Financial Markets Polluted with Risk
An Ounce of Prevention...

by Eric Janszen

April 5, 2006
Weekly Commentaries

3/2/06 - Prediction: Governor Mark Warner will win the 2008 U.S. Presidential Election

3/9/06 - Hedge Funds Still in the Dark

3/15/06 - iTulip.com II: The Sequel

3/22/06 - Frankenstein Economy

3/29/06 - Housing Bubble Correction Update


iTulip.com Ad Policy


For several decades, unregulated chemical companies polluted the ecosystem with toxic chemicals. One well-publicized ecological mishap was the Seveso dioxin disaster in Seveso, Italy in 1976 where 3,000 pets and farm animals died and 70,000 animals were slaughtered later to prevent dioxin from entering the food chain. When first confronted with the prospect of government regulation, the chemical industry took the position that the cost of environmental protection cannot be born by chemical companies without reducing the incentive to produce these beneficial products. There will be less investment in R&D, less innovation. Without a constant stream of new chemical products, society will suffer.

There is a seed of truth in any truly great lie. These toxic chemicals do help society. Thanks to DDT, for example, malaria was eradicating from Europe and North America in the 1950s. But that’s not why chemical companies produce these chemicals. They produce them to make money. Nothing wrong with that unless a meaningful portion of profitability depends on keeping the economic costs of environmental damage and cleanup off their balance sheets and on the backs of taxpayers.

First generation government pollution control policy in the U.S. was, no kidding, "The solution to pollution is dilution." Mix enough air and water with pollutants then toxicity is reduced enough to make them nontoxic. This policy did not take into account that many pollutants are extremely toxic and tend to concentrate in the food chain (e.g., dioxin), and as the economy and population grew, the sheer quantity of pollutants overwhelmed the environment; there is not enough air and water to dilute the volume of pollutants produced. Worse, allowing corporations to externalize the social costs of pollution made the business appear to be more profitable than it actually was when all the costs are taken into account, leading to, in effect, a tax-payer sponsored boom in the toxic chemicals business and a corresponding increase in pollution.

Hard to believe today that anyone ever seriously considered "the solution to pollution is dilution" as a practical approach by government regulators to protect the environment and the public from the chemical industry. But that’s the essence of the concept driving government regulation of many financial innovations today. As a result, various economic risk “toxins” pose the same threat to our financial system and economy as chemical toxins did to our environment forty years ago.

Before I go any further, let me say that this is not a rant about the general evils of derivatives. Derivatives are neither new nor especially dangerous. They are, generally, the opposite.

Commodities futures contracts are derivatives and have been traded over the Board of Trade of the City of Chicago starting in 1848. There are records of “forward” agreements related to the rice markets dating back to at least seventeenth century Japan. These derivatives smooth out price fluctuations created by unpredictable events, especially weather. Without them, farming would be so price inefficient that markets could not support much of it. We’d have neither the variety of foods nor the low costs we enjoy today. We’d be back to feast or famine. These derivatives put food on the table. Literally.



What I’m talking about here are the kind of credit related financial innovations that Fed Vice Chairman Roger W. Ferguson, Jr. alluded to in a recent speech at the Institute of International Finance in Zurich, Switzerland, March 31, 2006.

“When I talk about financial innovations, I have in mind several types of developments. A far-reaching set of innovations is the development and increasing popularity of products for the transfer of credit risk. Prominent among such innovations are credit derivatives, asset-backed securities, and secondary-market trading of syndicated loans. Another important development has been the rapid growth of the hedge fund industry and its expanded role in the financial system. On the retail side, we have seen a proliferation of new lending products in the United States, including home-equity lines of credit, interest-only and even negative-amortization mortgages, and sub-prime mortgages and consumer loans.”

Ferguson goes on to summarize the benefits and risks of credit related derivatives (my emphasis):

“Financial innovations hold the promise of improved efficiency and increased overall economic welfare… Risk-transfer mechanisms can not only better allocate risk but also reduce its concentration... .

“Although financial innovations have the capacity to improve economic welfare overall, it is natural for policymakers to worry that innovations may have unexpected and undesirable side effects and may even represent new sources of systemic risk.”

He goes on to say that no one really knows how these innovations will behave and interact with each other under real world conditions that do not conform to the theoretical models used to create them. He concludes:

“I would note that a significant number of substantial shocks to financial markets have occurred in recent years -- including, for example, the difficulties at Long-Term Capital Management and the unexpected and massive fraud at some high-profile companies -- and yet the broader effects on the real economy have ultimately been quite small. Our financial markets are flexible and resilient, and they can absorb shocks surprisingly well. As a result, most risks caused by new developments in financial markets should be manageable without heavy-handed regulation.”

This is equivalent to an EPA official stating in the 1960s, “PCBs hurt the environment but it didn’t collapse, and the benefits are compelling. So let’s wait and see what happens with these other products before jumping in too hastily with ‘heavy-handed regulation’ and potentially cutting off innovation in the chemical industry.”

