Subprime Crisis & Derivatives: Origins

by niccolo caldararo

The origins of the present subprime crisis can be found in the Nixon Administration when his appointment to the SEC, Mitchell, removed the prohibitions to trades in futures and similar "bets" that has made our markets so unstable.   A number of academics including Fisher Black, created a series of formulas by which traders could manipulate the markets and make huge profits. The result of this behavior would led to our crisis by creating the impression that risk could be eliminated.

Intro

The origins of the present subprime crisis can be found in the Nixon Administration when his appointment to the SEC, Mitchell, removed the prohibitions to trades in futures and similar "bets" that has made our markets so unstable.  A number of academics including Fisher Black, created a series of formulas by which traders could manipulate the markets and make huge profits. The result of this behavior would led to our crisis by creating the impression that risk could be eliminated.

The current crisis on trading floors of the major markets and the hedge fund offices and banks might lead one to think that no one has had any idea that such a crisis might unfold.   However, lessons from the Crash of 1907 and that of 1929 led to changes in the laws governing finance during the 1930s under FDR.

A number of articles have appeared recently in your paper attempting to describe the point of origin and the blame for the current liquidity crisis. Many feel, like that the government should step in and correct the problem by making the taxpayers pay for the imprudent acts of some, while noting that we have learned that financial institutions were too lenient with credit.  Others have traced the evolution of the crisis and shown that post-Depression (1929) laws regulating credit producing entities were removed in the last 30 years making way for the subprime collapse.  This is the correct lesson to learn.   As Donald MacKenzie and Yuval Millo have shown in their 2003 article, "Constructing a Market, Performing a Theory," J. of Sociology, v. 109, the legal barriers to the trading in derivatives were removed by political interference with the post-Depression experience with speculation. This grew out of the peculiar social environment of the Chicago markets in the 1960s and 70s and the way traders rediscovered option theory, taking advantage of volatility skew.

The Chicago Board of Trade hired former Presidential aide H.H. Wilson to become its president in 1967. Wilson hired Joseph W. Sullivan, a Wall Street Journal political correspondent as his assistant. Together they began to explore the feasibility of trading in futures on commodities of a variety of products with the involvement of a trader named Leo Melamed. This led to discussions to revive trade in financial futures that had fallen in disrepute during the first half of the 20th century.  

Gillian Tett, in an article in the Financial Times (8/27/07), noted that market collapses have been associated with innovations that seem to have changed the rules.  However, as in 1907 and 1929 our present dilemma is not due to a new innovation but one packaged as new.    Stock options and futures were, as MacKenzie and Millo note (from analysis by Max Weber in his time) "integral to 19th century exchanges."  The 1929 crash put such activities and speculation in derivative instruments under the category of wagers and gambling. They note that as late as the 1960s the SEC "remained deeply suspicious of derivatives....A futures contract was legal, the Supreme Court ruled in 1905, if it could be settled by physical delivery of a commodity such as grain. If it could be settled only in cash, it was an illegal wager."

Sullivan and his associates went to work on the political framework to undermine this institutional memory of disaster and the legal restrictions that reinforced it.   SEC Chair Manuel Cohen refused to listen comparing options to "marijuana and thalidomide."   But by using university economists like Burton Malkiel and Richard Quandt, Sullivan was able to create the argument that there was a mathematical and rational basis for options to make the market more efficient.   With help from William Baumol, Malkiel and Quandt, and with the resources of Robert R. Nathan Associates, they produced a campaign purporting to show that an options exchange was in the public interest.

In 1971 Richard Nixon appointed tax lawyer William Casey as chair to the SEC and the result was an end to the prohibition of a market in options and futures derivatives.  In the 1980s Fisher Black and Merton, two professors of economics, developed formulas to streamline this process in the modern context and a number of firms like J.P. Morgan invented financial devices in the 1990s to sell debt associated with securitized mortgages based on their ideas.

These began the current explosion in liquidity.  The devices were called derivatives and we know them from a number of letters, like LCDS (Loan credit default swaps), CDS of CDOs (credit default swaps of collateralized debt obligations), CFDs (contracts of difference) and basically they are means of placing bets on movements in the markets.  The way was open to the floodgates of speculation.

What we need is a longer institutional memory and to reinstitute the laws prohibiting speculation and to separate banking, insurance and brokerage functions as we learned was necessary after 1929.

It might also seem from a casual observer that money (Credit) from the central banks, and especially the American Federal Reserve, has no limit. It is almost like magic, like the "Primitive" Melanesian idea of Mana, a force that can be conjurer up by a magician.

