I’m going to do something more with this later, but for now check out this awesome and eerie quote (source, pdf):
“Thus a long term corporate bond could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk, and one would bear the risk of default. The last two would not have to put up any capital for the bond, though they might have to post some sort of collateral.”
– Fischer Black, “Fundamentals of Liquidity” (1970)
In case that doesn’t freak you out, let me explain why it should. That’s 1970 (!!!), and it predicts everything. It’s before the Black-Scholes Equation (same Black) is published and popularized, creating the derivative market, so it is during the first wave of thinking how derivatives would change everything.
He’s saying, in the far future, there will be a market for slicing off the interest rate risk on a bond. There is such an instrument, the interest rate swap, and that market was created in the 1980s. He’s also saying the risk decomposition could be completed by slicing off the credit risk and selling that wholesale. That’s the credit default swap, or the CDS you always hear about, and that was created in the 1990s and popularized in the 2000s. This is the complete market that lead us into the current credit crisis, and here is Fischer Black 28 years beforehand, a consultant at Arthur D. Little at the time, explaining exactly how it would go.
Two extra things of note.
1. This is an example of what I meant as how risk has changed since the 1970s, and our regulatory agencies need to change to handle them. Risk can be sliced and diced up, and having three agencies, all jockeying for money, personal, and access, monitor three instruments on one underlying strikes me as asking for trouble.
2. I like that he notes that “might have to post some sort of collateral” could be a potential issue for this perfect Brave New World of complete markets. Not posting any collateral at all is what AIG did of course (though they couldn’t have posted enough collateral to cover these systematic risk insurance portfolios, but that’s a separate story). It’s fun to contrast how the idea that this highly explosive risk would travel to those who most could handle it, because markets regulate themselves, with Michael Lewis’s AIG Story that AIG didn’t understand their portfolio, got everything wrong and were lead by an insecure madman instead of the rational calculating market.
Markets in the abstract, markets in practice.
what I dont get, how is it that there were bubbles and crashes before derivatives. I mean it all those nasty derivatives, they explain everything.
Bubbles have always been about excessive leverage. Derivatives are a handy way to hide the leverage from regulators.
So your larger point — that derivatives aren’t pure evil — is quite correct. They just need to be regulated competently. That in turn is a matter of keeping the so-called innovation (aka grifters developing new con games) to a slightly slower pace so the lawyers and accountants can follow which shell the leverage is under.
Think of the FDA approval process for drugs. Yes it is laborious and arguably a little too inflexible. But it saves lives that might otherwise be lost to greedy pursuit of the shortest path to market. If new securities contracts were subjected to ‘human trials’ — low volume experimental trading periods, say — maybe we could figure out how the cons are run *before* they reach multi-trillion dollar scale.
Pingback: Thursday links: records of the past Abnormal Returns
It is fascinating how much foresight was in the remark you cite at the beginning.
I think that the bit you put in parenthesis later on in relation to AIG – (though they couldn’t have posted enough collateral to cover these systematic risk insurance portfolios, but that’s a separate story) – is actually the steak of the story that lies beyond the sizzle
Did you read that bio of Black from a few years ago? A highlight: when he was working at Goldman Sachs he learned about call risk the hard way. It only cost the company $100 million. Genius!
Some people liken the CDS market to a casino.
But even at the casino you have to put up collateral. After all, you have to BUY your chips to play.
Since the whole issue with CDSs was that they needed a AAA issuer, in essence AIG was putting itself up as collateral. Lucky for them they were too big to fail.
Also, I don’t know if the fact that somebody thought of an idea that later came true is really that big of a deal.
I hate to say it, but this is another sign of the failing of macroeconomics vis-a-vis it’s cousin economics subfields: industrial organization and finance. So business guys take the lessons of IO for how they should competitively price their goods and such and finance profs are not just teaching the technicians, they are also inspiring 30 years of innovations. I can’t say the same of a great macroeconomist who’s really foreseen advancements in economic policy.
OMG Dave – read this paper, by the same guy. I’m going to get to it next week, but it is amazing. It is all about Fischer-Black-ian finance and Lucas-style macro, and up-ends the entire narrative.
Instead of the normal narrative of macro thought progressing in the 20th century in an ivory tower, it’s all about the post-war changing economy and people trying to keep up in figuring it out. Most noteworthy was that Keynesian economics died because derivative markets blew a hole through it, and they couldn’t argue in the new financial landscape. Fantastic.
Oh hey, Mehrling is the author of the Black bio I was talking about.
That last paper is a hoot.
“[R]isk has changed since the 1970s, and our regulatory agencies need to change to handle [these changes].” And they _will_, change, but with such a lag that regulation will from time to time prove to be disastrously ineffective.
Pingback: Sweet Georgia Brown « jss books