This is the Wizards of Money, your money and financial management series, but with a twist. My name is Smithy and I’m a Wizard Watcher in the Land of Oz. This is Part 11 of the Wizards of Money series and it is entitled “House Lever-Edge at the Derivatives Casino”.
In this, the 11th edition of Wizards, we are going to take a look at the wild and crazy world of financial derivatives through examining the role and dangers of leverage in our modern society. Our adventure will end with a story called “Because a little Bug with the Asian Flu went Ka-CHOO”. You might have heard a similar story when you were a child, but in this case the star of our story is the Long Term Capital Management Fund or LTCM. LTCM was an unregulated hedge fund, addicted to risk and high on derivatives, that could have easily sent us crashing into the next Great Depression in 1998, but for the intervention of the Federal Reserve.
The quiet rescue of LTCM by our federally insured banks, combined with the fact that LTCM was a private equity fund and hence shielded from public scrutiny, aided in this potential catastrophe being confined to discussion among the financial elite. That we came very close to a global financial collapse went almost unnoticed by the general public. The ability to sweep this embarrassing incident, revealing the true nature of risks emanating from the derivatives casino, under the rug thus prevented the regulatory spotlight from being shone on either the casino or its most secretive dealers – the private, unregulated hedge funds.
The keeping of the derivatives wizards behind the curtain has enabled them to come up with newer, and potentially deadlier, games. The newest game on the block is called the Credit Default Swap. Even the International Monetary Fund (IMF) is getting a bit worried about this one!
But before we step in to discussion of derivatives and leverage, lets discuss the “House Edge”.
Imagine you are stepping into a Casino in Vegas and imagine what you will see. In one section you will walk past the slot machines and nearby will likely be the Keno Room with the comfy chairs and table for all your free drinks. In a separate section there will be the games that are more complex and harder to play such as BlackJack, Craps and the like. Secured away upstairs or in some guarded area are the rooms for the high rollers. Think of the socio-economic classes you are likely to find in each area – in general, lower income people will be at the slot machines and in the Keno room and the highest income people will be in the High Rollers Room. In the middle are those at the regular Black-Jack and Craps tables.
Now ask yourself, given this distribution of class by game, which group has the worst odds? Which group is likely to lose the most of what they wager? The Answer: The Keno Players and Slot Machine Players. And not just by a small amount, by a very large amount as evidenced by statistics reflected in what is known as the House Edge. I am sure you might be surprised by the differentials if you haven’t seen them before.
The House Edge is defined as the average amount that a player will lose as a percentage of their initial bet in any game. This average is always positive by necessity, so that the House can a make a profit and thereby stay in business, or, in other words, avoid collapsing. The House Edge or Margin on an average bet is positive, and the rest of the money wagered is simply redistributed amongst the casino players and that is what gambling is all about. Those players that lose are simply passing on their funds to those that win. That the House Edge is positive simply means that, on the whole, the losers lose more than the winners win, and the House takes the difference for its efforts in arranging the distribution of wagers. Without the House to provide this function there would be no such gambling on such a large scale.
I got some data on House Edges from the web site of a professional gaming analyst. The web site is called www.thewizardofodds.com (which is no relation to the Wizards of Money) and I recommend you look at it if you are interested in the most probable amount of money you will lose if you hang out at the casino too long. Here’s the house edge data:
Keno has the worst odds with a House Edge of a whopping 25%-30%! This means the following – Let’s suppose you go to the Casino one night with a 1,000 of your closest friends (for statistical significance), and you all play Keno all night at a place where the House Edge is 25%. As a group you will walk out of the Casino with 25% less than what you came in with. Some of your friends will lose everything, while others may double or triple their money, but on the whole the group has lost a quarter of what it started with. You and your 1,000 friends have simply redistributed money between yourselves and paid the house a whopping premium for the privilege of doing it on their premises with all the wizardry that masks what is really going on.
Slot machines are next. You will lose, on average, between 5% and 15% of what you put into a slot machine, depending on the Casino and the type of machine.
