Why Large Derivatives Traders Need to be Managed

The Risks of Securitization

With so much money on the line, things can go very wrong when they go wrong with derivatives trading. This is a fact that has really only been brought to light during the collapse of the housing market that we saw in 2007-2008, a bubble that was to a large degree driven by securitization of mortgage debt.

There is no question in fact that securitization made this crisis much worse, something that detractors of institutional securitization are quick to point out. Securitization ended up watering down the normal controls that banks had in place to keep default risk in check, as they were able to look the other way to an alarming extent and just sell off the debt to those whose scrutiny and risk controls were significantly reduced.

The example of the strategy of basing one’s ability to repay mortgages on being able to refinance them in the future is a perfect example of how things can go wrong with this approach to risk management.

Provided property values kept rising, this will work very well, and even allow those who cannot afford the payments on a property to be able to keep things afloat. All we do is just set up a negative amortization schedule for now, where they end up owing more, not less, over time, and then tap into the increased equity from increasing property values to make up the difference.

Retail lenders would never go with such a hare-brained scheme if they had to bear the risk themselves though. This strategy does not just presume increasing property values, it depends on it. We know though that this does not always happen and property values do go down. When they do, if this means a huge amount of defaults, that’s just not an acceptable risk for a lender to ever take, even the ones with the largest risk appetites.

If they can sell this debt though to those who are not anywhere near as conservative, then this can all work, for the lenders that is. When the market for mortgage backed securities reaches a frenzy of demand that requires more supply, the standards can go down like this, where even having the income to even come close to qualifying normally can be overlooked.

Banks are normally regulated though, at least in terms of their traditional activities, taking money on deposit and lending it out to qualified borrowers. If they can offload the debt on the securities market though, this can greatly increase their ability to lend, and more lending naturally means lower standards of lending, something we need to be careful with.

Investments Generally Garner a Lot of Oversight as Well

While we seek to regulate banks pretty strictly, we also regulate financial markets at least as stringently, if not more. Securities are generally regulated very tightly, and some may argue that we over-regulate here if anything, at least at the retail level. At the institutional level though, there is far less oversight.

Why Large Derivatives Traders Need to be ManagedA big part of this regulation is the need to make the risks involved with securities investing transparent, although in this regard we really don’t do a very good job at this at all. We may tell people that a certain type of investment is riskier, and leave it at that, and if the investor takes on the risk, they have somehow been made more aware.

Mortgage backed securities have traditionally been a fairly conservative investment indeed, comparable to bonds, and less risky than stocks for sure. Provided that the mortgages included in them are good ones, this is indeed the case, although if they get watered down by a lot of mortgages that never should have been granted, and have a high degree of risk to lenders, that can be a whole different story.

It is fair to say that during the frenzy that traders, investors, and institutions had for mortgage backed securities prior to the collapse of this market, people really didn’t understand the risks involved until it was too late. This is entirely the fault of regulators, and even may have us wondering whether the tail did not wag the dog here, whether all that money put into this didn’t have regulators being too accommodating.

The truth is, this is exactly what has happened, as we never really did have any meaningful attempt at sufficient transparency with these securities, even though it should have been clear that the risks involved were much more substantial than what we were told by those selling these securities.

The mortgage backed securities debacle was merely the tip of the iceberg as far as what really happened during this crisis, as most of it had to do with much bigger deals involving much larger derivatives contracts, but does go to demonstrate that large institutions certainly cannot be trusted to manage their own affairs with no real oversight.

What Really Drives Institutions

Many people were appalled when they got a glimpse at how these institutions really operate and how risk management can take a big back seat to what we could call production.

The idea that people who run big financial institutions have the long term health of the institution at the forefront of their concern or even if this is considered to be much of a concern at all is one that is for the most part pretty naïve.

The people who work for them, from the top executives right down to the individual traders, are simply not incentivized toward this goal. If the institution collapses, they may be out of a job, so it’s not that this doesn’t matter, but the incentives they receive tend to place things like risk and long term organizational health on the back burner.

Instead, their sights get set more on the huge bonuses that they are eligible for should the short term profits of the institution move the right way. This can work out great for them, but not so well for the institution itself, which can be very easily exposed to excessive risks from this.

Imagine a retail bank having its people just paid on the basis of how much money they lend out. What would then happen is the bank would become over leveraged, and in particular, have too many loans that are too risky. Default rates would rise, the debts would mount, and this would eventually bring down the bank.

Some lenders do lend to those who do not qualify for bank loans but within reason, and get compensated with much higher rates, so they can bear this burden. What we take in must match the risk we take on, otherwise things may not end up that well.

We do need to be always aware of the risk side of things though and make sure that we can handle the risks, and this is where the large financial institutions that deal in huge amounts of derivatives can really drop the ball.

The source of this problem is when we provide people with all the benefits of positions without making them accountable enough for the risks involved in these positions. When you make a lot of money when you make the firm a lot of money, but you don’t bear the corresponding risk of losses, then it can only be expected that you will be more aggressive, and too aggressive.

The Impact of Competition

During a major upward run, you don’t want your firm to fall behind its competitors, and this is especially the case with large financial institutions. If one firm is making a lot of money taking on a lot of risk, even though the risks may be excessive and a poor idea, you don’t want your firm to be seen as a poorer performer.

This even extends to shareholders, and perhaps especially extends to them, as if the shares of your competitors are increasing in value more than yours, this is going to matter.

This can create an environment where there is a race on and everyone may be traveling at speeds well in excess of what is safe, but no one wants to be seeing as falling behind. In the words of one executive, they had to keep dancing as long as the music was playing, even though it may not even have been sensible to do so.

The Repercussions of All This

If this merely involved smaller, less significant companies, then we could just write this all off to the way business operates. Those who take on too much risk may fall, and that happens all the time in business.

Those who lose money lost the money they put up, and whether deservedly or not, that’s just what happens sometimes.

The real problem with large institutions failing though is the impact of all of this on the economy, which is plenty big indeed. So, some institutions are allowed to fail and some are deemed too big to fail, and receive huge bailouts, as we saw recently.

This worsens the situation, where the companies benefit from excessive risk taking and pocket the profits, while the public bears the risk. This is a perfect situation for them, but for us, not so perfect at all, in fact pretty terrible, because we just end up rewarding people for risky conduct and pay the price.

The nature of derivatives lend themselves very well to not managing the risks they represent, since managing these risks is so much more challenging then anything we’ve ever seen. This just makes trying to do so even more important though.

If we simply allow this to happen without a sufficient amount of oversight to at least require that more sound risk management be practiced, then this will just happen again, because there’s no good reason why not.

To the degree that the public has a vested interest in this risk management, and it’s clear we do since we do and probably still will bail out these firms, we need to be diligent in seeking to protect ourselves from these failures in the future.

While we do need to be careful to not seek to over-regulate financial institutions, erring too much on the side of caution, the proper balance does need to be sought, which isn’t leaving investment banks and other huge entities to just police themselves for the most part when it comes to their derivatives holdings and risks.

The recent events that we saw was indeed a wake up call, but we need to make sure we remember these lessons going forward. Wall Street does throw around a lot of money though, and they will no doubt be quite eager to eat drink and be merry, and not worry about the tomorrow you will die part, but someone needs to hold them accountable for this.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: [email protected]

Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.