Derivatives – a disaster we avoided or a disaster in the making?

I have quite a few quant friends (and family) who are occupied in derivatives.
They know very well how to run stochastics and
Monte Carlo codes to price these complex instruments, but are unaware of
more pressing issues, such as why this huge Ponzi scheme caused a market
crash in 2008, why such enormous bailouts around the globe were required
to save it. Unfortunately, the repeated bailouts and saves by the global
central banks only provided liquidity to this Ponzi scheme and fostered further
expansion, pretty much ensuring another financial crisis in the future. The first time
derivatives caused a crash was 1987, when portfolio insurance (or put options, in
modern equivalent) caused a meltdown due to hedging as the market fell through
put strikes. Of course, quants say they were not perfect, since implied volatility was
then flat.

Here is what Myron Scholes has to say on the subject, and I totally agree. I would add,
blow up not just OTC CDS market, but all of it. Scholes knows. Not only he is the Nobel
Laureate and the father of Black-Scholes, he also ran LTCM that blew up for the very
same reason in 1998. Cancelling contracts while things are good seems to be an
excellent option. The reason for a complete seizure of the libor market was the
market pricing of couterparty risk. It happened before, and it can happen again.
The notional size of derivatives market is 10 times the size of the global GDP,
and the usual Central bank liquidity fix will only make it bigger.

Myron Scholes, intellectual godfather of the credit default swap, says blow ’em all up

Myron Scholes, whose Black-Scholes option pricing model provided the intellectual underpinning for modern derivatives markets, thinks one particular derivatives market—that for credit default swaps—is due for a Red Adair style rescue. Or a Fred Adair style rescue.

Red Adair put out oil well fires by setting off gigantic explosions at the wellhead. “My belief is that the Fred Adair solution is to blow up or burn the OTC market in credit default swaps,” Scholes said this morning. What that means, he elaborated, is that regulators should “try to close all contracts at mid-market prices” and then start up the market anew with clearer rules and shorter-duration contracts.

This was at a conference at New York University occasioned by a new collection of papers on how to fix the financial system, authored by a bunch of NYU Stern School faculty. Scholes kept saying Fred Adair. Sometimes he’d notice and correct himself, sometimes he wouldn’t. The FT’s John Gapper, who was on a panel with Scholes, finally speculated that this was because the government response to the financial crisis has been such an unwieldy mix of Fred Astaire (dancing around the problems) and Red Adair (doing something to fix them). Scholes did not disagree.

The blow-up-the-CDSes option is intriguing, and I’m going to check in with Scholes later to see if he wishes to elaborate. But for now, a few more notes from the panel, which was moderated by Paul Volcker and also featured NYU finance professor Matt Richardson:

Some would say Scholes is partly to blame for this whole mess, and Volcker dropped a couple of hints in that direction. Scholes didn’t exactly accept responsibility, but neither did he give a blindered, Chicago-style defense. For one thing, he cited John Maynard Keynes—still a nonperson to many of Scholes’s fellow Chicago Ph.Ds—arguing that we’re currently stuck in a situation where the financial system needs to deleverage, but its current deleveraging is causing asset values to plummet, meaning that it’s not succeeding in deleveraging at all (that is, debt is down, but so is the value of everybody’s capital, so leverage ratios aren’t declining). For another, he seemed to agree with one of the main criticisms of the Wall Street risk models that evolved in part from Black-Scholes—that they have some ability to capture the risks faced by one investor operating in a financial market that the investor is too small to influence, but aren’t much good at capturing the risks faced by the entire market. “Risk aggregation is not linear,” he said. “It’s nonlinear.” (This is what Chapter 13 of The Myth of the Rational Market is about. Doesn’t that sound exciting?)

As the moderator, Volcker didn’t say all that much. He did talk for a bit, though, about how “maybe we ought to have a two-tier financial system,” with a heavily regulated “core part that I will for purposes of simplicity call commercial banking” and a less-regulated outer realm of hedge funds, proprietary trading desks, and such. Hmmm, said Gapper, that “reminds me of something I once heard of called the Glass-Steagall Act.” This Glass-Steagall revivalism is happening all over. I’m even beginning to feel the spirit. But Gapper had an interesting question: “If you wanted to set up a new Glass-Steagall, where would you draw the line?”

Scholes finally got his free-market Chicago dander up over the possibility of synchronized global financial regulation—something that Volcker has been advocating as chairman of the Group of Thirty project on financial reform—sparking this entertaining exchange:

Scholes: If we internationalize everything, we end up with rules that stifle freedom and innovation. Mr. Sarkozy and others say our system has failed and we should adopt theirs. Do we want to become French?

Volcker: I’m not an acolyte of Mr. Sarkozy.

Gapper: Actually, the French banks are big derivatives users.

Volcker: The U.S. is no longer in a position to dictate to the rest of the world.

Tuesday, January 5th, 2010 The global financial and economic crisis

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