In 2008, the world caught a glimpse of what happens when financial counterparties lose trust in each other as well as confidence in the system. Many of them refused to meet their obligations under all types of financial contracts including derivatives contracts. This led the entire system to the brink of collapse. The financial system has placed itself in an extremely vulnerable position by allowing more than $600 trillion of derivatives contracts, including at least $16 trillion of credit default swaps as of December 31, 2014, to proliferate in the hands of a small group of firms.
Efforts have been made to tame credit derivatives, but these efforts largely miss the mark. The primary focus has been to move derivatives trades onto clearing houses that can provide regulators with greater transparency27 as well as to establish collateral requirements and similar rules. The problem with this approach, as I noted in the first edition to this book, is that clearing houses can inadvertently become new “too big to fail” institutions if they run into financial trouble during a crisis and are themselves deemed to pose systemic risk. If a clearing house were to experience financial trouble and become unable to meet its obligations, there would be an enormous temptation to bail it out in the name of financial stability; this would merely replace one “too big to fail” institution (the banks) with a new one (the clearing house). Furthermore, as discussed in Chapter 7, significant volumes of derivatives trades are still being conducted beyond the scope of regulatory scrutiny.
Credit default contracts on subprime mortgages rendered AIG insolvent and forced the U.S. government to bail out the insurer. The volume of outstanding credit default swaps is much lower today than on the cusp of the financial crisis. The notional volume of single-name credit default swaps declined from $25.1 trillion in 2007 to $10.8 trillion in mid-2014.28 The notional volume of multi-name credit default swaps has also decreased significantly from $20.1 trillion in 2007 to $8.6 trillion in mid-2014 (most of these are swaps on index products such as high yield bond or loan indices). Nonetheless, these volumes still dwarf the capital of dealers and the $2.3 trillion of total capital in the high yield bond and bank loan markets in 2014.29 If counterparties were to become unwilling or unable to perform again, all bets would be off. The system remains overleveraged and unprepared for another crisis for which the only response would appear to be a blanket government guarantee of the obligations of the institutions carrying these trillions of dollars of derivatives on their books.
These risks are far from theoretical. In 2013 – a mere five years after the collapse of Lehman Brothers and near-collapse of AIG, the latter of which would have constituted an extinction-level-event for the global financial system – JPMorgan lost more than $6 billion on trades involving credit default swap bets on high yield bond indices in the incident infamously known as the “London Whale.” This multi-billion loss happened right under the nose of the bank’s CEO Jamie Dimon, widely believed to be the best risk manager in the business. This illustrates that even those considered to be the smartest guys in the room don’t understand derivatives, which are highly complex and specialized instruments.
Furthermore, this unfortunate episode demonstrated once again that credit derivatives markets are thinly traded and highly illiquid and volatile; when market conditions deteriorate, counterparties become unable or unwilling to perform and create systemic dislocations that sink the values of the securities underlying derivatives contracts. In point of fact, despite their large notional volumes, credit default swap markets have always been (and will remain) extremely illiquid as investors learned during the 2008–2009 crisis when relatively low trading volumes led to huge moves in the credit spreads of troubled firms such as Bear Stearns and Lehman Brothers as described in Chapter 7.
Rather than reducing systemic instability, credit derivatives significantly increase systemic fragility and render illiquid underlying cash markets far more prone to large price swings not only in a crisis but in normal market conditions. This volatility and potential for loss (particularly in leveraged portfolios) has been disguised since 2009 by central bank-distorted markets. When the next market dislocation arrives, as it inevitably will, these derivatives will again earn their reputation as the “weapons of mass financial destruction” that Warren Buffett bestowed on them (although that has not prevented the Oracle of Omaha from investing in them extensively himself!).
While the financial system is now populated by fewer “too big to save” institutions, it also appears that these firms are “too big to jail.” But the real story is that our government lacks the wherewithal to enforce its own laws.30 The highly concentrated nature of risk in the financial system is more problematic in view of the inability of regulators to rein in institutions’ bad behavior. Some of the world’s largest banks have engaged in serial violations of the law and paid large fines while being given multiple waivers shielding them from the loss of their banking licenses while virtually none of the corporate executives who committed the deeds in question have been punished criminally. Deutsche Bank’s ability to keep regulators at bay is just one example of the corruption of markets.
After the savings-and-loan crisis of the early 1990s, over 1,000 executives were prosecuted and more than 800 convicted. While some of these prosecutions, such as Michael Milken’s, were politically motivated and unjust, the lion’s share were appropriate. After the 2008 financial crisis, which unlike the savings-and-loan mess posed a true systemic threat, virtually none of the individuals who participated in the decisions that caused systemic harm has been prosecuted.
Speaking as a highly experienced attorney and market practitioner as well as a citizen, this breeds disrespect for the law and the government that is obligated to enforce the rules of fair play. As The Economist writes: “If banks have been involved in acts serious enough to qualify for billions of dollars in penalties, then a few more executives must surely have committed a crime.”31 Surely the crimes did not commit themselves, nor did they materialize out of thin air; they were the result of deliberate actions on the part of highly educated and presumably intelligent individuals who deserve to be punished. The fact that they were not punished is a profound regulatory and moral failure that weakens the financial system.
In his classic study of financial bubbles, Manias, Panics and Crashes: A History of Financial Crises, Charles Kindleberger pointed to a common characteristic of speculative booms: “Commercial and financial crises are intimately bound up with transactions that overstep the confines of the law and morality, shadowy though these confines be. The propensities to swindle and be swindled run parallel to the propensity to speculate during a boom.”32 In May 2015, the government entered into another in a long line of settlements with a group of large financial institutions: a $5.6 billion settlement for the manipulation of exchange rates in the foreign currency exchange spot market. This was just the latest in a series of instances in which individuals working at the heart of the financial system violated the law but nobody went to jail. This settlement followed a similar one involving the manipulation of LIBOR by some of the same institutions.
As part of the settlement, the SEC decided to give another waiver to these institutions that would allow them to conduct business as usual despite the fact that they were repeat offenders. This did not sit well with one SEC Commissioner, Kara M. Stein, who is a frequent target of The Wall Street Journal’s editorial page for being too tough a regulator. In this case, however, Ms. Stein should be applauded for speaking out; she should remind us of Brooksley Born, the former chair of the CFTC whose warnings about the risks of lax derivatives regulation were dismissed by The Committee to Save the World in 1999.
Ms. Stein dissented