Personal Thoughts on the Market

by Hugh

In 2000-2001, I worked in New York for an interdealer broker (a financial broker to banks and other big institutions) Prebon Yamane, now Tullett Prebon, setting up their Environmental Products division. I worked with a few former investment bankers, putting together structured financial instruments to help big energy companies hedge against the multi-million/billion dollar risk of Kyoto Protocol ratification. Kyoto ratification would mean that companies would be forced by their governments to reduce greenhouse gas emissions, to buy carbon credits, or do both. Our financial instruments were, more or less, derivatives: they were carbon credit futures contracts, packaged up as insurance. On one side we would have big energy companies paying insurance on the risk of Kyoto ratification; on the other side of the transaction, we would invest in large greenhouse gas reduction projects around the world that would create a pool of credits that we, along with our partners, a big investment bank and a big reinsurance company, would undertake to guarantee as “Kyoto Compliant.”

But as the Vice President of Sasol, the South African energy & chemical giant, told me when we met in Johannesburg in early 2001, “I spoke with Dick Cheney last week, and he told me the US will never sign on to the Kyoto Protocol.” He was right out of Lethal Weapon 2, and he was dead on. Despite campaigning on regulation of GHGs in 2000, Bush scuttled Kyoto. And that (along with September 11th) was the end of my involvement with Prebon and the world of fancy financial derivatives.

Prebon Yamane did lots of business with Enron. Tthey were hated by everyone, they were arrogant and abusive, which is par for the course in the financial business, but they were the worst. So I had a front row seat as Enron imploded that year, from more or less the same sickness that is now afflicting our global financial markets.

In short: complex financial derivatives had abstracted financial worth very far away from the underlying value of assets. This enabled magic “creation” of extraordinary wealth, built on manipulation and trading of the abstract derivatives, but not the asset itself. At it’s height, Enron generated $111 billion in revenues, with hardly any assets. Fortune magazine called them America’s Most Innovative Company six years running. In the case of Enron, there was a whole pile of fraud as well, as things started to unravel, but the *real* culprits were:

  • regulators, who closed their eyes because too much money was being made, and the “free market” was king
  • rating agencies, who gave positive ratings to institutions whose actual financial health was based on vapour
  • accountants/auditors, who stopped doing their job, which is to verify the financial soundness of the numbers provided by their clients.

And the problem was, and continued to be that so many people were making so much money, that no one wanted to upset the apple cart, even if there weren’t any apples in it to begin with. The system was “working,” meaning lots of people were getting rich, and you and I were living in prosperous times, relatively comfortable and happy. Who’s going to put a stop to that and still get elected next year? Well, it turns out: no one.

The same can be said today, and we’re going to face the consequence of a decade or two of fantasy.

Enron collapsed, and that should have been a warning that the modern financial markets were a disaster waiting to happen. Instead, interest rates were slashed through the late 90s and early 21st century, cheap credit flooded the market, and deregulation increased, rather than decreased.

One of Prebon’s most profitable businesses, even in 2001 was the credit default swap desk. Billions of dollars went through that desk.

Credit default swaps are insurance against someone defaulting on loans, bonds, or other financial obligations. Which makes sense. Except people started betting on likelihoods of defaults, buying default insurance on someone else’s assets. And then trading them on an open market, betting for or against defaults that had nothing whatever to do with them.

In 2007, there was something like $60 trillion (yes, trillion) worth of credit default swaps out there, based on an underlying asset value of about $5 trillion. The abstract “value” created by the magic of these derivatives is 12 times the value of the underlying assets … $60 trillion.

To put that in perspective, the world’s GDP in 2007 was $54 trillion. So outstanding credit default swaps are worth more than the entire world’s economic output. Make sense? Yeah. (Ps, sorry for the bold italics, but perhaps it’s justified here?)

This is, essentially, a colossal pyramid scheme, roughly the size of the entire wrold’s economy.

Credit default swaps have been completely unregulated, meaning no one in the financial business even knows who is exposed to what risk, because no one has to report their exposure anywhere.

For those counting, the $700 billion bailout is 1/85th of the exposure in the the credit default swap market, and who knows what other fancy financial eggheadery there might be out there.

Fasten your seatbelts.

[I highly recommend This American Life’s latest episode for a better explanation of what’s happening and why it matters].

[Inspired by a conversation with Ian Rae, and an email exchange with John Beckmann]