Integrity--It's a Big Matter

It's Capitalism, Jim, But Not as We Know It

Over recent months we have seen some of the largest and apparently most powerful financial institutions in the United States fail. Understandably, people are panicked. They do not know how far things will go. Fear and financial manic depression is the order of the day. When people are fearful of losing their money they “run for the hills” so to speak, and try to put their savings and financial assets into things they regard as safe. What they regard as safe on any given day can vary.

One of the key reasons fear takes over is when people do not understand what is happening—or more precisely, why it is happening. It is easy to jump to the conclusion that these unprecedented events mean the end of the world as we know it. Some have openly argued that the collapse of these vast institutions means the end of capitalism—implying that Karl Marx was right after all and that capitalism is so internally contradicted that it will self-destruct.

Others have argued that there appears to be a critical mass to institutions—that when companies get to a certain size they become essentially ungovernable, and spin out of control. This makes them even more large and reckless—and in the end they become so large that their collapse threatens the financial system itself. Thus, the need is to regulate in some way to keep companies smaller and more manageable.

It turns out, however, that the issues are very simple—at least in concept.In the most recent debacle age old problems have been evident, even though their particular manifestation may have been unusual.

Let's see if we can identify some of the key problems.

1.Key financial institutions artificially protected and propped up by Government. In the US, the two semi-government mortgage companies Fannie Mae and Freddie Mac have been artificially protected from competitive market forces. As a consequence they were given a free ride, and able to grow exponentially with little regard for consequences and risks.

We have seen this pattern many times over, but in the case of Fannie and Freddie they provided much of the money for the home mortgage market in the United States. They were implicitly guaranteed by the US government—a hangover from the days when it was thought to be a good thing that the government ensured that every citizen had the opportunity to own his own house, yet banks were reluctant to lend at the time.

So Fannie and Freddie could go out and borrow money at low interest rates (because of the implicit government guarantee) and lend to home owners at far higher interest rates.

Add to this some populist left-wing politics and the recipe for disaster is perfect. The Congress (both houses) had a majority of left-wing, socialist politicians who believed that the poor had a right to own a house and that social justice demanded that regardless of their financial situation they should be able to own one. Suddenly, reckless lending became a social good and a moral imperative.

Management of these two institutions (through donations and “lobbying”—read bribery) effectively conspired with these politicians to ensure that no regulation controlling them was successful. Meanwhile management was paying itself exorbitantly outrageous bonuses and salaries because of relentless increasing earnings.

But when the housing market began to decline, Freddie and Fannie were left with huge pools of worthless mortgages. People were defaulting left, right and centre. It was a classic credit collapse.

Moral of the story: when governments protect, prop up, or subsidize commercial enterprises the outcome is always bad, and more often than not financially disastrous.

2.Unbacked (naked) derivatives. The explosion in size of the derivatives market has been unbelievable—dwarfing the actual market from which they are derived. Now the variety and complexity of these instruments is so extreme that usually people just shake their heads and walk away. But at root, derivatives are very, very simple conceptual instruments.

At base, derivative instruments are designed to function as an insurance policy against an untoward event taking place. Just as a homeowner will insure the contents of his home against an untoward event such as fire, theft, or an earthquake, so derivatives are designed to insure owners of assets against untoward losses through prices or values going up or down.

In concept, derivatives are very useful even as insurance is useful. They serve as effective, risk reducing tools. Now, in the ordinary functioning of an insurance company, the company will keep assets on its balance sheet so that it can pay out on any claims. Or it will seek additional insurance from other (re-insurance) companies when its own resources are insufficient. In other words, the insurance policies are backed by capital and financial assets. This is an implicit contractual obligation between the insurance company and the insured person, deriving from the insurance contract itself.

A derivative is no different. In general terms,the owner of the derivative has a legal, contractual right to demand payment from the seller of the derivative if goods or assets decline in value over a set period of time. The owner of the derivative contract can require the other party to “make good.” So far, so good.

