Bernanke's Bet on Derivatives

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New data on
the size of the derivatives market have been released. There was
Reuters story last week that summarized this information
. The
story received no attention. It began with a paragraph almost guaranteed
to avoid attracting attention.

The global
derivatives market continued to grow in the second half of 2005,
though at a slower pace as the market matured, the Bank for International
Settlements said on Friday.

This did not
sound like anything important. Surely, it was not the stuff of front-page
and network news stories. But the second paragraph caught my attention.

amounts of all types of over-the-counter contracts excluding credit
derivatives stood at $285 trillion at the end of 2005, 5 percent
higher than six months previously. Gross market values, or the
cost of replacing all contracts, fell 12 percent to $9 trillion.

Let that number
sink in: $285 trillion. That is over a quarter of a quadrillion
dollars. Whenever the word "quadrillion" is applied to
dollars, I think the market in question is worth considering.

This figure
does not count credit derivatives. Also, because the derivatives
market is international, no agency supervises it. No agency mandates
that statistics of these contracts be reported under penalty of
law. The Bank for International Settlements (BIS) reports the statistics
it gathers, but it is not a government agency. It is the central
banks’ agreed-upon clearing house.

So, the derivatives
market is much larger than $285 trillion. We just don’t know how
much larger.

rate products saw 5 percent growth in the second half, slower
than in previous years and bringing the total outstanding to $215
trillion. Growth was faster in the over-the-counter market than
on exchanges, the BIS said.

The known market
is so huge that for all of the participants to close out their positions
and then rewrite them, the commissions would be $9 trillion.

That probably
doesn’t count lawyers’ fees.

How much is
$9 trillion? It is the entire product of the private sector of the
United States for a year: the estimated $12.9 trillion GDP, minus
the U.S. government’s $2.6 trillion, minus state and local spending/taxing.

Note: The
official overview of the Bush Administration’s spending
mentions the total spending figure. It offers only percentages.
It provides a chart of happy-face assumptions about the reduction
of the budget’s percentage of GDP that will take place between now
and 2009. It does provide specific figures for popular programs,
such as delightfully named "Health and Compassion."


Over the last
two decades, the derivatives market has come to overshadow all other
investment markets, yet few investors and few business owners use
them or even know what they are.

are a form of futures. People speculate on the move of interest
rates and the effects that these moves will have on specific prices.
To play in this market, you must have a lot of money to lose. Because
margins are low, meaning leverage is high, unexpected moves in a
specific market can produce huge profits for investors on one side
of the contract. These gains are matched by losses on the other

There can be
a domino effect, as losses spread for one derivative instrument
to another. These instruments are specifically designed to transfer
specified risks to parties that are willing to bear such risks in
search of a profit.

Yet these markets
allocate more than risk. They allocate uncertainty. Risk is what
insurance contracts deal with: calculated losses. The law of large
numbers applies to certain categories of events, such as life expectancy
and fires. Uncertainty applies to types of events for which no widely
known statistical formula applies.

An entrepreneur
may believe that he possesses such a formula, which converts uncertainty
to risk. He then enters the derivatives market and takes a position
in the belief that his formula can beat the market. This is what
bankrupted Long Term Capital Management in 1998. Their formula,
which had been developed by a pair of Nobel Prize-winning economists,
turned out to be the economic equivalent of a race track tout’s
easy money system. When that pony failed to win, place, or show,
large multinational banks had to pony up an additional $3 billion
in loans to keep the $4.6 billion company from defaulting, which
would have threatened the futures markets and the bank payments

On October
1, 1998, Alan Greenspan sat before the House Banking Committee and
defended the decision of the head of the New York Federal Reserve
Bank to call the bankers into an emergency meeting to suggest that
they cough up more loan money. In his speech, he rejected the word
"pressure." New York FED officials merely "facilitated

was in this speech that Greenspan
referred to the possibility
of a worldwide financial domino effect, which he called "cascading
cross defaults."

In that environment,
it was the FRBNY’s judgment that it was to the advantage of all
parties — including the creditors and other market participants
— to engender if at all possible an orderly resolution rather
than let the firm go into disorderly fire-sale liquidation following
a set of cascading cross defaults.