Craps is next, where you will lose, on average, between 1% and 15% depending on how you play the game.
Your best bet is Black-Jack, as long as you know how to play, with a House Edge of less than 0.5%, i.e. One half of one percent.
The very best bets, or best odds, will often be found in the High-Rollers room where the House knows it has a smaller edge on a much larger base.
In a spooky kind of way, the social and economic relations of the seedy casino world mimic the relations between humans and the financial markets in the broader world.
Consider the House in the broader world to be the financial markets themselves, backed up by the banks and central banks who create the most basic forms of money. Consider that for any attempt to generate returns a piece of your effort is going off to the financial markets, or the House, in order to keep it going. Consider that the wealthier you are to begin with, the higher are your chances of winning more money, and that the more money you have the better the House treats you and the better the terms of credit, should you wish to borrow from the House. Consider that the poorer you are the more expensive it is to play, and the chances of positive returns are much lower.
But the real world situation gets worse. Now consider that the dealers are incented to win for the House by participating in the gambles themselves. If the dealers want to borrow from the House to play, that’s OK. They will get good terms of credit. If they lose too much they get fired and you only keep the dealers that keep winning. To attract the very best dealers you decide not to regulate them and so you don’t keep track of what their betting positions are, or even how much they borrowed from the House. Why they are smart people – the best – some of them even came up with computer programs to predict the unpredictable…How pure chance gambles will come out!
But then one day the smartest, most winningest dealer of all, a private equity fund, loses a huge gamble, most of the wager having been borrowed from the House. There’s no way he can repay this loan to the House and the House looks like it could go bankrupt. But the House can’t fail! In order to avoid the Casino collapsing the Law of the Land says that all casino players PLUS all those that have never been to the Casino in their lives must be charged a certain amount to avoid the collapse of the casino. Now that’s what I call a House Edge!
We all have a basic idea of what a lever is and what leverage is in the physical world. Generally people will conjure up an image of leverage as being the ability to input a small amount of force or energy, and get a much larger result at the other end. The amplification of a small amount of input into a much larger output is facilitated by a lever. One of the first levers we come across as a child is the seesaw, where you are able to lift a person three feet off the ground – a feat you’d never achieve if you tried to lift them with your own arms. The seesaw can bring with it great fun and a great return on your investment in a visit to the park. But if it broke while you were playing on it, both you and your seesaw partner would be in a much worse position than if you had simply dropped the other person while trying to lift them directly, without leverage.
So too with any kind of leverage. Leverage can bring great benefits and higher expected returns on any effort, but like anything that can increase your returns, it also increases your risk. A sudden switch in the wrong direction of a highly leveraged system, by virtue of the fact that leverage multiplies the force of any input, can bring disastrous consequences, way beyond those possible in a less leveraged system.
The modern financial system is built entirely on leverage. The financial equivalent of physical leverage is the use of debt to enhance returns. The whole monetary system has been built on leverage ever since the invention of fractional reserve banking in the 1700s, whereby banks expanded the money supply by continuously lending out deposits backed by a much smaller reserve of real physical assets such as gold. But if there was ever a loss of confidence in the banks, a run on banks would collapse the whole banking system, thereby rendering money worthless. The collapse of the medium of exchange would then grind all trade to a halt, plunging people into immediate poverty and massively increasing all social tensions. Such a dramatic collapse of trade caused by monetary collapse would not be possible without the leverage.
Today banking works a bit differently, whereby the amount of leverage in the banking system is basically driven by capital requirements as we spoke about in Wizards Part 2 in discussing the new Basel Capital Accords. Let us suppose you have a $100 to invest by either depositing your money in a bank or becoming a shareholder of a bank. If you just become a bank depositor you can earn 5% a year on your $100. But if you are a bank shareholder, you get to borrow additional money from the depositors and lend this money out at a higher rate, keeping the difference in interest rates for your own profit. Let’s suppose that for every $100 of shareholder or equity capital a bank has, it can borrow $900 from its depositors and loan out the total $1,000 at a 7% interest rate. Then your profit as a shareholder is calculated as follows:
INCOME: 1000 * 7% = $70 from people that borrow from the bank
less OUTGO: 5% * 900 = $45 to go back to depositors, whose money you just borrowed, as interest on their deposits.
