Just in case you really do want to know who got us into this mess

Filed under: Hazlehurst |

“I view derivatives as time bombs, both for the parties that deal in them and the economic system.”
Warren Buffett, letter to shareholders of Berkshire Hathaway, 2004.

During 1997, Blythe Masters, a 34-year-old British-born Cambridge graduate, whose degree is in mathematics, conceived and created a new financial product at J.P. Morgan in New York. It was designed to separate the default risk on loans from the loans themselves.
The risk would be moved into a novel derivative security, which investors, corporations, speculators and any entity that sought to offload risk could employ. The first such security offered by the bank was called BISTRO, for Broad Index Secured Trust Offering.
Competitors quickly moved into the market, and the young mathematician’s invention came to be called a credit default swap.
A few years later, the bank collaborated in the publication of a “Guide to Credit Derivatives,” and fulsomely sung its own praises.
“As Blythe Masters, global head of credit derivatives marketing at J.P. Morgan in New York points out: ‘In bypassing barriers between different classes, maturities, rating categories, debt seniority levels and so on, credit derivatives are creating enormous opportunities to exploit and profit from associated discontinuities in the pricing of credit risk.’”
In its simplest form, a CDS is an agreement between two entities (the counterparties) in which one makes a periodic payment to the other and is guaranteed a payoff in the event of a third-party default. It sounds like a normal, useful banking transaction — except that it isn’t.
The CDS is itself a security, which in turn gave rise to yet more derivatives and, ultimately, to the whole opaque, rickety structure of securitized debt obligations. All of the players in what became a vast, multi-trillion dollar unregulated international market thought they were protected from risk — but, as they (and we) found out this year, they weren’t.
The very derivatives that they relied upon for protection brought them down, and nearly brought down the world financial system.
And the damage may be far from finished.
According to Nouriel Roubini, whose spot-on predictions about the present crisis were widely derided three years ago, there are four ways to solve our present problem, which he believes to be a classical case of debt deflation.
Grow out of the debt
Inflate the debt away
Default on the debt
Socialize the debt — spread it out over a larger population, such as having the government assume the loans.
With the economy falling into recession, alternative No. 1 is presently unworkable. Alternative No. 3 isn’t under consideration.
Instead, governments worldwide have chosen alternatives No. 2 and No. 4. Trillions of dollars have been committed to bail out debtors and creditors alike, in hopes of recreating the mildly inflationary, steadily growing international economy that was once propped up by BISTRO’s demon offspring.
These policies, which appear to condone and encourage reckless behavior by individuals and institutions alike, are in place because central bankers believe that the failure of the U.S. government to respond to debt deflation during the 1930s caused the Great Depression. Classical economic theory holds that modern governments can always reverse deflation.
Here’s how one economist put it during 2002:
“The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning … like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”
Unfortunately, that convenient technology only works as long as investors and individuals believe that the printing press actually creates value. Absent that belief, a general flight from the currency could trigger a massive inflationary spiral and effective liquidation of most dollar-denominated debt — as the author of the previous paragraph, a certain Ben Bernanke, surely knows.
And what does Blythe Masters think of her creation nowadays?
Apparently, she has no regrets.
“I do believe CDSs have been miscast, much as poor workmen tend to blame their tools,” she said.
Another brilliant mathematician, watching the product of his own arcane calculations, was less optimistic.
“I am become Death, destroyer of worlds …” (J. Robert Oppenheimer, Trinity Site, New Mexico, Aug. 6, 1945, quoting the Bhagavad Gita, chapter 11, verse 32.)
John Hazlehurst can be reached at John.Hazlehurst@csbj.com or 227-5861.