I believe the danger caused by this excessive gambling far exceeds the benefit of derivatives. However, at a scaled down level, derivatives can be very useful.

 

2. Origin of Credit Derivatives

The idea for credit derivatives came to the JP Morgan swaps team during a company retreat. Their idea centered on “using derivatives to trade the risk linked to corporate bonds and loans”. Default risks were the most significant form of risk to commercial interest. By allowing banks to bet with the use of derivatives, they could cover losses and thus be provided with a different type of insurance. Moreover, J.P. Morgan’s gigantic loan portfolio was creating menacing regulatory issues. Consequently, a financial instrument that could reduce default risk might also lessen the concern from regulators. (Tett 21)

 

The rationale behind credit derivatives is sound. It allows banks to spread out the risk of its loan portfolio and thus decrease the burden of defaults on its books. When banks extend loans, they rarely take on the entire commitment on their own books anyway. They generally syndicate the loan to other participating banks while retaining a share in order to reduce its exposure to a counterparty defaulting. As a result, credit derivatives are important to provide an additional channel to spread default risk around. By lessening the risk on the assets currently on the books of the bank, it will also free up banks to provide more loans and financing.

 

3. Leverage Created by Derivatives

While derivatives can amplify gains, it also amplifies losses. Fool’s Gold uses a great to illustrate point: “Using leverage in the derivatives world is thus the financial equivalent of a property developer who buys ten houses instead of five: owning more properties will leave that developer more exposed to losses and to gains if house prices rise or fall, particularly if the properties are financed with debt”. If house prices rise, you multiple your gross margin per house by 10 instead of 5. However, decreasing house prices will multiply that effect in the opposite direction. (Tett 31)

 

Again, this analogy points out the danger present in having derivatives create a de facto casino in finance. The potential for exponential gains also leaves an opportunity open for exponential losses. Some firms were like gambling addicts. They were blinded by the upside potential that they forgot they were also putting up a lot of chips on the table in order for the chance to win big. The credit crisis showed how this principle dearly cost a number of firms.

 

4. Dancing Around the Regulators

One of the most significant moves made by bankers was to create an industry body to represent swaps, the International Swaps and Derivatives Association (“ISDA”), which developed common guidelines for swap deals. This move was intended for the swap industry to show the government that it could police itself without regulation. Moreover, the ISDA also served as a powerful lobbying tool to fend off regulation. When Congress would attempt to enact some form of legislation over the industry, the ISDA would spring into action and convince Congress that it was ill informed and the derivatives world was fine. (Tett 26-40)

 

First, this situation is a great example of game theory. The bankers knew a lot more about the products that they conjured up than government. Based on the information asymmetry, bankers were able to successfully fend off regulation through lobbying. Government’s role in the game was to try to force the bankers to reveal what they knew. However, the government clearly failed in its attempt as the bankers were able to give it the wrap around. In addition, the bankers pulled a witty maneuver by creating the ISDA to send a signal that the industry could police or regulate itself without the intervention of government.

 

While it is a catchy idea that government should have saw it coming and prevented it, I doubt government could have done much. Derivatives got very complicated. As a result, it takes expertise in the field to understand the transactions. How was the government going to build up a base of experts? The best minds in the field are probably going to be with a bank instead of government as banks compensate employees significantly more than a government agency. Without that expertise, I cannot imagine how government could have enacted effective legislation that could have prevented some of the derivative related crises such as Long Term Capital in the late 1990s or AIG recently.

 

5. Securitization

In the 1960s and 1970s, banks started selling mortgage loans to investors to diversify their portfolios. Over time, banks came to the realization that they could package a number of loans into securities backed by the cash flow of the mortgage payments. With this securitization, the banks could make profits on the mortgage payments and the sale of the securities. More importantly, a significant if not most of the default risk will be borne by the investors in exchange for an opportunity to profit from the securities. Moreover, the securities provided some form of protection against default risk as individual defaults within the bundle of loans could be offset by the cash flow from the remaining loans. These securities are known as mortgage backed securities today. (Tett 52)

 

Similar to credit derivatives, the rationale behind securitization is sound. The banks get an opportunity to transfer risk to investors while still profiting. As a result, banks can extend more loans and thus provide more financing to the market. Investors get a pool of assets and are thus protected from individual defaults within the portfolio. Even though something is a good idea, it could be taken too far in the wrong direction and get corrupted.