For some reason,
this speech, which I regard as the most important public speech
that Greenspan delivered in his 18 years as Chairman, has disappeared
from the
list of speeches by Board members on the FED’s site
. You cannot
find it, even if you know the year he gave it. The speeches are
listed chronologically by each FED Board member. There is no speech
listed for October 1, 1998. It used to be there, but no longer.

Google can
locate it if you search for "Alan Greenspan" and "Long
Term Capital Management."


The phrase
"moral hazard" refers to a condition of the not quite
free market that arises when investors believe that the government
or its licensed central bank will intervene in a specific market
to keep it from harming the interests of investors. The belief that
the government will intervene leads investors to ignore market risks.
They believe that the government will bear the worst of these risks.
This leads to a higher level of prices in this market, or a larger
number of participants who put more of their money at risk than
is warranted by the safety of the market.

Greenspan usually
was content to say that moral hazard is a bad thing. He did so in
his 1998 speech — briefly.

Of course,
any time that there is public involvement that softens the blow
of private-sector losses — even as obliquely as in this episode
— the issue of moral hazard arises. Any action by the government
that prevents some of the negative consequences to the private
sector of the mistakes it makes raises the threshold of risks
market participants will presumably subsequently choose to take.
Over time, economic efficiency will be impaired as some uneconomic
investments are undertaken under the implicit assumption that
possible losses may be borne by the government.

But then he
invoked moral hazard to justify the Federal Reserve System’s interference
in the LTCM crisis. This crisis was larger than LTCM. It called
into question the solvency of an entire market. Here, the price
system must not be allowed to operate.

But is much
moral hazard created by aborting fire sales? To be sure, investors
wiped out in a fire sale will clearly be less risk prone than
if their mistakes were unwound in a more orderly fashion. But
is the broader market well served if the resulting fear and other
irrational judgments govern the degree of risk participants are
subsequently willing to incur? Risk taking is a necessary condition
for wealth creation. The optimum degree of risk aversion should
be governed by rational judgments about the market place, not
the fear flowing from fire sales.

What is a "fire
sale"? He did not say. Apparently, it is any sale in which
losses will spread to a large segment of the capital markets. But
the question remains: Who
is competent to judge when a fire sale has begun? Greenspan elsewhere
insisted that no one knows when there is a bubble market. How can
central bank officials know when a sale is a fire sale?

In other words,
he was arguing that the free market is just not good enough. What
is needed is intervention by wise men who have access to fiat money.

He argued that
moral hazard does not apply when the goal of the intervening agency’s
officials is to keep fear from spreading inside a highly leveraged,
low-margin market, which the futures market surely is.

The Federal
Reserve provided its good offices to LTCM’s creditors, not to
protect LTCM’s investors, creditors, or managers from loss, but
to avoid the distortions to market processes caused by a fire-sale
liquidation and the consequent spreading of those distortions
through contagion. To be sure, this may well work to reduce the
ultimate losses to the original owners of LTCM, but that was a
byproduct, perhaps unfortunate, of the process.

Six months
later, Greenspan
told that same House committee
that bank account deposit insurance,
i.e., the FDIC, is an example of moral hazard at work. First, he
explained the nature of moral hazard.

The benefits
of deposit insurance, as significant as they are, have not come
without a cost. The very process that has ended deposit runs has
made insured depositors largely indifferent to the risks taken
by their depository institutions, just as it did with depositors
in the 1980s with regard to insolvent, risky thrift institutions.
The result has been a weakening of the market discipline that
insured depositors would otherwise have imposed on institutions.
Relieved of that discipline, depositories naturally feel less
cautious about taking on more risk than they would otherwise assume.
No other type of private financial institution is able to attract
funds from the public without regard to the risks it takes with
its creditors’ resources. This incentive to take excessive risks
at the expense of the insurer, and potentially the taxpayer, is
the so-called moral hazard problem of deposit insurance.

Second, he
raised the question of that most feared of all economic conditions,
systemic risk.

