The Devil's in the Derivatives

Winton says the worries focus on two types of credit derivatives: investment funds known as collateralized debt obligations, and a specific type of these funds called collateralized loan obligations. The former buy bonds, including mortgage-backed securities. The latter buy corporate loans, including much of the debt used to finance the boom in takeovers by private-equity firms. Investors lost confidence in these obligations this summer. Restoring it might not be easy.

On July 24, when I did my first interview with Winton, he pointed to an important story breaking as we spoke. Rising mortgage defaults had led California-based Countrywide Financial, the nation’s largest mortgage lender, to post a big slide in second-quarter earnings and slash its outlook for the year. That story helped to stir worldwide tremors over the troubles in the U.S. subprime market, and in the country’s overall housing market. 

The housing market in the United States has turned down due to sluggish home sales and record numbers of mortgage defaults after years of robust growth, raising questions about the strength of the country’s overall economy. The longer housing troubles last, the more likely consumers are to cut their purchases.

But for some, the financial innovation Bookstaber explores in his readable and at times chilling book is taking center stage. The world is certain to face intermittent and worsening financial crises, he argues, unless Wall Street curbs its appetite for employing “every financial instrument that can be dreamed up,” and for leveraging transactions with staggering amounts of debt.

Bookstaber runs an equity hedge fund, and was a top risk manager on Wall Street during both the 1987 stock-market crash and the 1998 credit-market turmoil ignited by the collapse of the Long-Term Capital Management hedge fund. As a bit player in those crises, he takes a tiny share of the blame for both.

“The financial markets that we have constructed are now so complex, and the speed of transactions so fast, that apparently isolated actions and even minor events can have catastrophic consequences,” he writes. “And these cannot be easily disarmed through oversight or regulation.”

Bookstaber says simpler financial instruments and less leverage suggest a “painfully obvious prescription for fixing the design of our markets.” He believes disclosure or regulation would only make things worse by adding more layers of complexity.

Winton suggests requiring more disclosure, to strengthen investors’ confidence in the new financial instruments. He also suggests examining how markets have reacted in the past. Worth examining are the records of three publicly held Twin Cities companies that were sold off after risky excursions into subprime lending: Green Tree Financial (mobile-home loans), Metris (credit card loans), and Olympic Financial (auto loans). Tighter credit standards at these companies could have prevented their troubles, just as they could have kept some of today’s subprime debacles from happening.

Winton and Bookstaber agree that while financial innovation is out of control, there’s no way to turn back to a derivative-free era.

“I certainly don’t see how we can get the genie back in the bottle,” Winton says. So fasten your seat belt. We could be in for a lot more tumult in the global financial markets.