 

6. Perversion

 

Since the 1970s, bankers have used mortgages to create “bonds or bundles of debt” known as CDOs. In the late 1990s, mortgage lenders and brokers started creating CDOs for nonconforming mortgages or the subprime market. The rationale behind creating these securities is that subprime lenders pay higher interest rates as they are more risky. As a result, the higher rates provide an opportunity for higher returns. Even though there will be higher default rates in a pool of assets, the securitization would theoretically protect investors as the higher cash flows from the rest of the pool would cover the losses. However, there was an element of uncertainty that should have been emphasized more: there was no solid information on how the subprime mortgage defaults would react to a severe house price decrease. (Tett 94-96)

 

I concede that securitizing subprime loans to generate higher returns while having a pool to protect against potential losses was a clever idea to a certain level. However, replicating the securitization over and over again to dive deep into the subprime world is mind boggling. Economics is the allocation of resources. Allocating such a significant amount of resources to one area, that is by definition more suspect than the majority of mortgages, is insane. However, the unrealistic fair values caused bonuses to skyrocket and consideration of the potential risks took a nosedive. This scenario reminds me of a quote from Jurassic Park when Dr. Ian Malcolm, who was played by Jeff Goldblum, said “Yeah, but your scientists [in this case, financial engineers and traders] were so preoccupied with whether or not they could, they didn’t stop to think if they should.” In the business world, the dinosaurs that were unleashed ate a couple of brand name financial institutions such as Lehman Brothers and Bear Sterns.

 

7. Leveraging Lunacy

Financial institutions compounded the problem by substantially increasing leverage in order to raise capital to invest in the subprime industry. In the case of Citibank, it circumvented the leverage limits imposed by the US regulatory system by creating structured investment vehicles (“SIV”) off its balance sheet to place super-senior notes. (Tett 136)

 

In this specific case, I am surprised that regulators did not notice this issue quicker especially after the Enron fraud. Enron used SPVs to mask its liabilities by moving it into off balance sheet vehicles. While Enron’s SPV’s were clearly meant for fraudulent financial reporting purposes, at least Citibank’s SIVs had a business rationale as it was trying to invest more in securities that it felt were worthwhile. Nevertheless, it is surprising that more scrutiny was not placed on Citibank’s SIVs especially since they were used to circumvent regulations set up in a post Enron era.

 

8. Umbrella of Ignorance

One of the sections of Fool’s Gold that really caught my attention was the part about how very few bankers at Merrill Lynch had an idea what their CDO desk was doing. As the desk was posting more profits, it became more and more difficult for other departments or risk controllers to interfere. (Tett 135) When I read this section, I also wondered whether the CDO desk knew what it was doing. It clearly overlooked the risks of the transactions it was entering into at the time. Warren Buffet has been quoted as saying “Derivatives are financial weapons of mass destruction.” It is good that we have entrusted our country’s weapons of mass destruction to individuals who know how to handle it. Unfortunately, the handlers of the financial weapons of mass destruction did not realize in time before their bombs exploded.

 

In the movie Trading Places, the Duke Brothers enter into a wager. One part of the wager is that a less fortunate individual, Billy Ray Valentine played by Eddie Murphy, could thrive if given the opportunity on Wall-Street. In essence, it was a bet on whether they could take a person off the street and make them succeed in Wall-Street. If financial institutions can create these complex products but not have better judgment in assessing the risks of the products, how much value are they really adding? You might as well take someone off the street such as Billy Ray Valentine and teach him how to execute a trade when there is a popular fad for short term gains. On the other hand, all the individuals that do have a complete understanding of the products and utilize that knowledge to make substantial amounts of profits for their firms are certainly worth their weight in gold.

 

 

 

Pat Wong

About Pat Wong

Patrick is a contributor for Rookerville. He is an avid sports fan. Before joining Rookerville, he was part of a defunct New York Yankees message board, NYYankeefans, where he was its top poster and was inducted in its Hall of Fame for his contributions. Patrick is also a passionate fan of movies. He has enjoyed reading movie reviews over the years and is excited about the opportunity to review movies.

Comments

Share This Post On

Leave a Reply

%d bloggers like this: