The Astonishing $600 Trillion Interest-Rate Derivatives Market

A post from April 21, 2010 on Washington’s Blog calls derivatives “the world’s largest market, dwarfing the size of the bond market and world’s real economy” and says that the derivatives market “is currently at around $600 trillion or so (in gross nominal value).” — See “Are Interest Rate Derivatives a Ticking Time Bomb?

In contrast, Washington says that the worldwide bond market in 2009 was $82.2 trillion and the world economy was $58.07 trillion.

The most popular derivative, he says, are interest rate derivatives, in which “the underlying asset is the right to pay or receive a notional amount of money at a given interest rate,” according to the Wikipedia definition of interest rate derivative.

Washington quotes various economists to demonstrate why such derivatives have the potential to seriously destabilize the world economy (which we all know is so solid right now). He includes a long quote from portfolio manager Doug Noland, who compares interest rate derivatives with the so-called “portfolio insurance” that played a role in the stock-market crash of 1987.

One proponent of portfolio insurance is cited as making this breathtaking statement in 1985:

[I]t doesn’t matter that formal insurance policies are not available. The mathematics of finance provide the answer…The bottom line is that financial catastrophes can be avoided at a relatively insignificant cost.

About interest rate derivatives,Washington believes:

[N]o one – even the people that design, sell or write about the various interest rate derivatives – really knows how much of a danger they do or don’t pose to the overall economy. In addition to all of the other complexities of the instruments, the very size of the market is unprecedented.

AB — 22 April 2010

Defining Asset Bubbles

Here is an interesting interview with Jeremy Grantham of investment firm GMO, discussing asset bubbles, what they are, and how they should affect investment decisions.

Economist Edward Harrison at Naked Capitalism adds some analysis and explanation in his post “Jeremy Grantham on Bubbles.” Harrison’s “informal working definition of a bubble is “a price rise that is at least two standard deviations above trend.” He says that

Above two-standard deviations the psychology of prior price movements starts to dominate price activity and a bubble forms in which power law characteristics come into play.

In “power law” relationships, a quantity varies more than you should expect. It kind of refers to the “tall head” part of a distribution graph, the opposite of the “long tail.”

AB — 21 April 2010

The annoying thing about The Big Oligarchy

The annoying thing about The Big Oligarchy …

the banks

the insurance companies

the government

the giant firms

and their privileged controllers

… is that you pay into It all your life through premiums, taxes, and the money It makes from the float on your cash …

but then when you ask for the promised (or implied) benefits, It begrudges paying you and does Its best to stonewall.

AB — 26 March 2010

How the Wall Street Boom Went Kablooey

Reading Barbara Ehrenreich’s new book Bright-Sided recently, I became aware of Michael Lewis’s November 2008 article for Portfolio, “The End of Wall Street’s Boom,” which offers a fascinating inside look at how bubbles develop, sustain themselves, and then collapse.

Lewis makes an interesting connection with the delusional “positive thinking” mode that seems to be an important component of economic bubbles. This is the source of Ehrenreich’s interest in what Lewis has to say.

The main character of Lewis’s story is Steve Eisman, who built a busines toward the end of the bubble short-selling mortgage originators and homebuilders riding the subprime boom, as well as Wall Street firms and even rating agencies that were complicit.

Lewis relates that Eisman said something both interesting and funny to Brad Hintz, a prominent financial analyst at a conference in spring of 2007. Eisman told Hintz that his group had just shorted Merrill Lynch. Hintz wanted to know why.

“We have a simple thesis,” Eisman explained. “There is going to be a calamity, and whenever there is a calamity, Merrill is there.” When it came time to bankrupt Orange County with bad advice, Merrill was there. When the internet went bust, Merrill was there. Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit. That was Eisman’s logic—the logic of Wall Street’s pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things. The game, as Eisman saw it, was Crack the Whip. He assumed Merrill Lynch had taken its assigned place at the end of the chain.