If one refers to any current source on Nassin Nicholas Taleb's life since the publication of his book, The Black Swan, one is reminded of Gillian Tett's interview with Robert Merton (in the Financial Times, May 21st 2007).  Both articles produced some surprising comments.   Just as Taleb's performance as a hedge fund manager has been spotty at best, Prof Merton made the claim, following the LTCM collapse, that derivatives protect us from crashes and seems remarkable.

In both cases it would be like Lord Treasurer Robert Hartley, the inventor of the South Seas Bubble in 1711, asserting that his scheme had protected England from economic panics in 1720.  While Taleb is not an innovator of specific models underlying these devices as Merton is he has undertaken a similar role. Prof. Merton's view of a world of controllable risk by mathematics in the face of his admission that in the case of LTCM people did not behave in ways predicted by his model, based on his model's assumptions, that is, that people act rationally, is unconvincing.

Instead of acting as the model predicted, people behaved as a herd in panic.  Canetti described such patterns in 1962 and a number of scholars from Krondratieff and Schumpeter to Stornette have attempted to develop an understanding of such panics and their role in economics (see my book, Sustainability published in 2004 or you can download for free an article I wrote that provides more detail and background to this discussion from the Social Science Research Network.

I think Mary Douglas, in her work on risk in various cultures, has shown that how risk functions varies in different cultures at different times.   For Prof. Merton to say derivatives are like anti-lock brakes and if people drive faster because they have them we should do not blame the brakes, is preposterous, because is that not the problem?

If you reduce the probability of adverse events in people's minds, will they not engage in more risky behavior?   Many products exist which allow people to feel better and ignore the consequences of their behavior temporarily, like heroin, but we do realize that eventually reality does intercede.    It is an apt choice of words to refer to Prof. Merton's enthusiasm for his idea as "evangelical zeal," since we should recall John Maynard Keynes' caution that we should not mistake what is probable for either knowledge or reality.

We presently live in a globalized financial economy where if there are problems they affect everyone. A lack of diversity in any system makes it susceptible to any stress throughout the entire system. There is little resilience in a "flat world."   The Chinese and the Japanese are constantly under pressure to become more enveloped in this system.   At present the Japanese are less affected that other economies, but the Anglo-Americans the most. The idea of such an economic unity has been favored by a number of economic theories, but in historical comparison it looks little different from the binding of ones subjects by kings or as happened in the late Roman Republic.  It takes on the character of tribute to a hegemonic center, like Italy after the Civil Wars where little was produced and its people had to be increasingly supported by imports.  In like fashion, Americans have been on a spending spree for nearly 20 years with little or no saving.   We live on credit.  Some have come to regard American debt as money in a most strange view of value.

The Bush Administration, while criticizing any bailout of the banking industry has been doing just that.   The amount of this "bailout" is frightening today, but minor in effect in the financial markets, as described in Krishna Guha's article in the Financial Times (12/18/07). What is disturbing is the transfer of the risk created in the past 5 years via SIVs, derivatives, etc. from private financial institutions to the Federal Home Loan Bank system. Guha reports that roughly three-quarters of a trillion dollars a year has been assumed.

Essentially while we were all watching the Fed lower interest rates and create cooperative agreements to shore up the financial system, the "shadow banking system" that created the current subprime balloon and the derivative industry has been shunting off the risk to the public purse.

This reminds me of the old Welsh Sinne-eaters described by James Frazer, who were called upon to transfer evil from one person to another.   In our present case, the FHLB may eat all the sins of the banking industry but we cannot expect the process to take place without catastrophic effects on the dollar.

The only winners will be the financial wizards who have had sufficient connections to be able to regurgitate their risk on the taxpayer. It is also interesting that Japanese companies, like Nomura's recent interest in Collins Stewart, the British investment bank, are making purchases abroad.   We may be seeing Japan coming out of the collapse of credit and a property bubble, while we are heading into one.   This is like Einstein's dilemma of looking so far ahead in a circular galaxy that we then see the back of our heads.

While we have been fixed on the spread of the collapse of liquidity and credit, the answers to fix the problem have been "old tech" those based in past theories of governmental intervention when markets fail.    As Schumpeter argues in his analysis of Business Cycles (1939), these he noted are related to changing tempo in investments needed for the periodic renewal of productive forces.    However, he also saw that discovery of new resources or invention and innovations could affect this tempo.

Financial devices of the past 2 decades have been theorized to have been productive innovations.  This is debatable. Instead of productive innovations they seem to be in the class of wealth transfer devices, entertainment and gambling inventions (games, slot machines, etc.) and prestige display (like the destruction of wealth in a Northwest Coast Native American potlatch).  

When looked at in this light, it appears as if there has been little productive innovation since the advances of biotechnology and internet expansion in the 1990s. There have been none in energy, certainly biofuels and ethanol have been shown to be poor changes in existing technology and not very productive and raise the cost of food. The main overall change in technology investment in the past 8 years has been in security and military spending and this has produced little in new technology and general applications.

