Saturday, March 28, 2009

Frank Partnoy - Derivative Dangers on NPR's Fresh Air with Terry Gross

From article linked here.

Excerpts from Frank Partnoy's book:
Without derivatives, the total losses from the spike in subprime mortgage defaults would have been relatively small and easily contained. Without derivatives, the increase in defaults would have hurt some, but not that much. The total size of subprime mortgage loans outstanding was well under a trillion dollars. The actual decline in the value of these loans during 2008 was perhaps a few hundred billion dollars at most. That is a lot of money, but it represents less than 1 percent of the actual market declines during 2008.

Instead, derivatives multiplied the losses from subprime mortgage loans, through side bets based on credit default swaps. Still more credit default swaps, based on defaults by banks and insurance companies themselves, magnified losses on the subprime side bets. As investors learned about all of this side betting, they began to lose confidence in the system. When they looked at the banks' financial statements, all they saw were vague and incomplete references to unregulated derivatives. By the time banks voluntarily disclosed some additional information about their complex positions, it was too late. The dominos already had fallen.

Instead, derivatives multiplied the losses from subprime mortgage loans, through side bets based on credit default swaps. Still more credit default swaps, based on defaults by banks and insurance companies themselves, magnified losses on the subprime side bets. As investors learned about all of this side betting, they began to lose confidence in the system. When they looked at the banks' financial statements, all they saw were vague and incomplete references to unregulated derivatives. By the time banks voluntarily disclosed some additional information about their complex positions, it was too late. The dominos already had fallen.

Ironically, the banks that had prided themselves on ripping the faces off their clients ended up bearing the largest losses. Morgan Stanley was right there, announcing billions of dollars of write-offs. The subprime risks that originally had appeared to move away from the banks returned, like a financial boomerang. This time, the biggest victims were not the banks' clients. They were their own shareholders.

Ultimately, what lessons should anyone draw from my experience? I believe derivatives are the most recent example of a basic theme in the history of finance: Wall Street bilks Main Street. Since the introduction of money thousands of years ago, financial intermediaries with more information have been taking advantage of lenders and borrowers with less. Banking, and its various offshoots, has been a great business, in part because bankers have an uncanny knack for surviving century after century of scandal. In this way banking resembles politics. Just as political scandals will continue as long as we have politicians, I believe financial scandals will continue as long as we have bankers. And, despite several bank failures, massive pain, and much consolidation, there is no evidence of the banking profession disappearing anytime soon.

It might seem inconceivable, but in a few years the banks will recover and reemerge. Memories of the egregious excesses will fade, as they always do. Bankers will return to recapture their informational and regulatory advantages. The government's "Troubled Asset Repurchase Program" engineered by Bernanke and Paulson ensured that banks will survive to fight another day. And when they do, the cycle will repeat.

The main reason Wall Street will return is that we will want it to. Our financial culture is infused with a gambling mentality. Even in the midst of crisis, we don't seem to think we deserve a better chance. We continue to play the lottery in record numbers, despite the 50 percent cut. We flock to riverboat casinos, despite substantial odds against winning. Las Vegas remains the top tourist destination in the U.S., narrowly edging out Atlantic City. The financial markets are no different. Our culture has become so infused with the gambling instinct that we afford investors only that bill of rights given a slot machine player: the right to pull the handle, the right to pick a different machine, the right to leave the casino, but not the right to a fair game.

Gamblers are not steady hands. They either play too much, or not at all. When they lose faith in the markets, as they did in 2008, they will not lend or invest. Instead, they swear "never again," and sell at the bottom, when they should be buying. Investment choices oscillate between the financial equivalents of stuffing cash in a mattress and betting on the ponies. That is not an efficient way to allocate capital, but that cycle will continue. It always has. Cash can remain stashed away for only so long. Eventually, what economist John Maynard Keynes called the "animal spirits" will return, and the gambling will begin again.

Excerpted from F.I.A.S.C.O.: Blood in the Water on Wall Street by Frank Partnoy. Copyright © 2009, 1997 by Frank Partnoy.


Direct link to interview with NPR's Terry Gross on Fresh Air here. (MP3 Format)

No comments:

Post a Comment