Congress Had a Role in the Financial Crisis
Mortimer B. Zuckerman
Corn and hogs in the Midwest seem a long way from condos in
Derivatives -- the new bad word -- used to be called "futures." They've existed since the Civil War, invented basically to protect farmers, traders, and merchandisers from ruin when they could not sell a crop to cover their costs because a bumper harvest created a glut, or, conversely, to protect buyers when a bad harvest led to price inflation. Hence the creation of contracts with third parties who agreed to buy or sell at a certain price, whatever the future might bring. This stabilized the market and freed farmers from looking around for a buyer in what might be a frantic market.
The original futures markets in commodities functioned virtually without incident throughout our recent roller-coaster financial crisis. Put simply, this was largely because the markets had evolved a guarantee system following periodic defaults on futures deals by one party or another. Middlemen stepped in to assume that risk for a price, provided the parties posted collateral. In this way, clearinghouses minimized both the risks and the interconnections brought about by derivatives transactions.
In the evolution of these necessary instruments furthering stable trade, financial traders came to bid on the value of the paper guarantees: Bid offers went up if the risks seemed high, and down if they seemed safe.
We have come a long way from the original trading in futures contracts for corn and hogs, first standardized in
These are mortgage-backed securities fundamentally transacted between "shorts" and "longs." The "shorts" judge that the price of the security will go down, so they promise to buy it at some price lower than current. If they judge wrongly -- if it goes up, or goes down more than they assumed -- they suffer, since they have to deliver the security at a loss. The "longs" judge that mortgage bonds will strengthen in price, so they stand to earn more for the security than they paid. A perfect illustration is the now-famous case involving
Synthetic CDOs (collateralized debt obligations), of which we have heard a lot, are really instruments for betting on the housing market; their value is linked to a series of mortgage bonds. Again, if the price of those bonds declines, one set of investors will win, whereas if the mortgage bonds strengthen, the other side wins. This is the way in which a player bets on the success or failure of other people's investments -- a financial version of high-stakes poker.
These securities also reduce the costs of the loans that lubricate our economy. They make them more affordable and available by enabling lenders to offload risks to other investors with steadier nerves -- in short, to hedge their bets.
When the U.S. housing market collapsed, so too did the value of investments in residential mortgage-based securities, especially those tied to subprime mortgages of borrowers who could not meet their payments.
Not so long ago, these mortgage-based securities were viewed as among the safest investments in the market. Before the housing bubble burst, the overwhelming view of investors, rating agencies, and economists was that the housing market was strong and would continue to strengthen. Average housing prices rose by double-digit percentages in every year from 2002 to 2006. Investment-grade, mortgage-backed securities between 2005 and 2007 were considered almost as safe as U.S. Treasury securities but paid a higher interest rate. Defaults on these investment-grade securities, most of which were rated AAA, were virtually nonexistent.
There was enormous global demand for these products. Experts estimated that for every
The markets in the fancier new derivatives didn't have the instruments that the original futures markets for corn and hogs had developed with the clearinghouses. They didn't have rules for transparency. The original clearinghouses compiled and released data on volume and prices so investors could see, with some degree of clarity, what was happening by watching trades over time, or by comparing related instruments, like oil and gas futures.
What we have learned from the financial crisis is that we not only had institutions that became too big to fail, but also some that became too interconnected to fail. Today, roughly 90 percent of over-the-counter trading in derivatives is between two financial entities, including banks, finance companies, pension plans, insurers, and hedge funds. The danger is the domino effect -- that one entity's failure can mean a run on the other, which is interconnected through their derivatives. This poses difficult decisions for public officials.
What we now need is to greatly reduce the risks of a domino effect (and a government bailout) by imposing standards for over-the-counter derivatives so they can be cleared by central clearinghouses.
But we also need to understand how the housing market got as hot as it did. Why did it keep rising, generating more and more derivatives geared to a rising market? It turns out that
That is at the heart of the now-famous Goldman - Paulson saga. Hedge fund manager
The American public has hereby had a peek into the bewildering complexities of the world of finance. The natural instinct is for the public to blame the housing decline on those who shorted. But it is the other way around. They should be blaming those who let the market get pumped up, inviting a dramatic and painful correction that took most people by surprise.
This is one thing that must be reformed. Derivatives should be on exchanges and, to a large degree, in standard contracts, so they would be more fully disclosed and transparent. Companies that rate these securities should be given stronger incentives to provide independent and accurate analyses -- and remove the suspicion that high ratings can be bought. Lenders that bundle loans secured by mortgages or other financial assets for
Many of the reforms touched on here are included in the financial overhaul bill moving through
As the administration tries to assess blame for the economic decline, let's not forget the role of
The oversimplification of these issues in hostile congressional hearings is a disservice to the public.
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Congress Had a Role in the Financial Crisis
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