Saturday, October 3, 2009

Derivatives not the root of financial crisis: Satyajit Das

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Can derivatives traders be tamed and can derivatives be made serve their prime purpose of hedging? Answering these questions is Satyajit Das says derivatives did help the economy go into a financial crisis, but it is a little simplistic to say derivatives are the cause of it. “They definitely made it worse because they allowed risk to hide in places and risk became fragmented and also they assisted in creating leverage and complexity in the system and that complicated the crisis and it is also complicated how we are going to have to deal with it.”

Q: First let me begin with your book. In Traders, Guns and Money you begin with a derivative product sold to an Indonesian company, where the company has to pay more if rates rise and if interest rates fall, they don't get lower rates but they have to pay fixed rates and the principal doubles. It is a product which a fool will know is heads you lose and tails also you lose. How close is this example to reality? Are such products actually sold or were you caricaturing?

A: It is actually based on real transactions I saw but I cannot tell you the details because I would have to kill you because if the liable laws. But interestingly enough the transaction that is outlined actually has a parallel in real life at the moment because as you may be aware the municipalities in Italy have entered into some transactions which bear a striking a resemblance. So perhaps somebody copied them from the book.

Q: How much would you say that derivatives were the root of the financial crisis?

A: I think derivatives helped but it is a little simplistic to say derivatives are the cause of the problem. They definitely made it worse because they allowed risk to hide in places and risk became fragmented and also they assisted in creating leverage and complexity in the system and that complicated the crisis and it is also complicated how we are going to have to deal with it.

Q: The Financial Stability Board (FSB) and the BIS have put forth some plans to tame derivatives—like Central Counterparty Clearing (CCC). Will it work at all?

A: I think one has to come back a little bit from what the issues are to look at where the central counterparty fits in. What has actually happened is that after the AIG episode and the Lehman’s episode, the issue of counterparty risk—this is the risk that one bank has on another—became very central to the concerns of regulators because I always took about daisy chains of risks—somebody deals with somebody, somebody deals with somebody and if anybody in that chain breaks down then you have a systemic crisis and I think the central counterparty goes to the heart of the problem. Now the first comment I would make about that is it’s not new. It has been around for a quarter of century but it is not in my view the complete answer for a whole bunch of reasons. The first reason is the idea of putting these on an exchange takes the idea of two big to fail to an entirely new level because as I have said some divine power ought to be supporting this because fundamentally if this counterparty every has a problem then you have got a huge, huge issue. And there are also mechanics of how you do it which I don’t think the FSB and central banks under stand fully and haven’t thought through.

Q: Already you have members of derivatives organizations—the International Swaps and Derivatives Association (ISDA)—arguing that the purpose of derivatives is to customize a product to a customer. They are actually arguing for non standardized products. So do you think the CCP will make headway at all? Would you say that this is a legitimate counter coming from the derivative traders?

A: The first thing I would say is ISDA obviously is speaking on behalf of the industry and I have never known an industry, no matter how toxic the products they sell, effectively turnaround and say the product has any side effects. So I would not expect an industry lobby group to take an opposite view. However, let us examine the argument on its merits. I think the fundamental thing here is firstly what is being proposed is that standardized derivatives go on. Geithner went to the senate and was asked what a standardized derivative meant and he said he’d have to get back to the senators on that and as best as I know he hasn’t. And the legislation at the moment merely says in a very secular definition that a standardized derivative is something which can be cleared through the CCP, which is a complete oxymoron.

So the first thing is the ISDA objection are not clear at one level simply because what they’re saying is only standardized derivatives go on. So some of the more customized products have the scope to be traded in the OTC market but overall the line of delineation is far from clear. But if one looks at the next line of ISDA’s position, ISDA is saying something far, far more interesting. ISDA is saying that even if we could define something as standardized, they may not actually be able to be priced or valued and therefore cleared through the CCP and this is quite an astonishing statement from ISDA because over the last 12-months they’ve been arguing how wonderfully liquid, how wonderfully transparent and how easy to value derivatives are, so this represented interesting change of heart which is perhaps convenient at this juncture.

Q: What you are saying is making me feel that not only should you not have over the counter derivatives but you can’t even have standardized derivatives—are you arguing against derivatives?