That leaves you with a clear $25 of profit on your $100 investment which is a 25% return on investment. That’s much better than the $5 or 5% you would get as a depositor and the reason is quite simply, leverage. You could borrow 9 times your own capital investment to make a much larger return than you could have done with just your own money. We say that your leverage was 9, which is the ratio of debt to equity in your total investment.
But such leverage comes with many more risks than if you just invested your own $100. One obvious risk is that some of the $1,000 borrowed from the bank will not be paid back. If this amount is less than $100 plus any interest profits you make, then the loss simply hits your investment, but the bank still has enough money to pay back the depositors. But what happens if $100 or more, of the $1000 of bank loans don’t get paid back. Then the bank will be insolvent or bankrupt and some of the bank depositors will have lost their money. Well, unless there is a government bailout, that is. This is just the type of loss that can trigger a further series of loan defaults and thereby start a chain reaction of defaults, asset sales, lost confidence and mad panic, that can lead to financial collapse.
It is clear that the higher the leverage, or multiple of your own investment, you can borrow from depositors to lend out then the higher your potential returns, but also the higher the risk of potential catastrophe. For example if the bank’s leverage was now 19 instead of 9, they could borrow $1,900 from depositors added to your $100 investment. This huge leverage could bring a 45% return if nobody defaults on their bank loans and interest rates stay the same. But the risk of losing $100 in the larger pool of bank loans is now much greater and it’s this loss that can cause bank collapse.
Financial leverage lies at the heart of the development of modern societies. It is the great facilitator of our massive production and distribution of energy and goods, and our rapid technological advancement. Without such leverage there would not have been enough money to fuel the industrial revolution or the technological revolution as they happened. Without the confidence in this highly levered system you would not have the cooperation between people to get such big projects completed. Many people in the developed world would not want to give up their modern luxuries nor, in fact, could many even survive now without them. But this exposes another danger of financial leverage – that it has lead the developed world into complete dependence on physical leverage created through financial leverage. In our high-tech world we are used to easy access to massive physical energies – food, electricity, transportation and so forth – for very little effort of our own. Not only does the increased financial leverage increase the risk of a breakdown in the system of trade, but a history of dependence on the physical leverage brought by financial leverage could multiply the physical consequences of a financial collapse many times over.
One feature of today’s financial markets, now that we are more than a generation away from the Great Depression of the 1930s, is that the thrill of returns from leverage and the excitement of greater technological advancement mask the reality of the risks imposed by leverage. We have gone so long without a collapse, indeed partly due to various innovations that have helped to put out fires that could have caused collapse, that potential and systemic risks do not get the attention they deserve.
Hedge Funds, Derivatives and Credit Default Swaps
We know the banks are pretty highly leveraged and that these risks of leverage must be controlled since the banks lie at the heart of the financial system. The way this leverage is controlled so that risk of collapse is not too high, is to set limits on leverage commensurate with the risks of the loans or investments any bank is making. This is what the new Basel Capital Accord being discussed now at the Bank for International Settlements (the central bank of central bankers) in Basel, Switzerland is all about. These accords specify a certain amount of shareholder or equity capital or “safety net” (from a depositors perspective) that banks hold as a function of the riskiness of their loans or investments. Such a safety net sets a bound on leverage and provides protection for depositors and taxpayers who are ultimately on the hook for massive bank failure.
But under the current adrenaline-fed mindset of the capital markets, even these controls are continuously circumvented. Like I said earlier, one of the newest kids on the block, is the Credit Default Swap or Credit Derivatives and they are being used to get around these safety nets or caps on leverage.
