The Financial Crisis: Law matters.

Introduction[1]

The past few years, politicians, economists and the media could not stop talking about the financial crisis. This should not be surprising, since billions of tax dollars/euros were needed to avert a complete financial meltdown.

When you ask someone on the street what the cause of the financial crisis is, they will probably note it is due the mortgage crisis in the United States, which triggered the financial crisis. The financial crisis could not have been foreseen, it was just tough luck. This narrative can be called the mainstream picture of the financial crisis.

This essay, however, will argue that the cause of the financial crisis was a change of the law in the United States, and that the financial crisis could have been, and was in fact, foreseen.

This essay will first explore the basic concepts needed to understand how a change in the law was a condition sine qua non for the financial crisis to occur. Secondly, the evolution of the legal approach to derivatives in the United States and how a change in the law made the financial crisis possible, will be explained. Lastly, this story will be analyzed with the help of legal theory.

Hedging vs. Speculation

Definitions

The essence of all derivatives is not hard to describe. In fact they are all ‘bets’. This is not just a figure of speech, they are literally bets. They are agreements between two people where one will pay the other depending on whether or not a certain event occurs. Financial derivatives are derivatives where the ‘certain event’ is a financial phenomenon. This is e.g. interest rates, value of a certain stock or commodity, whether a debtor will default on its loan or not,… Every time the requirement of the derivatives contract manifests itself, money changes hands.

The difference between hedging and speculation lays in the fact whether or not a contracting party has exposure to the manifestation of the event in the derivatives contract. This can be demonstrated through credit default swaps (CDS), a derivative where the certain event is if the debtor will default on its loan.

Example Hedging: Bank A issues a loan of 1 million to debtor B. However, Bank A does not like the risk and concludes a CDS with a third party X. X receives a fee for the obligation it has taken on, namely to pay the difference between the face value and the market value of the bond when the debtor defaults.

The example above, is hedging, because A has exposure to the loan and A chooses to pass on the risk of a default to X.

Derivatives are used for speculation when both parties do not have any exposure to the financial phenomenon underlying the derivative.

Example Speculation: Bank A concludes a CDS with X. Neither party is exposed to the underlying asset.

In other words, bets can be used as insurance against an undesirable event or bets can be used as speculation, namely trying to gain a profit by better predicting future events than your counterparty.

Financial derivatives: consequences for social welfare.

Derivatives contracts are always zero sum games, because no value is actually being created. These derivatives can be used for hedging and speculation purposes, consequently, the benefits for social welfare will vary accordingly.

Hedging can have significant social welfare benefits. The whole insurance market is in essence a derivatives market used for hedging. Take for example a fire insurance contract. This is a bet, where the policyholder is betting that the house will burn down by an act of God. Consequently when it does, you win the bet and the loss of the house has been set off by the winning of the wager. The insurer is betting that not too many houses will burn down, so the premiums yield a profit. The insurance buyer and seller are both better off at the end. This use of derivatives has social value.

Speculation does not produce these welfare benefits, since there is no exposure to the underlying event. It is just a gamble, not much different than betting at the horse or dog track.

Financial derivatives: consequences for systemic risk.

The consequences will again vary in function of the purpose of the financial derivatives. Hedging does not create additional risk. One is just transferring the impact of the manifestation of a risk to another entity in return for a fee. Speculation on the other hand, does create additional systemic risk, because there is no exposure to the underlying phenomenon until the derivatives contract is concluded, but after the conclusion of the contract, the systemic risk has increased since the parties has exposed themselves to the underlying event.

Example Hedging does not increase systemic risk: Bank A issues a loan of 1 million to debtor B. However, Bank A does not like the risk and concludes a CDS with a third party X for the full amount of the bond. X receives a fee for the obligation it has taken on, namely to pay the difference between the face value and the market value of the bond when the debtor defaults.

When B defaults on its financial obligations, B will go bankrupt, pay part of the bond back to A and X will have to pay the difference between what is paid by B and the face value of the bond. Let us suppose that B can still pay 200.000, which means that X will have to pay 800.000. Because of the CDS, A does not incur the loss, but X does.

The element that is important for systemic risk in the example above is that the total impact of the manifestation of the risk that B defaults on its loan, never increased. It was always 1 million, but the party that needs to incur the loss shifted.

Example Speculation increases systemic risk: We take the factual situation above, but instead of one CDS between A and X, there are now 4 CDS contracts (W-X-Y-Z), all for the full value of the bond.

Again B defaults on its obligation, and again B can pay 200.000 back. This implies that W,X,Y and Z need to pay 800.000 each. This means that A will receive a total of 3,4 million.

The total impact of the manifestation of the risk that B defaults on its loan, increases in this example to a total of 4 million. This shows that betting on underlying events to which neither party is exposed, increases systemic risk.

The Story

Old common law

Some experts give the impression that financial derivatives are something new, an innovation of the past few years. This idea, however, is quite mistaken. Derivatives have been around for many centuries.