Lewis is a former Wall Street hack who wrote the 1989 expose Liar’s Poker about his experiences in the industry in the 1980s.

His 2008 article ends on a curiously touching note as he recounts his recent lunch meeting with John Gutfreund, the ex-CEO of Salomon Brothers who took the company public and then led it during its period of prominence in the 1980s.

In relating his meeting with Gutfreund, Lewis offers an interesting analysis of the shift that took place in the 1980s, led by figures such as Gutfreund:

You can’t really tell someone that you asked him to lunch to let him know that you don’t think of him as evil.

Nor can you tell him that you asked him to lunch because you thought that you could trace the biggest financial crisis in the history of the world back to a decision he had made. John Gutfreund did violence to the Wall Street social order—and got himself dubbed the King of Wall Street—when he turned Salomon Brothers from a private partnership into Wall Street’s first public corporation.

… From that moment … the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished.

The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith.

AB — 15 January 2010

Simon Johnson: ‘What kind of catastrophe would you like?’

Economist Simon JohnsonOn CNBC’s “Squawk on the Street” on 7 January, MIT economist Simon Johnson delivered a perky, upbeat prediction of economic catastrophe in the next year due to the megalomania of banks that have drunk the too-big-to-fail Koolaid — see “Crisis Just Beginning: Economist“.

You’ll get a kick out of Johnson’s collegial banter with CNBC’s Erin Burnett and Mark Haines — for example:

Johnson: “The next 12 months could really be exciting. People could be very positive. But we are setting ourselves up for an enormous catastrophe.”

Haines: “Aw, man! Here we go again! Isn’t there anybody who comes on this show and doesn’t see storm clouds on the horizon? What kind of catastrophe?”

Johnson: “Ah, well, what kind of catastrophe would you like?”

Enjoy the full five minutes of comradely back-and-forth in this video linked from YouTube:

AB — 8 January 2010

‘The whole economy is a pyramid scheme’

That was a quote I picked up from the recently-posted trailer for a documentary called Collapse, which features the ideas of Michael Ruppert, an independent journalist who predicted the current financial crisis in his newsletter From the Wilderness. The movie opens in theaters Nov. 6, 2009.

From the trailer I picked up an interesting quote from Ruppert in the movie:

It’s not that Bernie Maddof was a pyramid scheme. The whole economy is a pyramid scheme.

The mortal blow to human industrialized civilization will happen when oil prices spike and nobody can afford to buy that oil, and everything will just shut down.

Watch the trailer here:

AB — 28 Oct. 2009

‘Life Inc.’ author Douglas Rushkoff on Colbert Report

Douglas Rushkoff, who writes about media and popular culture, appeared July 15, 2009, on The Colbert Report. Rushkoff is currently promoting his new book, Life Inc.: How the World Became a Corporation and How to Take it Back.

Rushkoff does a great job explaining the premise of his book, which is that corporations are only happy when individuals are contributing to the GDP, which is why they are always bugging us to do something productive rather than something useless like, for example, going out and watching birds.

As always, Colbert does a great job of helping Rushkoff explain his book by pretending not to like it. Here’s a link to the video — it’s a great six minutes.

AB — 17 July 2009

The Value of Extremist Economics

An article by Justin Fox in the June 1, 2009, issue of Time called my attention to the economic commentary and libertarian views of Peter Schiff, president of brokerage firm Euro Pacific Capital. (Justin Fox writes the column “The Curious Capitalist” for Time. The article I’m referring to was called “Excluding the Extremist” in the print magazine but is called “Why We Should Listen to Peter Schiff’s Bad News” in the online version.)

While most other economic commentators were trying to prop up the smiley-face view of the economic prospects during 2006 and 2007, Schiff was warning that the economy was heading into a serious recession because of too much debt and a broken banking system, and that the stock market was due for a crash.

Commenting as part of a panel for Fox News on 18 Aug. 2007, Schiff said the following:

The worst is yet to come, the fundamentals are not sound, they’re awful. If the fundamentals were sound we wouldn’t be having these problems.

