When Lawrence Summers testified against regulating derivatives in July 1998, it could be argued he was testifying on the basis of a limited legal point, and not on the basis of being opposed to any derivative regulation. When the Commodities Futures and Trading Commission prepared their 'concept release' to consider regulating derivatives, the CFTC was attempting to use its authority to regulate futures contracts to regulate derivatives. In his testimony, Summers - while glossing over many well-documented problems with derivatives - focused on the legal argument the CFTC didn't have the authority to regulate derivatives. In this testimony, Summers also promised to study the merits of regulating derivatives as part of the President's Working Group on Financial Markets, (the Working Group).
In his July 1998 testimony, Summers gave two reasons for being skeptical of regulating derivatives (1);
- The parties to derivative contracts were largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies.
- Given the nature of the underlying assets involved...there would seem to be very little scope for market manipulation of the kind seen in traditional agricultural commodities.
The failure of the hedge fund Long Term Capital Management (LTCM) - coming less than two months after his July 1998 testimony - would show these two reasons to be completely wrong. The Working Group didn't release its report until November 1999. The report recommended providing derivative markets 'legal certainty' and removing 'legal obstacles' to the development of new derivative clearing systems. (2) Basically, Summers and the Working Group concluded the derivative market should remain as unregulated in the future as it had been in the past. The fact that these conclusions were made roughly one year after LTCM's spectacular collapse proves the Working Group's report was a total whitewash.
If any firm exemplified both the mind-numbing complexity and the enormous risk of the derivatives market it was LTCM. LTCM developed mathematical models to determine what prices should be. It used the result of the calculations to enter into derivatives contracts. Because the prices predicted by its model were often only slightly different than the prices which prevailed in the market, the only way for LTCM to make serious money was to use enormous amounts of leverage with its derivative trades. (In these trades, LTCM would essentially 'bet' that the market price would move toward the price predicted by its model.) For every $1 in capital, LTCM might borrow $30. With this amount of leverage, very small losses could wipe the firm out. Stripped of its mathematical complexity, the geniuses at LTCM thought they could make a fortune by picking up pennies in front of freight trains.
Some idea of the complexity - and the enormous intellectual arrogance - behind LTCMs mathematical models can be gleaned by a review of the educational background of some of LTCM's partners. Greg Hawkins, Larry Hillibrand, William Krasker, Robert Merton, David Mullins and Eric Rosenfield all had PhDs from MIT. Merton was also a professor at MIT and won the Nobel Prize in economics. Rosenfield and Mullins both taught at Harvard, and Mullins was also vice-chair of the Federal Reserve. (Mullins was replaced at the Fed by Alan Blinder, Dunce #5.) The mistake all these MIT educated geniuses tripped over was merely the first rule of counting cards. LTCM made enormously large bets via their derivatives contracts. However, the basis of their bet - their mathematical models - was never accurate enough to justify the high leverage they routinely used. It didn't matter that LTCM's models were correct 90% of the time when it only took a 5% level of inaccuracy for the firm to collapse!
The presence of so many sophisticated and (supposedly) well-educated financiers in key positions with LTCM completely undermines Summers first reason for not wanting to regulate derivatives - 'sophisticated financial institutions who are able to protect themselves from counterparty risk.' Not only was LTCM comprised of sophisticated traders, so were all of LTCM's counterparties. LTCM's counterparties included the largest Wall Street banks. When LTCM was on the verge of failure, the Greenspan Fed organized an enormous bailout of LTCM to protect these counterparties from LTCM defaulting. Not only did this bailout eviscerate Summers' first reason for being opposed to regulating derivatives, it also precipitated the largest mistake of the Greenspan era; the Fed's emergency rate cut of October 1998. (3)
When it came to undermining Summers' two reasons for believing derivatives could remain unregulated, LTCM's collapse wasn't done. In August 1998, when LTCM had just started to enter its death throes, some traders apparently became aware of LTCM's troubles and began to push the market against LTCM. Evidence of this is provided by a conversation LTCM's founder, John Meriwether, had with a former Salomon Brothers colleague, Vincent Mattone. In spite of not having worked with Meriwether for several years, Mattone remained a close personal friend of Meriwether - a rarity on Wall Street. The fact that Mattone nurtured, maintained and valued friendships wasn't the only thing that made him stand out on Wall Street.
Mattone was a throwback to the Wall Street of old; before the MIT PhDs thought they could reduce trading to a mathematical exercise, and before twenty-five year old Harvard art history majors thought they were ill-served when they only made $750,000 in a year. Mattone started at Salomon Brothers as a clerk at nineteen. He never earned a college degree and preferred pinky rings to Hermes silk ties. With little more than his wits and his work ethic, he worked his way up to very senior positions with both Salomon Brothers and, later, with Bear Stearns. Unlike the MIT PhDs and Harvard professors - whose ridiculous ideas formed the basis for LTCM's trading strategies - Mattone recognized that markets were human affairs, not scientific exercises. (4) In August 1998 Mattone asked Meriwether how much capital LTCM had lost. When told by Meriwether LTCM had lost 50% of its capital in the past few weeks, Mattone quickly concluded, 'You're finished....when you're down by half, people figure you can go down all the way. They're going to push the market against you." (5)
Recall that Summers - whose useless PhD came from Harvard, not MIT - believed 'little scope for market manipulation' existed with derivative trades! Vincent Mattone - who had forgotten more about market behavior than Summers would ever learn from a million Harvard PhDs - came to the opposite conclusion. The collapse of LTCM - which came very rapidly - proved, incontrovertibly, Mattone correct and Summers wrong. Indeed, after LTCM collapsed, John Meriwether completely endorsed Mattone's assessment of the derivative market when he said,
"A hurricane is not more or less likely to occur because hurricane insurance has been written. In financial markets this is not true. The more people write hurricane insurance, the more likely it is that the disaster will happen because the people who know you sold hurricane insurance can make it happen." (6)
LTCM's failure and the subsequent Fed bailout of LTCM came just two months after Summers' July 1998 testimony. In spite of completely undermining his two reasons for leaving derivatives unregulated, LTCM was only mentioned three times in the Working Group's report on derivatives. Given the fact that LTCM's failure completely undermined the basis of Summers' 1998 testimony, the reports conclusion - to leave derivatives unregulated - can only be described as laughable and transparently fraudulent. In addition to Summers, the Working Group report was also signed by Fed Chair Alan Greenspan, SEC chair Arthur Levitt and CFTC chair Wiliam Rainer. As hard as it may be to believe, Greenspan, Levitt and Rainer are frauds every bit as big as Summers.
Sugar Land, TX
August 11, 2019
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(1) Treasury Deputy Secretary Lawrence H. Summers Testimony Before the Senate Committee on Agriculture, Nutrition and Forestry on the CFTC Concept Release, July 30, 1998
(2) Over-the-Counter Derivatives Markets and the Commodity Exchange Act, Report of the President's Working Group on Financial Markets, November 1999
(4) In the movie "Trading Places," Eddie Murphy's character, Billy Ray Valentine - a Capricorn, demonstrated the same earthy knowledge of markets. Rather than purchasing pork bellies at the price recommended by the all-powerful Duke Brothers, Valentine recommended waiting for a lower price. He reasoned because it was so close to Christmas, traders caught on the wrong side of the trade in bellies would be in a panic to sell out of concern they wouldn't be able to buy their son the 'GI Joe with the kung-fu grip.'
(5) Roger Lowenstein, When Genius Failed, Random House, NY, 2011, p. 156-157
(6) James Grant, Mr. Market Miscalculates, Axios, Mount Jackson, VA, 2008, p. 348