If there is a recession it is due to low real investment in the developed countries and low saving and too much spending on luxury and prestige goods in the Anglo-American sector and this includes a large segment of spending in the housing area on renovations and overbuilding of large energy dependent housing units.

Niccolo Caldararo, Ph.D. Dept. of Anthropology San Francisco State University

Body

The current crisis on trading floors of the major markets and the hedge fund offices and banks might lead one to think that no one has had any idea that such a crisis might unfold. However, lessons from the Crash of 1907 and that of 1929 led to changes in the laws governing finance during the 1930s under FDR. A number of articles have appeared recently in your paper attempting to describe the point of origin and the blame for the current liquidity crisis. Many feel, like that the government should step in and correct the problem by making the taxpayers pay for the imprudent acts of some, while noting that we have learned that financial institutions were too lenient with credit. Others have traced the evolution of the crisis and shown that post-Depression (1929) laws regulating credit producing entities were removed in the last 30 years making way for the subprime collapse.

This is the correct lesson to learn. As Donald MacKenzie and Yuval Millo have shown in their 2003 article, "Constructing a Market, Performing a Theory," J. of Sociology, v. 109, the legal barriers to the trading in derivatives were removed by political interference with the post-Depression experience with speculation. This grew out of the peculiar social environment of the Chicago markets in the 1960s and 70s and the way traders rediscovered option theory, taking advantage of volatility skew. The Chicago Board of Trade hired former Presidential aide H.H. Wilson to become its president in 1967. Wilson hired Joseph W. Sullivan, a Wall Street Journal political correspondent as his assistant. Together they began to explore the feasibility of trading in futures on commodities of a variety of products with the involvement of a trader named Leo Melamed. This led to discussions to revive trade in financial futures that had fallen in disrepute during the first half of the 20th century. I Here Tett, in an article in the Financial Times (8/27/07) noted that market collapses have been associated with innovations that seem to have changed the rules. However, as in 1907 and 1929 our present dilemma is not due to a new innovation but one packaged as new. Stock options and futures were, as MacKenzie and Millo note (from analysis by Max Weber in his time) "integral to 19th century exchanges."

The 1929 crash put such activities and speculation in derivative instruments under the category of wagers and gambling. They note that as late as the 1960s the SEC "remained deeply suspicious of derivatives....A futures contract was legal, the Supreme Court ruled in 1905, if it could be settled by physical delivery of a commodity such as grain. If it could be settled only in cash, it was an illegal wager." Sullivan and his associates went to work on the political framework to undermine this institutional memory of disaster and the legal restrictions that reinforced it.

SEC Chair Manuel Cohen refused to listen comparing options to "marijuana and thalidomide." But by using university economists like Burton Malkiel and Richard Quandt, Sullivan was able to create the argument that there was a mathematical and rational basis for options to make the market more efficient. With help from William Baumol, Malkiel and Quandt, and with the resources of Robert R. Nathan Associates, they produced a campaign purporting to show that an options exchange was in the public interest. In 1971 Richard Nixon appointed tax lawyer William Casey as chair to the SEC and the result was an end to the prohibition of a market in options and futures derivatives. n the 1980s Fisher Black and Merton, two professors of economics, developed formulas to streamline this process in the modern context and a number of firms like J.P. Morgan invented financial devices in the 1990s to sell debt associated with securitized mortgages based on their ideas. These began the current explosion in liquidity, the devices were called derivatives and we know them from a number of letters, like LCDS (Loan credit default swaps), CDS of CDOs (credit default swaps of collateralized debt obligations), CFDs (contracts of difference) and basically they are means of placing bets on movements in the markets. The way was open to the floodgates of speculation. What we need is a longer institutional memory and to reinstitute the laws prohibiting speculation and to separate banking, insurance and brokerage functions as we learned was necessary after 1929.

It might also seem from a casual observer that money (Credit) from the central banks, and especially the American Federal Reserve, has no limit. It is almost like magic, like the "Primitive" Melanesian idea of Mana, a force that can be conjurer up by a magician.

If one refers to any current source on Nassin Nicholas Taleb's life since the publication of his book, The Black Swan, one is reminded of Gillian Tett's interview with Robert Merton (in the Financial Times, May 21st 2007). Both articles produced some surprising comments. Just as Taleb's performance as a hedge fund manager has been spotty at best, Prof Merton made the claim, following the LTCM collapse, that derivatives protect us from crashes and seems remarkable. In both cases it would be like Lord Treasurer Robert Hartley, the inventor of the South Seas Bubble in 1711, asserting that his scheme had protected England from economic panics in 1720.