A derivative on an underlying asset basically allows you to make a bet on the future price of that underlying asset by betting just a fraction of the cost of that asset. The leverage comes about because the instrument basically replicates borrowing or lending of the underlying asset, without you ever having to physically own it.
Derivatives can help you manage risk if you already trade in the underlying asset. Let’s say you are wheat farmer worried about wheat prices. Then derivatives can be used to buy insurance on wheat prices. Say if wheat prices go down, you can get compensated for your loss by buying insurance in the form of something called a futures contract or even a a “put option” on wheat. Your outlay for this protection is fixed – the cost of the insurance premium – but it has removed the potentially larger loss of plummeting prices.
However, like all such things with a good use, there is a large downside. That is that the leverage and potential returns available on derivatives attract speculators from all over the globe to play and to become major dealers at the Derivatives Casino. This includes what is known as the Private Equity Hedge Fund, capitalized by wealthy investors and then often also borrowing many multiples of this capital from federally insured banks. With this highly leveraged capital base they then enter into the highly leveraged and potentially lucrative world of derivatives gambling. Private hedge funds are not regulated on the grounds that their investors are sophisticated, and that regulators don’t seem to understand or be worried about the risks that depositors and taxpayers are exposed to by the largest and most highly leveraged of these bodies. In addition the huge hundreds-of-trillions-sized market known as the Over-The-Counter (or OTC) derivatives market is not regulated. Of course, our banks themselves are among the major players and dealers at this Casino.
Consider the young, unregulated credit default swap market, the newest, hottest game on the block. This enables institutions that lend money to high credit risks to buy insurance on those risks. For example, a bank with high loan exposures to certain lenders can pay a premium to a third party for a credit default swap, a form of credit insurance, whereby the bank would get reimbursed by the credit swap seller if the borrower defaulted. The bank is thus able to take this credit risk OFF its balance sheet and thereby is no longer required to hold the regulated amount of equity capital, or “safety net”, against the risky credit risk. This means that the bank can further increase its leverage. If the seller of the credit default swap is not a bank, and especially if it is one of the unregulated hedge funds, then there may be no capital requirements (safety nets, or leverage limits) on such credit exposures. Therefore through the use of credit default swaps the overall financial system safety net shrinks and leverage and associated risks of collapse are increased, as always to be borne by depositors and taxpayers if things get too out of hand.
Add to this the fact that banks and others in need of credit protection are entering into these swaps through the now famous off-balance sheet Special Purpose Vehicles to remove the underlying transaction from public and regulator scrutiny. So it’s very difficult to tell what’s going on, and where and what the real risks are.
On the issue of the private hedge funds, some important regulators would argue that hedge fund operators perform an important function by helping build the base of counter-parties for valid risk hedges at the other end, and by ironing out pricing anomalies. They argue hedge funds should not be regulated for fear that this will add friction to these functions and/or send them offshore. The same people often argue that OTC derivatives also should not be regulated as they help ensure capital and risk get allocated efficiently around the markets, which facilitates our economic prosperity. But these arguments always ignore the larger risks being added to the system
as a whole and the unfortunate reality that the higher you climb up the ladder of leverage, the further you will eventually fall.
Now lets hear from the Great Wizard Greenspan of the US Federal Reserve on these issues from a March 7, 2002 report to the Senate Banking Committee. He talks first about the risks of the US economy becoming increasingly dependent on abstract concepts rather than on the production of real goods, and then about the risk/return trade-off of derivatives and leverage.
Excerpt: Greenspan Testimony on Concepts, Derivatives and Leverage. March 7, 2002
While Wizard Greenspan gives a good picture of the uncertainty of the risks of massive leverage he is also, on balance, in favor of it and the continued lax regulation of both hedge funds and OTC derivatives markets. He argues that derivatives play an important role of distributing risk efficiently and this helps build resilience into the markets against shocks.
That’s true but he forgets that some shocks just can’t be swallowed by the market and the implications for the market are catastrophic due to the size of the underlying leverage involved. How he could forget this I just don’t know, for one such incident took place just 4 years earlier with the near collapse of the huge private, unregulated, hedge fund known as Long Term Capital Management or LTCM.