This to the derisive laughter of the other Fox panel members. In the following video you can see fascinating clips of Schiff during that period going up against the prevailing optimistic wisdom of the time:

Even now in 2009, says Fox, Schiff has not changed his tune:

He thinks the “phony economy” of the U.S. is headed for even harder times. He believes that the crisis-fighting measures coming out of Washington are merely delaying the inevitable, debasing the dollar and loading future taxpayers with huge debts.

Doomsday prophecies aside, though, one of the most interesting aspects of Fox’s column is what he has to say about the value of diversity of opinion, even extremist views. Fox refers to the work of University of Michigan Professor Scott E. Page, an expert in complex systems, political science, and economics.

Including a diversity of views in a set of people working on a problem, writes Page in his book The Difference, increases the possibility that a crucial “savant” will be included in the group and that that is the person who will contribute the nugget that solves the problem:

If we sample widely, we’re more likely to find the one person who can solve the problem or who can make the key breakthough. We did not get the theory of relativity from a crowd. We got it from a diverse, novel thinker in a patent office.

Page’s book explains the research that backs up this assertion.

Some of our research at the Institute for Innovation in Large Organizations (ILO) jibes with what Page is saying. In our 2007 report “Effective Cross-Functional Innovation Groups,” we cited research by Harvard business professor Lee Fleming, who studied 17,000 patents. Fleming encountered an interesting tendency when studying the diversity of innovation teams:

The financial value of the innovations resulting from such cross-pollination is lower, on average, than the value of those that come out of more conventional, siloed approaches. In other words, as the distance between the team members’ fields or disciplines increases, the overall quality of the innovations falls.
However, he adds a big but:
But my research also suggests that the breakthroughs that do arise from such multidisciplinary work, though extremely rare, are frequently of unusually high value—superior to the best innovations achieved by conventional approaches.

The financial value of the innovations resulting from such cross-pollination is lower, on average, than the value of those that come out of more conventional, siloed approaches. In other words, as the distance between the team members’ fields or disciplines increases, the overall quality of the innovations falls.

However, he adds a big “but”:

But my research also suggests that the breakthroughs that do arise from such multidisciplinary work, though extremely rare, are frequently of unusually high value — superior to the best innovations achieved by conventional approaches.

We wrote:

Fleming comments that “when members of a team are cut from the same cloth,” as with a group of all marketing professionals, “you don’t see many failures, but you don’t see many extraordinary breakthroughs either.”

As an example, Fleming says that economists and physicists seem to be able to “team up and innovate efficiently and produce many moderate-value innovations, because their fields are fairly well aligned,” sharing “the common foundational tools of mathematics.”

However, as team members’ fields begin to vary, “the average value of the team’s innovations falls while the variation in value around that average increases. You see more failures, but you also see occasional breakthroughs of unusually high value.”

To me, this emphasizes the value of giving more extreme views a place at the table when tackling complex problems, rather than just laughing them off.

AB — 1 June 2009


Author of ‘Life Inc.’ Bashes Corporatism, Points to a New Way

Recently I’ve learned about a new book, Life Inc., by Douglas Rushkoff, scheduled for release June 2, 2009.

In a recent video, Rushkoff says he believes humanity is at a crucial point, not just a crisis but an opportunity. He thinks this is “probably the first moment in the last couple of hundred years that we’ve had to rebuild our society and our economy on principles that serve humanity instead of killing life.”

Rushkoff says he doesn’t believe banks should be rescued — but that we should let them die “so that we can get on with business.” What he means by that is new forms of business and investment that focus on local communities.

In his new book and in the video talk, Rushkoff advocates ways people can “start investing in one another and with one another and make their towns better, actually earn returns that you’re not going to get from your Smith Barney broker – I promise you that – and see the return of your investment in the place you actually live. That’s not hard to do.”

