July 30th of this week marked the 21st anniversary of Lawrence Summers', (Dunce #45) testimony to Congress on derivatives. (1) The hearings were prompted by the May 7, 1998 'concept release' by the Commodities, Futures and Trading Commission (CFTC) to consider regulating derivatives in much the same way commodities futures contracts were regulated. Before reviewing Summers July 1998 testimony, some context for the place derivatives held in the financial universe at the time is warranted.
A complete timeline of the role derviatives played throughout the financial crisis can be found elsewhere on the site. (2) Here, only some limited aspects of the general perception of derviatives at the time of the 1998 hearings will be discussed. In his testimony, Summers described derivatives as an unalloyed economic good. However this was hardly an industry consensus. Indeed, in January 1992, Gerald Corrigan, the Governor of the Federal Reserve Bank of New York, cautioned Wall St. banks about the dangers of derivatives by telling them to 'take a very hard look at off-balance sheet activities' and later adding, 'I hope this sounds like a warning because it is.' ('Off-balance sheet activities' is a euphemism for derivatives.) Later that year, in September, Allan Taylor, Chairman of the Royal Bank of Canada, likened the market for derivatives as a 'time bomb that could explode just like the Latin American debt crisis (LDC) did, threatening the world financial system." Finally - and also picking up on the bomb metaphor - Felix Rohatyn of Lazard Freres characterized the market for derivatives as "26-year olds with computers creating financial hydrogen bombs."
However the most timely and prescient observations about derivatives would be made by John Succo, an executive, ironically enough as it would prove to be, with Lehman Brothers. In May 1998 and while speaking at a conference organized by Jim Grant of Grant's Interest Rate Observer, Succo described how Lehman's senior management was almost completely ignorant of the risks the firm was exposed to in its derivatives contracts;
"I don't think that the people running our firm, our equity floor, have any idea of the things that we actually do, of how we...(audience laughter)... I'm serious...of how we hedge, the products that we're involved with, the amount of risk we take or the lack or risk we actually take.....If your making money, (management) kind of leaves you alone until there is a crisis situation. And I don't think that's a way to run a firm." (3)
When told of Succo's comments, Lehman management summarily fired him. Of course in a little over ten years Lehman Brothers would vanish from the face of the earth as a direct result of the derivative trades Succo was concerned with.
Of course, in July 1998 the failure of Lehman Brothers was a long way off in a future that few people could envision. Nevertheless, the concerns expressed in the sentiments quoted above should make it clear that derivatives had some rather considerable downsides - at least in the minds of many people. Moreover, there was also the notion that perhaps derivatives - which were only a very recent development - weren't really the 'be-all and end-all' their proponents constantly, and breathlessly, claimed them to be. After all, somehow the US economy had developed to the state that it had without derivatives. With this being case, were derivatives really everything their proponents claimed them to be?
In this regard, the observation of Admiral James Stockdale, winner of the Congressional Medal of Honor is especially relevant. Stockdale claimed that absent the perspective history can provide, 'busy opportunists' will leap into the breach to pursue agendas that benefit themselves;
"In my view, the single most important foundation for any leader is a solid academic background in history. That discipline gives perspective to the problems of the present and drives home the point that there is very little new under the sun. Whenever a policy maker starts his explanation of how he intends to handle a problem with such phrases as 'We are at the take-off point of a new era...' You know you are heading for trouble. Staring by ignoring the natural yardstick of 4,000 years of recorded history, busy people, particularly busy opportunists, have a tendency to see their dilemmas as so unique and unprecedented that they deserve to make exceptions to law, custom or morality in their own favor to get around them." (4)
In his testimony on derivatives, (5), Lawrence Summers would prove to be Stockdale's archetypal 'busy opportunist.' Among Summers' observations that both ignored the recent past and didn't age well in the future were the following;
- 'The OTC derivatives market is a vast, increasingly global industry. By some estimates, the market now has a notional value of around $26-trillion, with contracts for more than $4-trillion undertaken in 1997 alone.' (In 1997, US GDP was under $12-trillion. How then did it make sense for there to be $4-trillion in new derivatives contracts or $26-trillion in total derivative contracts? Don't these statistics indicate much of the market for derivatives was trading as an end in itself and not a means to an end? author)
- 'The growth of the (derivatives) market in recent years is testament not merely to the dynamism of modern financial markets, but to the benefits that derivatives provide for American business.'
- 'By helping participants mange their risk exposures better and lower their financing costs, derivatives facilitate domestic and international commerce and support more efficient allocation of capital across the economy.'
- 'OTC derivatives directly and indirectly support higher investment and growth in living standards in the United States and around the world.'
- Derivatives are an important 'risk management tool.'
In fairness to Summers and his testimony - while he certainly gilded the lily when it came to describing all the benefits provided by derivatives - he promised to participate in the President's Working Group on Financial Markets to fully review the case for regulating derivatives. In the follow-up article to this one, the working group's report will be discussed. This report was written after the collapse of Long Term Capital Management - a collapse almost exclusively driven by financial derivatives that Summers sought to protect. Apologists might be able to claim with a straight-face that Summers' testimony in July 1998 was given objectively. No such defense will be possible in November 1999 with the report Summers helped prepare.
Peter C. Schmidt
Sugar Land, TX
August 04, 2019
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(1) A derivative is a financial asset but 'derives' it value from some other, more conventional financial asset. For example, a conventional financial asset, like stock or a bond, has value in and of itself. Stock is a claim on the profits of a company while a bond gets value from the interest payments the bond holder is entitled to. A derivative isn't anything like this. To use the most infamous example from the 2008 crisis, a mortgage bond derivative - or credit default swap (CDS) - derived its value from how likely a particular mortgage bond was to default. AIG - which took part in more mortgage bond CDS trades than any other firm - was happy to receive about $50-million per year to provide as much as $1-billion in 'insurance' against a mortgage bond defaulting. The $50-million 'premium payment' could rise and fall as the likelihood of a bond default became more or less likely.
(2) Derivatives and the Financial Crisis - An Introduction to the Timeline, www.the92ers.com, May 28, 2018 http://www.the92ers.com/blog/derivatives-and-financial-crisis-introduction-timeline
(3) Derivatives Strategy Magazine (Archive), June 1998
(4) Admiral James B. Stockdale, "Educating Leaders," The Washington Quarterly, Winter 1983, Quoted in Warrior's Words, Arms and Armour Press, London, 1992
(5) Treasury Deputy Secretary Lawrence H. Summers Testimony Before the Senate Committee on Agriculture, Nutrition and Forestry on the CFTC Concept Release, July 30, 1998
(6) Over-the-Counter Derivatives Markets and the Commodity Exchange Act, Report of the President's Working Group on Financial Markets, November 1999 https://home.treasury.gov/system/files/236/Over-the-Counter-Derivatives-Market-Commodity-Exchange-Act.pdf