Thus, two
offsetting implications of deposit insurance must be kept in mind.
On the one hand, it is clear that deposit insurance has contributed
to the prevention of bank runs that could have destabilized the
financial structure in the short run. On the other, even the current
levels of deposit insurance may have already increased risk-taking
at insured depository institutions to such an extent that future
systemic risks have arguably risen.

Third, he justified
the need for government regulation of a government-protected market,
since the protection — or perception of protection — undermines
the free market’s phenomenon of self-policing.

Indeed, the
reduced market discipline and increased moral hazard at depositories
have intensified the need for government supervision to protect
the interests of taxpayers and, in essence, substitute for the
reduced market discipline. Deposit insurance and other components
of the safety net also enable banks and thrift institutions to
attract more resources, at lower costs, than would otherwise be
the case. In short, insured institutions receive a subsidy in
the form of a government guarantee that allows them both to attract
deposits at lower interest rates than would be necessary without
deposit insurance and to take more risk without the fear of losing
their deposit funding. Put another way, deposit insurance misallocates
resources by breaking the link between risks and rewards for a
select set of market competitors.

The problem
with this argument in the capital markets today is that there is
no government agency that regulates the derivative markets. If that
is what is needed to overcome moral hazard — I mean other than
removing the cause, government intervention in the first place —
then what protects the world from systemic risk of a bank payments


Modern capital
markets rest on the assumption that central bank’s monetary policies
should, can, and will protect investors from a systemic breakdown.

The modern
division of labor has come into existence because investors have
faith in two factors: (1) the free market’s ability to allocate
risk and uncertainty in an efficient manner; and (2) central banks’
ability to insure against the breakdown of the fractional reserve
banking system. In other words, investors believe that systemic
risk can be mitigated by central banks. Or, more to the point, investors
believe that the inherent risk of fractional reserve banking can
be overcome by the concerted intervention into the capital markets
by central banks.

Greenspan in
1998 warned Congress about cascading cross defaults. Cascading cross
defaults impose the threat of gridlock on the bank payments system
— the ultimate fire sale.

Investors today
believe that Milton Friedman was correct in his 1963 book, A
Monetary History of the United States
. They believe that
the Federal Reserve System could have intervened to save the American
banking system from a wave of bankruptcies in 1929—32.

It is not just
investors who believe this. Most economists also believe it. Most
important, Ben Bernanke believes it. He said so in his 2002 speech
congratulating Friedman on his 90th birthday. I have
never seen any more laudatory review of Friedman’s book. He wrote
that "the direct and indirect influences of the Monetary History
on contemporary monetary economics would be difficult to overstate."
He was quite correct in this assessment.

Today I’d
like to honor Milton Friedman by talking about one of his greatest
contributions to economics, made in close collaboration with his
distinguished coauthor, Anna J. Schwartz. This achievement is
nothing less than to provide what has become the leading and most
persuasive explanation of the worst economic disaster in American
history, the onset of the Great Depression — or, as Friedman
and Schwartz dubbed it, the Great Contraction of 1929—33.

Bernanke identified
the book’s major discovery: "the Great Depression can reasonably
be described as having been caused by monetary forces."

Rothbard made
the same argument in America’s
Great Depression
, also published in 1963. But his book was
ignored by the academic world for the opposite reason that Friedman’s
was accepted: He showed that the FED’s policies in the 1920s had
caused the boom, which produced the bust when the FED ceased inflating.
Friedman’s book was a call for further FED inflation. Rothbard’s
was a call for no more inflation. It
is available free of charge here

The cause of
the depression, as Bernanke described Friedman’s conclusion, was
the gold standard.

and Schwartz’s insight was that, if monetary contraction was in
fact the source of economic depression, then countries tightly
constrained by the gold standard to follow the United States into
deflation should have suffered relatively more severe economic
downturns. Although not conducting a formal statistical analysis,
Friedman and Schwartz gave a number of salient examples to show
that the more tightly constrained a country was by the gold standard
(and, by default, the more closely bound to follow U.S. monetary
policies), the more severe were both its monetary contraction
and its declines in prices and output. One can read their discussion
as dividing countries into four categories.