A: No. I don’t think that’s the case. I think it is essentially a case of the instrument and the use. One of the most fascinating thing is about the regulation debate is it is not going to the real issue. The real is should you be allowed to use derivatives to effectively take speculative positions, in other words to gamble, to put it very colloquially. Now the interesting thing is that is got to be the starting point in this and I’ll give a very good analogy. Let us say you have to house or some property—you can insure it and it is a very legitimate form of risk transfer because you have something which you want to protect. If you’re house is now insured by 30 other people including me or just merely having a bet on whether or not your house is damaged in any way—that’s a completely different kettle of fish and I think under those circumstances that’s the first debate you have to have. Then the next part of the debate is, okay if effectively you have essentially got a legitimate reason for using derivatives then what kind of derivatives are need.

My view has always been despite the fact that I worked in structured products for very long periods of time is that essentially standardized derivatives allow most forms of risk transfer but if you want to go to non standard in certain cases I can find it defensible but the fundamental thing has to be whether or not it is used as a hedging tool. The case is very close to India because there are a number of Indian companies at the moment who have losses as a result of entering into transactions which on the ones that I’ve had seen or seeing coverage of don’t look to be hedges at all.

Q: Exactly my point. They’re often entered into only for speculative purposes and to have a trading income to supplement of course the main business income to supplement of the main business income. But there is an argument in favour of entering into these kinds of transactions for their own sake. The argument is that that provides liquidity to the market if you only have customized products or if you insist like the RBI used to some year’s ago that every hedge should be backed by an actual export contract or an actual real economy contract. In that case you will have an illiquid market. The argument of those who say that you should not insist on this underlying is that that will create liquidity—you don’t buy that?

A: Fundamentally Mike Milken once said that liquidity is one of life’s great delusions. It is there when you don’t need it—it is never there when you need it. And in OTC derivatives or derivatives in generally there is always an issue of liquidity and the point that you’re making is essentially about will speculators necessarily improve liquidity. They do but as we observe from September-October last year there are some social costs—some externalities—that are quite important as well. It is a delicate balancing act in that sense but I come back to the fundamental point is that there would be people who would offer liquidity through speculative activities but then the question is how does the system cope with when things go wrong because as we have observed we endow and we did this with long-term capital management in 1998 and we are doing it now—we have to bail them all out. So essentially you’re giving them almost a derivative payout—call option—when they can privatize the gains and socialize the losses is that socially an outcome that you want in terms of financial markets.

Q: Banker bonuses—how do you look at the way in which the G20 has gone on to tackle this problem? Can you really design a package that can control risk taking?

A: Fundamentally you have to go back to how the bonus structure works and I am confining my comments here primarily to financial products and derivatives. Now the products are quite complex in some cases where the profit and loss (P&L) on these products and the hedging on these products and everything is done according to models and these models are imperfect. We wouldn’t call them models otherwise and under those circumstances you have a problem of the attributable income that you’re reporting is actually essentially an assumption based outcome. So the first point is I have no problems with people getting rewarded for efforts—Bill Gates has done very well out of Microsoft—there is no problems with that. However, in this case Bill Gates sells something and gets some cash and he gets a share of that. In the case of derivatives some of that is as we have discovered over the last 12-18 months were never really profits in the first place—so that’s a first issue.

The second issue is they’re up fronted—Bill Gates could only basically book Microsoft Office earnings or Microsoft Windows earnings when he makes the sale. In our case we now have contracts going out to 30-years where we are present valuing back all those earnings and there are lot of things that will emerge in the future like hedging costs—all of those types of things. So essentially we are actually up fronting income and this very much distorts essentially the incentive structure and moral hazards as we have discovered. Now whether the BIS and the G30 or the G20 proposals can deal with them—I think is very interesting because I am not sure that they can control every part of the economy and we are already seeing people splinter off. I mean what has not been talked about a lot is Barclays recently created a vehicle to transfer some of their portfolio off balance sheet. One of the clear reasons they did this was two executives in question are now not going to be working for Barclays—they are going to be working for this company, which is not associated with Barclays.

We are going to see that type of way to get around it. So I see some huge difficulties but there is a populist streak here which will lead to executive compensation being controlled undoubtedly so but whether it will be successful is a different issue.