That people do not understand the risks exposed by the LTCM saga is evidenced by the much greater attention given to a recently collapsed derivatives player who did not pose even a sliver of the threat to the financial system that LTCM did – that recently collapsed player being Enron. LTCM was not allowed to collapse because this could have triggered a major global financial collapse. The reason Enron was allowed to collapse was because their collapse posed no such threat. Since LTCM didn’t collapse, because it wasn’t allowed to, the lack of awareness of the risks exposed by it resulted in their being nothing done to prevent another LTCM type calamity.
LTCM was started by 4 smarty-pants wizards with an amazing betting program that did the impossible – it predicted the outcome of derivatives gambles. Two of the wizards had even won a Nobel prize for their derivatives pricing theories that were widely used to price transactions. Needless to say The Street thought they were geniuses and this gave their hedge fund easy access to credit and the ability to borrow at rates of a much less risky operation. Respectable banks and investors across the country wanted in on this action that had returned stellar amounts in its first few years of operation. To this day, the fancy bank capital requirements coming out of the Bank for International Settlements in Switzerland still do not address the risks of lending to these unregulated hedge funds so the banks were, and still are, feeding at the trough of all this gambling madness.
By mid 1998 LTCM had about $4 billion in equity capital and borrowed funds of about $120 billion, a hefty leverage of about 30 times. But, amazingly, that leverage was compounded further by another TENFOLD, by LTCM’s off-balance sheet derivatives exposures whose notional principle amounted to more than another $ 1Trillion! To be clear, this notional principle does not represent the full amount owed to anyone but rather the full value of assets underlying various derivatives transactions. The biggest bet that LTCM had on its books in the summer of 1998 was to do with interest rates on underlying bonds. The biggest bet that LTCM had its money on was predicting that the difference between interest rates on risky bonds and interest rates on the safest of all bonds, US Treasury Securities, would go down in the near future.
But in August 1998 Russia unexpectedly defaulted in its domestic debt, causing the market to panic, sell off risky assets and rush into the safest investment – US Treasuries. This pushed up the price of US Treasuries and pushed down the price of riskier bonds which is the same as saying that interest rates on US Treasuries went down while rates on riskier bonds went up. That is, the spread between risky bonds and US Treasuries widened – exactly the opposite of the LTCM bets.
When you trade in derivatives and gamble that the price or rate on an underlying asset will move in a certain direction you are said to be “in-the-money” when the price of that asset is in line with the direction of your bet. You are “out-of-the-money” when the price moves against the direction of your bet. Counter-parties see how much they are in or out of the money by marking their positions to market on a regular basis. If you are out-of-the-money your betting counter-party to your derivatives transaction, or your derivatives clearing agent, will call on you to deposit some type of collateral with them in line with the amount your bet is wrong or “out-of-the-money”. This deposit serves as security toward you being able to settle the full transaction on the agreed upon date in the derivatives trade.
When the real world went in the opposite direction to the massive LTCM bets, LTCM counter-parties were getting worried about getting their money from LTCM, especially since LTCM was so highly leveraged. LTCM might be forced to liquidate its assets in a fire sale in order to meet margin calls triggered by their sudden slide out-of-the-money. Either they would have to sell off a massive amount of assets quickly to meet these large calls, or, if they couldn’t do this they would default. Either way a chain reaction of panic would ripple through the markets.
Soon after the Russian default it became clear that LTCM’s positions were such that it had now lost most of its equity capital in just a few days. Not only were its bank loans now at risk but if LTCM defaulted on meeting its margin requirements with derivatives counter-parties, all counterparties would have immediate claims on LTCM and its many derivatives positions would be shut down. This would have sent a wave a panic through the derivatives markets because LTCM was such a big player, and this would probably bleed into most other major financial markets.