While Taleb is not an innovator of specific models underlying these devices as Merton is he has undertaken a similar role. Prof. Merton's view of a world of controllable risk by mathematics in the face of his admission that in the case of LTCM people did not behave in ways predicted by his model, based on his model's assumptions, that is, that people act rationally, is unconvincing. Instead of acting as the model predicted, people behaved as a herd in panic. Canetti described such patterns in 1962 and a number of scholars from Krondratieff and Schumpeter to Stornette have attempted to develop an understanding of such panics and their role in economics (see my book, Sustainability published in 2004 or you can download for free an article I wrote that provides more detail and background to this discussion from the Social Science Research Network at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1007819). I think Mary Douglas, in her work on risk in various cultures, has shown that how risk functions varies in different cultures at different times. For Prof. Merton to say derivatives are like anti-lock brakes and if people drive faster because they have them we should do not blame the brakes, is preposterous, because is that not the problem? If you reduce the probability of adverse events in people's minds, will they not engage in more risky behavior?

Many products exist which allow people to feel better and ignore the consequences of their behavior temporarily, like heroin, but we do realize that eventually reality does intercede. It is an apt choice of words to refer to Prof. Merton's enthusiasm for his idea as "evangelical zeal," since we should recall John Maynard Keynes' caution that we should not mistake what is probable for either knowledge or reality. We presently live in a globalized financial economy where if there are problems they affect everyone. A lack of diversity in any system makes it susceptible to any stress throughout the entire system.

There is little resilience in a "flat world." The Chinese and the Japanese are constantly under pressure to become more enveloped in this system. At present the Japanese are less affected that other economies, but the Anglo-Americans the most. The idea of such an economic unity has been favored by a number of economic theories, but in historical comparison it looks little different from the binding of ones subjects by kings or as happened in the late Roman Republic it takes on the character of tribute to a hegemonic center, like Italy after the Civil Wars where little was produced and its people had to be increasingly supported by imports. In like fashion Americans have been on a spending spree for nearly 20 years with little or no saving. We live on credit. Some have come to regard American debt as money in a most strange view of value. The Bush Administration, while criticizing any bailout of the banking industry has been doing just that. The amount of this "bailout" is frightening today, but minor in effect in the financial markets, as described in Krishna Guha's article in the Financial Times (12/18/07).

What is disturbing is the transfer of the risk created in the past 5 years via SIVs, derivatives, etc. from private financial institutions to the Federal Home Loan Bank system. Guha reports that "roughly three-quarters of a trillion dollars a year" has been assumed. Essentially while we were all watching the Fed lower interest rates and create cooperative agreements to shore up the financial system, the "shadow banking system" that created the current subprime balloon and the derivative industry has been shunting off the risk to the public purse.

This reminds me of the old Welsh Sinne-eaters described by James Frazer, who were called upon to transfer evil from one person to another. In our present case, the FHLB may eat all the sins of the banking industry but we cannot expect the process to take place without catastrophic effects on the dollar. The only winners will be the financial wizards who have had sufficient connections to be able to regurgitate their risk on the taxpayer.

It is also interesting that Japanese companies, like Nomura's recent interest in Collins Stewart, the British investment bank, are making purchases abroad. We may be seeing Japan coming out of the collapse of credit and a property bubble, while we are heading into one.

This is like Einstein's dilemma of looking so far ahead in a circular galaxy that we then see the back of our heads. While we have been fixed on the spread of the collapse of liquidity and credit, the answers to fix the problem have been "old tech" those based in past theories of governmental intervention when markets fail. As Schumpeter argues in his analysis of Business Cycles (1939), these he noted are related to changing tempo in investments needed for the periodic renewal of productive forces. However, he also saw that discovery of new resources or invention and innovations could affect this tempo.

Financial devices of the past 2 decades have been theorized to have been productive innovations , but this is debatable, instead of productive innovations they seem to be in the class of wealth transfer devices, entertainment and gambling inventions (games, slot machines, etc.) and prestige display (like the destruction of wealth in a Northwest Coast Native American potlatch). When looked at in this light, it appears as if there has been little productive innovation since the advances of biotechnology and internet expansion in the 1990s. There have been none in energy, certainly biofuels and ethanol have been shown to be poor changes in existing technology and not very productive and raise the cost of food.

The main overall change in technology investment in the past 8 years has been in security and military spending and this has produced little in new technology and general applications. If there is a recession it is due to low real investment in the developed countries and low saving and too much spending on luxury and prestige goods in the Anglo-American sector and this includes a large segment of spending in the housing area on renovations and overbuilding of large energy dependent housing units.

Niccolo Caldararo, Ph.D. Dept. of Anthropology San Francisco State University

,