However, the problem has arisen insofar as sellers of derivatives were not required to keep sufficient capital to ensure that they could honour their contractual commitments. Instead, they were allowed to “nett off.” Now, once again, this concept is very simple. If I write and sell a derivative contract that will require me to pay money to the owner of the contract if a (say) certain currency went lower over a period of time, I am exposed to risk if that particular currency were to decline. If however, I write and sell a derivative contract that promises the opposite—that is, that another owner will pay me if that same certain currency declines, then my net risk is zero. I have no risk.

Oh, but here's the rub. All I have done is effectively passed the risk on to someone else—to a counter party. I am relying that in the event I will have to pay out on my first contract, the owner of the second derivative will also be able to pay me. I don't actually need to own any capital myself to back the first derivative contract I created and sold. I am relying on the capital resources of someone else. Well, not quite. Due to "netting" my counterparty does not have any capital either: it just has its own set of "netted" off liabilities to another counterparty. Effectively the derivatives are all naked: there is little or no capital backing them. It is one vast daisy chain with no financial substance.

This ability to “nett off” derivatives contracts is the key reason why they have ballooned in size and number. No capital was needed: it was one great big money-go-round. Therefore, derivatives contracts could be written without constraint.

Now derivative contracts can be very lucrative, generating nice fees. So the leading investment banks on Wall Street (of which there were relatively few—and even fewer after recent days) made billions of dollars in fees through writing and selling derivatives—then turning around and cancelling out their risks by selling “opposite” derivatives, to, well other investment banks—of which there were precious few.

Several years ago it was pointed out that eighty percent of the global derivatives trade by volume volume was conducted between eight investment banks in the United States, as they bought and sold to each other, seeking to “nett off.”

What resulted was a huge concentration of risk in the hands of a very few large institutions--none of whom had adequate capital to support their risks. All it would take is for one link in the “counter party” chain to fail, and they would all fail. So, Lehman Bros going bankrupt is a perfect example. The other Wall Street investment banks would all own billions of dollars of derivative contracts which depend upon Lehman Bros as their “nett off” counter party, relying upon Lehmans to paying up in the case of certain events. Now that Lehmans is bankrupt, all of these Wall Street banks suddenly have hugely reduced “offsets” to their derivative risks. Overnight they desperately need to find more capital, or themselves go into bankruptcy. The weakest link has broken the whole chain.

Moral of the story: “netting off” allowed a huge expansion of derivatives liability and concentration of risk to occur, with little or no requirement for capital to back and support the obligations.

With these two problems (subsidized, uncontrolled federally supported mortgage companies out of control, and the ability for investment banks to "nett off" derivatives) we have all the ingredients for financial nuclear fission. The actual nuclear reaction began when financial derivates related to mortgages began to become popular--and the two problems merged into one great financial bubble.

So, these two problems effectively lie at the root of all the troubles. If these two problems had not been allowed to exist, there would have been no global problem: no bubble, no vast expansion of debt and credit, no huge unsupportable out-of-control institutions, no systemic collapses. We are not saying that there would have been no problems, or business failures, or bankruptcies. There will always be those. However, what we are saying is that there would have been no widespread systemic collapse requiring intervention by most of the governments of the world.

Is this a failure of capitalism? Absolutely. It turns out that if markets are going to work they have to be as free as possible from fraudulent activity. Any commercial contract must be backed by performance of the terms of contract: if the terms are not met, theft has occurred and judicial retribution must result. No market can long survive without this ethical and juridical foundation. All markets depend upon truth and trust if they are to survive. Therefore, any financial contractual arrangement has to be backed by sufficient capital to meet all potential obligations. Otherwise it is just flat out fraud.

This means that netting off financial derivatives must be severely regulated and curtailed and that the significant proportion of derivatives instruments must be held as liabilities on balance sheet and appropriate capital adequacy measures required by law. It also means that all government subsidies, protection, and implicit guarantees of private and semi-private financial institutions must be done away with.

Such measures will go a long long way to preventing such a systemic collapse ever occurring again. But this will only occur if the overwhelming consensus in the United States (or any country for that matter) is that integrity and honesty at every point is more important than personal or political advantage, making money, and advancing financially. And what are the chances of that being the case? Well, maybe we will see at least some steps in the right direction.