If LTCM had to liquidate assets to meet margin calls then, because of the size of the assets that needed to be sold, this massive sell-off would have depressed prices and caused panic, pushing asset prices down even further. In turn, this would have hampered LTCM’s ability to meet its margin requirements, as well as its ability to repay the banks they borrowed their gambling funds from. Compounding these problems was the realization that many market players, including major banks and securities firms, made “copy-cat” bets and their positions would be further harmed by an LTCM fire sale.
The Federal Reserve Bank of New York intervened and called together a consortium of banks who were complicit in this hedge fund madness by both lending to LTCM for their gambling needs and by being major players in the unregulated OTC market themselves.
It was decided that the bank consortium would lend MORE to LTCM, by lending them the funds necessary to meet margin calls and prevent the massive panic that default and/or massive asset sales would have caused. The thinking was that these loans would tide over LTCM until its betting positions turned around, so the banks were thereby also participating in the gamble (even more!). And therefore, unbeknown to all of us, the public was also participating in the gamble. Who knows what would have happened if the betting positions continued to get worse? The banks, and therefore their depositors, would have been more and more on the hook for the LTCM gambles. But as things turned out, LTCM gradually came back into the black and, through the combined management of LTCM and the bankers, the LTCM gambles were eventually wound down in an orderly fashion and a financial catastrophe averted.
Interestingly the LTCM founders and some of its investors and creditors blamed the whole thing on a “distorted market”. Apparently their gambling was perfect except for these external forces.
Even more interesting is the fact that the general public to this day still has no idea how close their lives came to changing drastically overnight in September of 1998, thanks to the extreme leverage of 4 smarty-pants wizards with easy access to credit. No safeguards were ever put in place to prevent future such incidents.
Shall we be content to leave it up to the markets and the bank regulators to continue with the adrenaline driven speculation as is, and then put out fires as needed?
Of course there is no guarantee that their attempts to put out such leverage-induced fires will always work. Indeed in the case of the LTCM saga if the betting positions didn’t change direction for an extended period our lives may well be very different today. We were, as gambling goes, just plain lucky that it didn’t get worse.
The real problems do not lie in external distortions that mess up bets. They lie in the over-confident betting culture that on the one hand, has brought great prosperity to a small proportion of the world’s people. But the danger lies in the inability to appreciate the balancing dark side of all this prosperity for the few. The dark side includes the lack of prosperity for the many upon which such levers are built. But it also includes the huge devastation that would result from the collapse of high financial and physical leverage that we, on the prosperous side of the fence, are now completely dependent on.
No treatise on financial leverage would be complete without appreciation of the fact that human financial and physical leverage has another dark side – its effect on the non-humans and the natural ecosystems that support us. Always remember that the leverage that supports us and benefits us can be turned against us with just a small amount of force amplified many times by our own systems of leverage. All it requires is a small trigger in the wrong direction, which may flip another switch in the wrong direction and before long, this turn in an undesirable direction is multiplied by our massive human created leverage. With that we go out with a fictional story based on one you might recall from your childhood entitled “Because a Little Bug Went Ka-CHOO”. I consider this book, from the Cat in the Hat Books, to be Chaos Theory for Kids.
Story: Because a Little Bug With the Asian Flu went Ka-CHOO
Chapter 1: The Origins of a Financial Crisis
You may not believe it, but here’s how it happened,
One fine summer morning in rural Asia, a little bug with the Asian Flu, sneezed.
Because of that sneeze, a little seed dropped.
Because that seed dropped, a worm got hit.
Because he got hit, the worm got mad.
Because he got mad, the worm kicked a tree.
Because of that kick, a nut dropped off the tree.
Because that nut dropped, a turtle got bopped.
Because he got bopped, that Turtle named Jake, fell on his back with a splash in the lake.
Because of that splash, a hen got wet.
Because she got wet, that hen got mad.
Because she got mad, that hen kicked a bucket.
Because of that kick, the bucket went up.
Because it went up, the bucket came down.
Because it came down, it hit Farmer Brown.