The tragedy,
according to Friedman, was that Benjamin Strong, the head of the
New York FED, died in 1928. Strong could have staved off the great
contraction. Bernanke believes this: "Friedman and Schwartz
argued in their book that if Strong had lived, many of the mistakes
of the Great Depression would have been avoided." Rothbard’s
book shows that it was Strong, in association with his close friend,
Montagu Norman, the head of the Bank of England, whose policies
created the boom.

Bernanke told us in 2002
what he and the world’s central bankers
have learned from Friedman.

For practical
central bankers, among which I now count myself, Friedman and
Schwartz’s analysis leaves many lessons. What I take from their
work is the idea that monetary forces, particularly if unleashed
in a destabilizing direction, can be extremely powerful. The best
thing that central bankers can do for the world is to avoid such
crises by providing the economy with, in Milton Friedman’s words,
a "stable monetary background" — for example as
reflected in low and stable inflation.

Let me end
my talk by abusing slightly my status as an official representative
of the Federal Reserve. I would like to say to Milton and Anna:

the Great Depression. You’re right, we did it. We’re very sorry.
But thanks to you, we won’t do it again.

The reigning
assumption in this speech is obvious:

Central banks
can offset systemic risks in a market, thereby transforming them
into nonsystemic risks. Money creation is the ultimate risk-reducing


the 2002 Annual Report of Berkshire Hathaway
, Warren Buffett’s
famous firm, he issued a warning on derivatives. He said they are
like hell: easy to get into, but difficult to get out. He warned
of systemic failure.

Before the
Fed was established, the failure of weak banks would sometimes
put sudden and unanticipated liquidity demands on previously strong
banks, causing them to fail in turn. The Fed now insulates the
strong from the troubles of the weak. But there is no central
bank assigned to the job of preventing the dominoes toppling in
insurance or derivatives. In these industries, firms that are
fundamentally solid can become troubled simply because of the
travails of other firms further down the chain.

Buffett might
ask today: "Given the size of the derivatives market —
over $285 trillion — what world central bank could deal with cascading
cross defaults?"

Many people
argue that derivatives reduce systemic problems, in that participants
who can’t bear certain risks are able to transfer them to stronger
hands. These people believe that derivatives act to stabilize
the economy, facilitate trade, and eliminate bumps for individual
participants. And, on a micro level, what they say is often true.
Indeed, at Berkshire, I sometimes engage in large-scale derivatives
transactions in order to facilitate certain investment strategies.

[Close associate]
Charlie [Munger] and I believe, however, that the macro picture
is dangerous and getting more so. Large amounts of risk, particularly
credit risk, have become concentrated in the hands of relatively
few derivatives dealers, who in addition trade extensively with
one other. The troubles of one could quickly infect the others.
On top of that, these dealers are owed huge amounts by non-dealer
counterparties. Some of these counterparties, as I’ve mentioned,
are linked in ways that could cause them to contemporaneously
run into a problem because of a single event (such as the implosion
of the telecom industry or the precipitous decline in the value
of merchant power projects). Linkage, when it suddenly surfaces,
can trigger serious systemic problems.

The derivatives
market is much larger today than it was in 2002.


The problem
today is simple to state but difficult to solve: The derivatives
market is huge. It is far beyond the ability of any or all central
banks to solve, once cascading cross defaults spread to the international
bank payment system. The modern division of labor, which keeps billions
of people alive, has a sword of Damocles above it: the threat of
fractional reserve banking’s gridlock in a wave of defaults. This
is the ultimate fire sale.

The combination
of moral hazard, fractional reserve banking, faith in central banking,
and speculators’ desire to make a bundle of money from highly leveraged
futures contracts has created a time bomb condition.

following Milton Friedman, thinks that a government-licensed monopoly,
the Federal Reserve System, can overcome cascading cross defaults.
He has bet your life on this.

I hope he wins
the bet. But I always keep assets on the other side of the table.

24, 2006

North [send him mail] is the
author of Mises
on Money
. Visit
He is also the author of a free 17-volume series, An
Economic Commentary on the Bible

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