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Bet you haven't seen this on a bumper sticker lately: "Save the derivatives market."
Hardly catchy. Especially since almost no one actually knows what a derivative is. And it sure goes against the emotions of the crowd right now.
Along with Christopher Cox, the head of the Securities and Exchange Commission and of a Wall Street culture of greed, derivatives are the villains in the current collapse of the global financial system.
But we'd better stop pointing fingers at these tools and start figuring out how to get this market functioning again if we're at all interested in ending the financial crisis before it drags all the economies of the world into a decade of stagnation with low growth and high interest rates.
This crisis is no longer about the U.S. housing market or mortgages, or even about failing Wall Street institutions. We're way beyond that. What's at stake now is the entire global financial system that has underpinned world economic growth over the past two decades or more.
If we don't fix that, the cost will be slower economic growth around the world, and especially in the U.S., over the next decade and perhaps longer. Here in the U.S., we'll be able to measure the cost in higher interest rates and a weaker currency, but the effects will be felt in every economy in the world.
Money in motion
What's broken is the financial conveyor belt that moved dollars around the world and made global economic growth go.At the receiving end, this conveyor belt loaded up the dollars that the developed world, and especially the U.S., had paid to the oil economies of the Middle East, Russia, Nigeria and the rest of the gang, and to the global factory economies of China, India, Brazil and the rest of that group. It then delivered those dollars to the great financial recycling centers of New York and London, where they were turned into T-bills, mortgage-backed securities, Fannie Mae (FNM, news, msgs) debt and derivatives such as collateralized debt obligations and credit default swaps. The belt then returned its load of financial products back to the Middle East, Russia and China.
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The smooth operation of this conveyor belt meant that the dollars paid for oil and for manufactured goods didn't just sit in bank vaults in Beijing, Moscow and Riyadh, Saudi Arabia. Instead, they were recycled into houses built in Sacramento, Calif., engineering contracts in Osaka, Japan, and crane orders in Düsseldorf, Germany. That kept the economies of the developed world chugging along, which in turn kept up global demand for oil and other raw materials and for manufactured goods. That demand meant that China would have money to build roads and buy railroad cars, that Russia would be able to hire Schlumberger (SLB, news, msgs) to manage Siberian oil fields and that Saudi Arabia could build chemical plants.
It's no simple matter to recycle a cash flow that has amounted to $700 billion a year from the U.S. trade deficit alone.
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To keep all those dollars rolling down the conveyor belt back to the New York and London financial markets, the Chinese and Russian and Saudi holders of those dollars had to be convinced that the U.S. Treasury bills they were buying wouldn't be devastated by U.S. inflation or a falling dollar.
They needed to be convinced that the U.S.-dollar-denominated corporate bonds they were buying wouldn't go down the tubes when a company thousands of miles away failed.
They wanted to know that the bundles of mortgages they were buying in markets that they'd never seen were AAA-rated -- and that their money was safe even if that rating turned out to be wrong.
They needed to know that it was safe to invest so much money outside their home market and that their own national cash flows wouldn't take a huge dive if oil prices or exports plunged.
In good hands?
What they wanted was insurance. And that's exactly what derivatives promised.In the derivatives market, you could buy a contract, for a price, that would insure you against the rise in inflation or a rout in the U.S. dollar. You could buy a contract that would insure you against the failure of General Motors (GM, news, msgs) or IBM (IBM, news, msgs) -- at very different costs, of course. You could buy a contract that would insure you against a plunge or a spike in oil prices.
In fact, for a price, you could lay off the risk of just about any event -- corporate or financial or economic -- that you could think of. And the ability to lay off that risk was critical to keeping the global conveyor belt running.
Derivatives were a key lubricant in the system that kept dollars moving around the world.
That lubricant gradually failed over the past year as the financial crisis kept growing deeper. Companies and countries that bought derivatives as insurance discovered that first some, and then many, buyers of derivatives realized their insurance was only as good as the counterparty on the other end of the contract. If the financial company that had sold insurance against a rising dollar or a default by Fannie Mae didn't have the cash to pay up, then the derivative was worthless as insurance. Better to keep your money at home in your own pockets if you couldn't trust the derivatives market to deliver on its insurance promises.
The lubricant also failed as the price of insurance went up. If the price of buying a derivative to insure against some unpleasant possibility rose high enough, then it was again better to keep your money at home than to pay the extra premium.
The bankruptcy of Lehman Bros. (LEHMQ, news, msgs) and the near bankruptcy of American International Group (AIG, news, msgs) produced an almost complete breakdown in the lubricant.
Lehman was a party to hundreds of billions in one-off derivatives that covered risks of default, interest rates, equity moves and moves in commodity prices.
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AIG was an even bigger player. Its near bankruptcy and then its $85 billion government buyout led the London Stock Exchange to suspend trading in 113 exchange-traded commodity funds run by ETF Securities. All had been backed on matching derivatives from AIG.
Market makers had stopped making prices for the funds because they were worried that trading in the funds would leave them open to risk if AIG went into bankruptcy.
The Lehman bankruptcy shows the London traders were right to worry. Investors are discovering the collateral Lehman posted against its derivative swaps isn't enough to cover the cost of buying comparable derivative insurance from another company.
Investors are faced with taking a hit if they want to buy the same insurance – because prices are higher -- if they can find a counterparty at all now that the derivatives market is shrinking.
Problems in the derivatives market don't stay confined to that market. In the short run, we've already seen the effects at work in the commodities market. AIG was a counterparty to a good part of the $30 billion invested in the Dow Jones AIG Commodity Index ($DJAIGCH), the second-most-popular benchmark for commodity investors.
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