And that bucket got stuck on his head.
Farmer Brown happened to be the President of the Regional Farmers Association.
Just before the bucket landed on his head he was on the phone to his banker trying to sort out repayment terms for his fellow farmers since the weather had been unkind to the crop yields that season. But the bucket slamming onto the farmer’s head disconnected the telephone and made it impossible for the banker to call back.
The farmer’s wife was out gathering up the neighboring farmers to help remove the bucket from her husband’s head, so the banker couldn’t call them either. The banker immediately jumped to the conclusion that the farmers were all going to default on their loans. Word spread quickly around the banking industry and pretty soon the international speculators caught wind of this and started selling off their Asian currencies and investments for fear that a banking crisis was looming.
The selling off of Asian currencies put downward pressure on their values and soon the Asians had to devalue their currencies. This proved disastrous for the Asian banks whose assets were mostly in local currencies, but who also had large US dollar denominated debt. Almost immediately the major banks were near insolvency and a run on banks had started. The expectation of the international speculators of a banking crisis was a self-fulfilling prophecy.
The Asian crisis then spilled over to Russia, already in a precarious position due to high levels of debt. Before long the Russian government defaulted on its debt.
After this series of events the international speculative community was in a mad panic and began what is known as a “flight to quality”, selling down bonds of foreign governments and riskier firms and buying up on the safer US government bonds. This pushed down the prices on foreign bonds, and pushed up the prices on US treasuries. This is the same as saying that interest rates on US bonds went down and those on foreign bonds went up. In the financial world we say that spreads on foreign debt over US treasuries got bigger, or widened.
Back in the US, if you had been in the upscale town of Greenwich Connecticut, you might have been woken by a loud scream upon news of the Russian default. For little did anybody know, the massively leveraged hedge fund known as the Long Term Capital Management Fund or LTCM, had bet a substantial amount of the worlds economy on the future narrowing of interest spreads over US treasuries. But with the Russian default these spreads just got much, much wider.
In contrast to the Enron case, Federal Regulators and the US Federal Reserve realized that a major financial catastrophe may result from not intervening in the LTCM case. LTCM’s collapse would have effected us all and caused the type of collapse that can cause a major depression.
In the subsequent months Wizard Greenspan was called before congress to discuss the LTCM crisis, why the Federal Reserve stepped into the supposed “free markets” and what should be done to prevent future LTCMs.. Perhaps one of the most dangerous outcomes of Wizard Greenspan’s testimony was his support of the continued lax regulation of both hedge funds and the derivatives markets. In line with this, no regulation of these instruments was forthcoming. Overall, the wild derivatives markets and hedge fund players got off lightly, indeed. More blame was put on external factors than on the dangers of the extreme speculative behavior facilitated by both derivatives and private, unregulated hedge funds.
Chapter 2: The Extinction of Sneezing Bugs and Hot-Tempered Worms
During the grilling of the Chief Wizard of the Federal Reserve over the LTCM Crisis and the near collapse of the global economy, Congress wanted to know the real cause of the financial crisis. They wanted to know the root causes so they could stop the possibility of any future such crises.
Recall that our story started with the sneezing bug that caused a worm to kick a tree which then triggered a series of events, that later ended in financial crisis.
Not wanting to blame the crisis on the unchecked gambling of smarty-pants wizards, their hedge funds and derivatives bets for fear that this would be detrimental to the lucrative financial markets, the Chief Wizard sought to place the blame on just the right external factors. He placed blame squarely on the sneezing bug and hot-tempered worm that had originated the sequence of events that triggered the Russian default, which upset the LTCM bets. He stopped short of putting any blame on humans who are, after all, key market players and he also didn’t want to blame the chicken that kicked the bucket for fear that this could trigger massive short selling on poultry futures at the Chicago Exchange. Bugs and worms, not having been commoditized, securitized and bundled up into neat financial instruments by investment bankers, were safe things to blame.