Q: This crisis has made us like previous crisis look at traders as the rogues. But surely companies that went into this for trading gains are at least half as guilty. Can they be protected or punished by the law—any regulations that can protect an unsophisticated buyer or penalize someone who went into it with their eyes open?

A: The question you have raised is actually a very critical one. There is a very famous story that Warren Buffett tells about a person on Wall Street standing on a pulpit rallying against the evil of drugs and at the end he asks effectively are there any questions. The only person to put up his hand is a banker who says who sells the needles? In one sense I think my sympathies are effectively not necessarily with anybody here. I do a lot of work with different parties here. My sympathies are certainly not with the bankers and certainly not with the client and certainly not with the investors and let me explain to you why. I find it rather disingenuous in some case that sophisticated investors and sophisticated companies are now claiming they didn’t understand—it just doesn’t jive well.

But you have to go to the root cause. One of the reasons that I observe around the world that investors and companies have got into this is simply because they’re returns, if you’re an investor, have come down and they need the extra return and similarly companies core operations are no longer profitable and given the regular grind of turning out quarterly results which have to go by 10% or whatever the magic number is—people are now looking for the easy buck. And what they’re doing is speculating and so there are huge complex of pressures and derivatives are just one of the manifestations of that.

So coming back to your question—I think essentially there is a whole complex of factors and perhaps all of them have to be dealt with simultaneously. I don’t think dealing with one necessarily solves it. I always think that this is a ball of jelly—if you push it here it just pops out there and I think we have to be very careful of that and I don’t think people are focusing on that—they think there is a magic bullet and there is no magic bullet here – we have to adjust our rates of return, our expectations—all of those things.

Frankly, companies when they were using these derivatives to boost their earnings I didn’t hear shareholders complain terribly much or company management complain that much.

Q: That leads me the next question. Now that a whole host of regulators, the G20, the BIS, the Financial Stability Board and individual regulators are all looking for prescriptions—give me 1-2-3—your top three possible solutions that they should be looking at?

A: Focusing on derivatives, I think the first question would be to look at essentially whether there should be some restrictions on non hedging transactions. So should we put some sort of restrictions on them—I am not suggesting you eliminate all non hedging transaction but should there be some limits on that. Number one would be that, that would be the first place I would go to. Number two, I would deal with the issues of complexity and valuation. One of the key things is may be markets have become terribly complex and unnecessarily so and they have exacerbated the stresses in the market and we don’t have effectively the right valuations of this which complicates dealing with it. Third is to try to deal with the CCP but think it through to make sure that it works in an effective way and there is a concomitant to that which is to deal with the liquidity risk as is being pointed out as we talk in Europe, many companies are now saying to the BIS that if they get dragged in CCP that they will be actual victims of this in the sense they will have to purchase margins and collateral and that will place huge liquidity strains and one of the companies said last night that effectively that would create huge problems.

Q: There is a lot of pressure on Indian regulators to start credit default swaps now that we know what the risks are. What would you’re advice be to Indian regulators in this entire world of derivatives?

A: Indian regulators should hasten slowly which is what they did very well. Effectively they get a now a very good model of what can go wrong and they should move cautiously to deregulate and fundamentally also in India you have to be very careful. You have a wide variety of players both in the banking and non banking sector with different levels of sophistication. You do not want first world technology in a world where the people haven’t got the right skill base. So they should move very cautiously to deregulate but making sure that all the infrastructure of the market, the skills in the market and the controls in the market are right and I frankly think there are deficiencies on all three fronts.

Q: What's your comment on the way in which the Indian regulators went about their task? There is one segment of people who believe that Dr. Reddy and the contemporary RBI actually did a good job by being alert and there is another category which says that why should they boast that there were accidents when in any case it was a village road where motorcars were not allowed?

A: I think you should take credit for whatever works and the central bank is quite justified in taking credit for it. It was a bit of luck and a bit of good management and I actually think that, that is actually the right combination. They have been cautious since the Asian crisis having seen what can happen and that caution has been proved to be justified. At the end of the day India has come out of this less affected than other places. It has not been unaffected and I think that’s a huge positive. They should continue to deregulate but do it in a sensible cautious way. Just because everything is foreign doesn’t mean it is better or necessarily beneficial to the Indian financial markets.

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