In the Life Inc. book, and in the video in a briefer form, Rushkoff traces the history of the current economic predicament. He points to the Renaissance as a crucial starting point. During that period, he proposes, the world economy changed fundamentally when monarchs, to stem their loss of power, ceded monopolies to corporations:

The renaissance was not a golden age. It was the end of a golden age. The renaissance was the moment in history when kings decided they were going to monopolize all of the value that people were creating throughout western Europe.

Instead of letting people make stuff and trade stuff, they created chartered corporations ….

 They picked individual businesses to charter and in return for the exclusive control over an industry or over a region, that company would then give the king shares of stock.

People would have to work for corporations. Instead of letting people in different towns make their own money, everyone would have to use coin of the realm. Instead of people creating and trading and selling art, now you would have to have a sponsor, a patron, who would then bring you to court and let you be an artist.

This centralization of economic power has continued as the model up to our time, says Rushkoff, and has resulted in a worldwide “dehumanizing trend,” in which humans are disconnected “from their own labor, from their own consumption, from their own pleasure”:

The society that we built for the industrial age was built to mythologize the mass-produced object, because we needed to create a society of consumers who thought that buying all of this stuff would somehow make them happier.

Here is the entire video talk:

AB — 11 May 2009

Did “animal spirits” mess up the economy?

Could “animal spirits” explain the unpredictability of economies and the emergence of economic bubbles? Economists George A. Akerlof and Robert J. Shiller believe so, as they explain in their recent book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism.

Their use of the term “animal spirits” does not derive from animism or from its cousin sociobiology, but from a statement by John Maynard Keynes in his 1973 book The General Theory of Employment, Interest and Money (pp. 161-2, boldface mine):

Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits — a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

In an excerpt from their Animal Spirits book in The McKinsey Quarterly, Akerlof and Shiller describe these animal spirits as irrational forces that can cause volatile market fluctuations, often contrary to the rationality that should guide markets under classical economic thinking.

While acknowledging that markets are indeed influenced by people’s rational self-interested behavior, Akerlof and Shiller maintain that

they are also guided by noneconomic motives—“animal spirits”—which Adam Smith and his followers largely ignore. Sometimes people are irrational, wrong, shortsighted, or evil; sometimes they act for action’s sake; and sometimes they uphold noneconomic values like fairness, honor, or righteousness.

In the excerpt, they lay out five aspects of animal spirits that affect the economy:

  1. confidence and the feedback mechanisms that amplify disturbances
  2. the setting of wages and prices, which depend largely on attitudes about fairness
  3. the temptation toward corrupt and antisocial behavior
  4. the “money illusion,” or confusion between the nominal and real level of prices (so that people, for example, often miss the fact that conservative investments may be risky in times of inflation)
  5. the story of each person’s life and the lives of others—stories that in the aggregate, as a national or international story, play an important economic role

The authors believe a new regulatory regime is needed that takes into account the animal spirits that drive markets. New regulations could help prevent volatility and collapse of markets, as well as the need for crippling public bailouts.

But interestingly, they also highlight the need for a new “story” about the economy:

For decades, the dominant story about the economy maintained that all the fluctuations described previously had a rational basis. During the bubble years, the story also held that any risk arising from assets such as houses and subprime mortgages could be managed through complex financial devices like securitization and derivatives, which were largely unregulated.

Then the story changed. The new one suggested that all this complexity was just a novel way of selling snake oil. As the new story about Wall Street and its products took hold, the life drained out of financial markets. Housing prices sank, the demand for exotic products collapsed, and the credit crunch began.

Now, they stress, “there must be a new story about markets — a story that doesn’t always predict sunshine.” This story acknowledges “that animal spirits play a significant and largely destabilizing role.”

Although regulation takes place at the level of government, stories or narratives play out in the public forum and in the media — as well as in people’s own minds and their interactions with others. The need for a new story has implications about how people set personal goals and what they strive for in life.

AB — 20 April 2009