The Great Wizard then proceeded to imply that eradication of Asian sneezing bugs and hot-tempered worms would be the most effective route to prevention of future financial crises. The leaders of America, known to hang on every word of the Great Wizard, put the following as the next item on their agenda. “Bring Resolution of Eradication of Asian Sneezing Bugs and Hot-Tempered Worms to the next UN Security Council Meeting”.
This was done and the UN Security Council passed the resolution without a peep of dissent. A plan for eradication was immediately put into effect. The people of Asia near and dear to the Asian forests tried to tell the UN of dire consequences that would come from this eradication. But nobody listened. After all, the bugs and worms were responsible for a near global financial collapse, and what could be worse than that?
Within a few years all the sneezing bugs and hot-tempered worms of Asia were gone. The financial markets did tremendously for the major gamblers over the next few decades and not a single negative incident threatened this blissful state. Everybody assumed that the markets would be just fine now that the troublesome bugs and worms were gone.
But within a few years something funny was happening to the Asian forests. You see, the sneezing of bugs was supposed to make seeds drop off in order to distribute seeds throughout the forest for new growth. And the worms were supposed to be hot-tempered and go around kicking trees to distribute their nuts around the forest floor. In this way, Nature had built a system of controlled leverage so that a small force like a sneezing bug or a worm of short temper could push the right levers to keep the forest going.
Mother Nature had been observing the whole human financial crisis saga with some amusement knowing that the relatively young species really had not learned the art of controlled leverage at all, and that this was their real problem. Eventually they would either figure it out or wipe themselves out. Either way was quite OK.
Without the bug and worm seed distribution mechanisms the seeds only fell off when they were dried up and dead. So the forest was essentially “fixed” so it couldn’t produce more trees and shrubbery. It took about three decades before the urban people finally realized the forests were thinning. But it was too late. The thinning of the forests left them susceptible to pest and disease outbreaks, and pretty soon the forests were collapsing. With forest collapse came major climate changes and water related disasters of floods and droughts.
Financially these environmental disasters hit the balance sheets of the Japanese insurers who had insured a good part of Asia’s physical economic infrastructure. The problems of the Japanese insurance companies then bled into the already troubled Japanese banking sector, and soon the whole Japanese investment community was suffering. The Japanese, being the world’s largest foreign creditors, then began liquidating their foreign assets to meet cashflow needs at home and stemming from the Asian forest collapse, and related environmental disasters.
Included in this sell-off were Japanese holdings of US Treasury Securities, which panicked other investors who also started selling off US government bonds and rushing into gold. The safest of the sovereign bonds had now been put into question. This pushed down the price of US government bonds and spiked up the cost of borrowing for the US government. Since US government borrowing is more about funding the military than anything else, the Pentagon was essentially shut out of the credit markets for the first time ever!
Unable to raise capital, the Pentagon was unable to pay its bills to its dependent private defense contractors. This then triggered massive defaults by huge defense companies on both their corporate bond issues and their bank loans. While the Great Wizards had been claiming that derivatives built more resilience into the market against financial shocks, in this unexpected scenario derivatives made the problem much, much worse and triggered additional layers of default risks and incredible panic. This panic forced more and more people away from the US dollar and into gold. Gold went from $300 per ounce to $5,000 almost overnight.
The Federal Reserve who, as we know from Wizards Part 1, just makes money up out of thin air, couldn’t do very much because the linchpin of its success, the might of the US dollar, was now disappearing before its very eyes. They pooled their gold resources with the US Treasury, counted their ounces and then realized they only had enough to either keep the Pentagon going, OR to bail out the now collapsed US Banking System. But they couldn’t do both.
This gave birth to the Great Squabble between the Wizards of the Great Empire and its Warlords that, for all we know, could go on for hundreds of years.
Meanwhile the people got tired of this squabbling and developed a healthy new interest in the important work of worms and bugs. Amazingly enough, the Great Wizard of the now collapsed Central Bank was rumored to have uttered at a recent party that he wished they had had some ecologists on the Federal Reserve Board.
THE END