The common law tries to make a distinction between hedging and speculation in order to take into account the different implications on social welfare and systemic risk. It accomplished this by focusing on whether a party is exposed to a change in value of the underlying asset. This is the case if a party owned the asset or was expected to take delivery of it. Problems relating to the enforcement of speculator’s contracts needed to be addressed by the speculators themselves, since the courts deemed them unenforceable. The case law of the 19^th century clearly shows the economic reasoning behind it.

Firstly, the courts wanted to avoid the waste of human capital, because speculation would be a negative sum game. Secondly, there was the understandable fear of manipulation of the value of the underlying events by speculators in order to win bets. Lastly, there was the fear that speculation would increase systemic risk.

Private exchanges

Since courts refused the enforcement of difference contracts used for speculation purposes, speculators needed to enforce their contracts privately. They used a system where one could only trade in derivatives if there was another exchange member who guaranteed performance. To become a member, one needed to fulfill all kinds of requirements.

Codification of the common law

The system described above, worked for centuries. The exchanges were stable and it does not seem they added systemic risk. Some dealers in physical commodities complained that speculators were fixing prices and in response to this concern, Congress took an interest, which resulted in the Commodity Exchange Act (CEA). It created The Commodity Futures Trading Commission (CFTC), which was in charge to enforce the CEA.

The CEA prohibited Over The Counter derivatives (OTC-derivatives) outside of regulated exchanges, unless it was a futures contract that was going to be settled by actual delivery. The CFTC was given the power to regulate the private exchanges and oversee them

Innovation in the derivatives market

Until the 1980’s, speculators bet on the rise and fall of commodity prices. But then Wall Street stumbled upon the idea of betting on all kinds of financial events. One of the most prominent examples is the rise of the OTC market for Interest Rate Swaps (IRS). These OTC swaps would have been void under the CEA, since it is an OTC derivative. The industry was aware of this problem, and lobbied to ensure that the OTC Swaps would be left alone. Following this, the CFTC issued in 1989 a safe harbor statement in relation to these OTC Swaps. This was the first time that an OTC derivative was enforceable before a court and could be traded outside of the regulated exchanges.

 In 1992, the CFTC was given power to exempt various OTC derivatives from the CEA.

The CFTC received a new head who tried to exercise control over the OTC derivatives market. The OTC derivatives industry was an organized, powerful and influential interest group by that time and the CFTC was no match for them. Following this struggle, congress limited the power of the CFTC to regulate OTC derivatives and enacted the CFMA.

CFMA

The Commodities Futures Modernization Act (CFMA) was enacted in 2000. For the first time, legal certainty was given to virtually all OTC financial derivatives if the parties were eligible contract participants (banks, pension funds, hedge funds, corporations,…). The CFMA accomplished this by excluding most OTC derivatives from the CEA and its ban on off-exchange trade.

The stage becomes set

Following the enactment of the CFMA, the OTC market grew from 88 trillion dollar in 1999 to 670 trillion dollar in 2008. 670 trillion dollar equals four times the total per capita wealth of the human population.

This dramatic increase in size of the OTC market, gives evidence that the legalization of OTC trading resulted in an increase in financial risk, if the preponderant part of the growth of the OTC market is due an increase in speculation. There are several reasons to believe that it was the case.

Firstly, there is the size of the OTC market in comparison with the size of the real economy.  It is hard to see how insurance for 1 million dollar on a 250.000 dollar house can be qualified as hedging.  Furthermore, it is important to note that the OTC market works with a few favorite underlying assets, which makes the disparity even greater. Secondly, there is the fact that the OTC market only grew so much after the legalization of pure speculative derivatives. Thirdly, there are the different players. The big OTC market was flooded with institutional investors, while the small OTC market was characterized by big companies active in the real economy. Lastly, there is the fact that the CFMA’s passage combined with the growth of the OTC market, resulted in the sort of risks that economic theory predicts in the case of increased speculation.

How the CFMA ‘caused’ the Financial Crisis

Congress investigated the causes of the financial crisis and concluded in relation to the CFMA that it was the primary cause of the Panic of 2008, in the sense that the crisis would have been smaller, more confined and less economically destructive and might even have been averted entirely, if the CFMA had not been passed.

The growth of the speculation in the financial economy explains how a big shock in a relatively small market, namely the real estate market of the US, triggered a global financial crisis. Investors, who lost their bets because of this sudden collapse in prices and the increase in defaults of mortgages, needed a bail out from the government. This caused rumors and distrust between banks, resulting in the refusal of banks to loan to each other.

In other words, the impact of the materialization of a certain risk has increased tremendously because of the astronomical seize of the OTC derivatives market. Speculation is why an American mortgage crisis became a global financial crisis.

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[1] This essay relies heavily on the article of L. Stout, “Derivatives and the legal origin of the 2008 Credit Crisis”, Harvard Business Law Review 2011, Vol. 1, p. 1-38.