From Derivatives to Debt Crisis

On August 11, 2011, in derivatives, by Jon Lewis

The Devil’s Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . And Are Ready to Do It Again. Nicholas Dunbar. Harvard Business Review Press 2011, pp.291, $27.95. If one were a college student in the mid-to-late 1990s with an interest in working on Wall [...]

The Devil’s Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . And Are Ready to Do It Again. Nicholas Dunbar. Harvard Business Review Press 2011, pp.291, $27.95.

If one were a college student in the mid-to-late 1990s with an interest in working on Wall Street, it was likely that one had a fascination with the new complex and mathematically derived OTC (over-the-counter) derivatives and their market. After all, a position in an investment bank and in working in that sophisticated area of finance was perceived to be both lucrative and prestigious. Today, those same derivatives have far fewer champions; one would be hard-pressed to find nearly as many university students today whose dream is to work in trading derivatives. Because of the nature of the global economy and the ever-increasing need to manage risk, however, the market for derivatives is not going away any time soon. End users, in particular, continue to see advantages in derivatives.

In The Devil’s Derivatives, financial journalist Nicholas Dunbar paints a skeptical picture of the growth of the derivatives industry within the financial sector and introduces the reader to the bankers who advocated for, and worked in, derivatives, financial products that “piggybacked on—or ‘derived’ from—those humdrum activities that involved exchanging currencies, trading stocks and commodities, and lending money.” Derivatives, as Dunbar notes, had been around for a long time. What was new about the post-1970s’ derivatives were their highly complex, mathematical nature and the amount of risk that they were designed to manage.

Dunbar, who was trained as a physicist and has written extensively on financial markets, argues that there was a cultural shift in banking that led to both the rise of the new derivatives industry and the subsequent financial crisis. “To truly understand what brought upon the great financial meltdown of 2008,” he writes, “requires a thorough understanding of the men who love to win, and how they came to fundamentally change not just the practice of a financial system that had been in place for centuries, but its very DNA.” Indeed, the greatest strength of Dunbar’s work is that he does not treat the financial crisis as merely the culmination of economic and historical trends, but as the product of real (and, in his opinion, flawed) choices made by real individuals. These individuals, of course, acted in an historical context in which the very business of banking was undergoing fundamental cultural changes.

Dunbar contrasts the traditional actuarial approach to credit risk, one traditionally associated with life insurance companies, with the market approach to rating loans and bonds. “Think about owning a bond or loan in this new world. The idea of patiently waiting for years to be proved right by long-term statistics becomes almost absurdly antiquated, even laughable. The uncertainty of market prices now rules.” In Dunbar’s opinion, the actuarial and market approaches to credit risk “have created two distinct cultures in finance: the long-term world of lending banks, insurance companies, and pensions funds, and the short-term world of trading firms and hedge funds.” He is spot on in analogizing credit default swaps to “a bit like buying a life insurance policy on someone else’s life.” It should be noted that credit default swaps (CDSs) are very much like insurance, but have not been regulated as such. Indeed, the concept of moral hazard in insurance regulation stems from eighteenth-century England, when individuals were allowed to take out life insurance policies on other persons, thus increasing the moral dilemma – or hazard – of wishing to see them die so as to be able to collect the insurance payout.

Another quite interesting aspect of Dunbar’s work is his discussion in Chapter 3 wherein he integrates a discussion of Abraham de Moivre, binomial mathematics, and the invention of probability theory in eighteenth-century London with Moody’s, the bond-rating agency. For those readers interested in statistics and Moody’s utilization of the binomial expansion technique (BET) to “convince hate-to-lose investors that a CDO containing a portfolio of risky assets could be much less risky than the individual assets themselves,” this particular chapter is well worth consideration.

In light of the public’s worries generated by Standard & Poor’s decision to downgrade the United States’ debt rating from AAA to AA+, Dunbar’s parting thoughts are worth consideration. Indeed, Dunbar concludes his vast work with a most pessimistic assessment and links the current debt crisis to the derivatives market. “The lesson of history is clear: faced with such debts, either Americans themselves . . . will lose out, or their dollar-owning creditors will—in a big way. What started out as an arcane twist of high finance—derivatives—has now corrupted the entire financial world, and has set a hellish trap for taxpayers and their representatives that offers no way out.”

Although perhaps hyperbolic, it should be noted that as a journalist with a clear mission to convince people of the dangers of the derivative market and contemporary less-risk averse, banking culture, Dunbar is far freer to say such things than a politician is. Indeed, one could hardly imagine an aspiring presidential nominee saying that, even if he or she believed it to be true. Of course, there are ways out of the current debt situation; but all of them would increase great hardship in the short term, something many politicians would rather not do.

In conclusion, The Devil’s Derivatives is a welcome addition to the growing corpus of literature on the financial crisis of 2008. Unlike some of more purely academic and scholarly tomes on the subject, Dunbar’s work is written with a lively journalistic style that combines a first person narrative with a generally accessible introduction to highly technical finance concepts. For readers unfamiliar with seemingly arcane concepts as cross-currency swaps, regulatory capital arbitrage, and special purpose vehicles (SPVs), this recent work is as good as any place to start. Advanced undergraduates and graduate students interested in derivatives would find this recent book particularly compelling.

Jon Lewis (c) 2011

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