Goldilocks and the Three Lessons from the Derivatives Market

The Moral of the Story Is to Lock Your Damn House

Imagine for a moment that you are a commercial bank called the Papa Bear Bank Company. You accept deposits from large businesses and use the money to make loans to other businesses and consumers. The interest on the money you loan out is a little bit higher than the interest you pay to your depositors, and as a result you make a tidy bit of revenue. You use this revenue to pay your workers, dole out dividends to your shareholders, and host the occasional junket in Yellowstone.

All is well.

But then you notice something unnerving. Maybe the places you’ve chosen to lend to have some common factor that affects them all. It could be the interest rate set by the Fed, or the exchange rate with some foreign country, or even weather conditions — whatever it is, if it moves, then the default rate on your entire portfolio goes up.

You still like where you loaned your money and believe that, on average, this set of investments will give you the highest rate of return, but you don’t like this idea that all your risk is correlated. You’d much rather have a consistent small number of businesses not paying you back than alternating between periods where everyone pays you back and no one does.

Then you come across another bank, the Mama Bear Bank Association, which has a similar, but opposite problem. Whereas you don’t like it when the weather is too cold, Mama Bear runs into trouble when the temperature is too hot. You strike upon a brilliant idea — you’ll create a new financial instrument whose value is tied to the temperature (as measured by some reputable agency). Then, you’ll sell this instrument to Mama Bear. If the temperature goes up, you’ll pay Mama Bear some amount of money. And of course, with the money from this sale, you can buy a financial instrument from Mama Bear wherein you get paid if the temperature goes down. By hedging each other’s losses in this manner, your banks can make the risk “just right.”

You decide to call this new financial instrument a “derivative” because the value of the instrument is “derived” from some underlying item (in this case, temperature). You tell other banks about your brilliant idea, derivatives are hailed as the best new thing in risk management since bowls of porridge, and soon everybody is using them to hedge all kinds of risk.

At the end of 2000, commercial banks in the U.S. held derivatives with a total notional value of $40 trillion dollars. By the third quarter of 2008, the value had ballooned to more than $175 trillion, representing nearly a third of the world-wide derivatives market. 80 percent of these derivatives use interest rates as the underlying, another 10 percent are so-called “Credit Default Swaps” which are insurance against the default of some enterprise, and the remaining 10 percent are tied to various odds and ends like the temperature or exchange rates or some such. Of this $175 trillion in bets, $162 trillion are held by the three largest banks: JP Morgan Chase, Bank of America, and Citibank.

Here’s where derivatives start to get a little disconcerting. The combined assets of these three banks are only $4.3 trillion. The sizes of the derivative bets that have been taken are all out of whack with the assets they are supposed to insure — it’s as if two men, each with only ten thousand dollars to their name, decided to sit down and make a $1 million bet with one another. Papa Bear’s idea was fantastic, but clearly some little blond-haired femme fatale has snuck in and used it to engage in some highly leveraged speculation. Maybe Goldilocks had calculated that 99.5% of the time she’d get away scott-free, but one has to wonder what her contingency plan was for the rare situation when the bears came back.

Indeed, if the children’s tale is any guide, banks are in for a very grisly reckoning when they wake up from the bed they’ve made. The problem with letting two bankers make a trillion dollar bet with each other is that when one of them loses, they may simply go bankrupt rather than pay out. The “winner” of the bet can actually lose money in this way — we call this “counterparty risk.”

In the euphoric days before the crash, counterparty risk was the distant concern of academics — today, when some banks may very well topple (even if for reasons unrelated to derivatives), counterparty risk may be the mechanism by which banks fall like dominoes, each bank failure leading to a growing number of devastated derivatives partners until the cascade fells them all. Today, some banks find themselves in the odd position that while derivatives are supposed to be zero-sum games (one bank’s loss is another’s gain), neither side in a bet is able to sell their stake for more than they originally purchased it. The reason is simple: the market doubts that the winning side will be able to collect.

Still, there are some reasons to praise derivatives. The housing bubble was colossal… all things being equal, one would have expected more bank failures than we’ve seen today. But instead, when the bad assets came to surface, it turned out that the risk was very well spread. Instead of one or two banks taking the hit and leaving taxpayers with the tab, a whole slew of banks, from Asia to Europe to the U.S, took their share of the pain. The success of this risk management is due in part to the wonderful flexibility of derivatives.

The original moral of the Goldilocks tale was to keep one’s nose out of other people’s houses. The main lesson from the derivatives market is somewhat the opposite: regulators should have been overseeing derivatives just like any other asset. Unchecked, derivatives pose a risk not only to a bank’s ability to pay off its own creditors, but also to the health of the financial system as a whole.

A second lesson is that derivatives are a pretty effective way to manage risk. The $175 trillion holdings of the U.S. commercial banks might be unjustifiably high, but the optimal size of the market is clearly non-zero.

The third lesson, unappreciated by lawmakers, is that now is not the time to lobotomize bank leadership. In the aftermath of the financial crisis, banks are unwinding their complicated instruments, a task made even more herculean by the absence of a liquid market to price these bets. Including an executive pay cap in the stimulus bill as a punitive measure might have had popular appeal, but these are not the right circumstances to go bargain hunting for executives — this is a time to break out the top-shelf brains. Anything less is tempting fate.

As the bank crisis abates, legislators are turning their attention to the weighty task of changing the regulatory structure that governs the financial system. Reining in derivatives must take a place on the agenda.