The most toxic financial market innovations today that have polluted the financial system with risk, and helped keep the housing bubble alive, are:
- Credit derivatives
- Asset-backed securities
- Secondary-market syndicated loans
- Home-equity lines of credit
- Interest-only mortgages
- Negative-amortization mortgages
- Sub-prime mortgages and consumer loans

Warren Buffet weighed in with a less sanguine assessment of this class of derivatives in his annual letter to shareholders, March 2003. Note that Buffet gets right to the point. The purpose of these innovations is to make money for the people who sell them, not to help society:

“We view them as time bombs, both for the parties that deal in them and the economic system… Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values… Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses -- often huge in amount -- in their current earnings statements without so much as a penny changing hands.

“Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one's commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on "earnings" calculated by mark-to-market accounting. But often there is no real market… and "mark-to-model" is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions… two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth… Both internal and outside auditors review the numbers, but that's no easy job. For example, General Re Securities at year-end (after ten months of winding down its operation) had 14,384 contracts outstanding, involving 672 counterparties around the world. Each contract had a plus or minus value derived from one or more reference items, including some of mind-boggling complexity. Valuing a portfolio like that, expert auditors could easily and honestly have widely varying opinions.

“The valuation problem is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” -- until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be “mark-to-myth.”

Buffet goes on to point out who makes money selling these products.

“I can assure you marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive "earnings" (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.”

Buffet concludes: “The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.”

This brings us back to our environmental analogy. “Innovative” interest-only mortgages, negative-amortization mortgages and the like that are being sold to homeowners, clearly resulting in higher aggregate default risk.
The housing bubble has continued in line with the continuous creation of new credit-based financial innovations that allow households to leverage ever larger portions of a their income stream to purchase ever less affordable housing. We have a government policy in line with the academic theory behind the derivatives that underlie these products that “the solution to risk pollution is risk dilution.” The regulators and manufacturers of financial innovations both agree that if they are “over-regulated” that there may not be enough money to be made to make the business worthwhile. They’ll stop innovating and economy will suffer.

As we pointed out in last week’s piece Frankenstein Economy, with the advent of financial innovations we gained a highly flexible credit machine but have lost personal accountability for default risk. The risk of default on mortgages and consumer loans has been shifted from the bank making the loan to a credit market that relies on derivatives to spread the risk of thousands of defaults on bad loans among millions of shareholders. This has encouraged greater credit risk taking, the proliferation of credit risk polluters and an increase in the production of credit risk pollution.

This is not the first time such a credit expansion has resulted from the advent of new credit products. As Charles E. Persons stated in “Credit Expansion, 1920 to 1929, and its Lessons,” November 1930, The Quarterly Journal of Economics: "The check to expansion is sharp and is intensified by the excesses inevitably associated with periods of over-rapid expansion. Such a course of events is clearly proven by the evidence as to credit expansion in the period 1920 to 1929. The depression into which the nation fell in the latter year was undoubtedly due in part at least to these developments in our complicated economic structure. Manifestly these events are too recent and our records too incomplete to attempt to measure their relative importance as compared with other factors of great weight. But there can be no doubt that their influence was large."

We are experiencing a replay of an out-of-control credit expansion and a classic battle between the public good and corporate gain play out in the market for unregulated financial innovations. Hedge funds, banks, mortgage companies and other financial institutions are busy cranking out and selling new financial innovations faster than central banks and governments can control or monitor them. Many of these products help society, for example by giving households access to credit that did not have access before and deserved it. But let’s not lose sight of the reason financial institutions are creating and selling these products: not to help society, but to make money. Due to lack of regulation, much of the potential future costs of financial toxins to society have been externalized. They are making a lot of money and in the process polluting the financial system with risk.

In truth, no one knows who will be left holding the bag when defaults on loans made using these innovations occur. But we can be fairly certain it won’t be the institutions that made the money selling them. Most likely, it will be the same folks that paid for the Super Fund projects that cleaned up after the chemical industry -- you and I.

Our new Fed Chairman Ben Bernanke is turning the screws on the credit markets, in the process bringing this credit cycle to a close. We can expect to see a few financial market disasters sooner than later. No thousands of dead pets, but certainly thousands of insolvent households. After that, I predict the emergence of a kind of financial markets and economic ecology movement. The question is, what kind of movement? The last one of these occurred after an out-of-control credit system crashed and burned in the 1930s. The resulting financial markets and economic ecology movement was called Socialism, a 70 year long economic disaster in and of itselt, the effects of which are still being felt today.

I say, get going on regulation and control of this credit system and check the excesses now before it’s too late.

Join our FREE Email Mailing List

Copyright © iTulip, Inc. 1998 - 2006 All Rights Reserved

All information provided "as is" for informational purposes only, not intended for trading purposes or advice.
Nothing appearing on this website should be considered a recommendation to buy or to sell any security or related financial instrument. iTulip, Inc. is not liable for any informational errors, incompleteness, or delays, or for any actions taken in reliance on information contained herein. Full Disclaimer