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Mr. Greenspan: a Proponent for Derivatives

by David Tice

The week is off to a bearish start as the Dow, S&P500, Utilities, Morgan Stanley Cyclical index, and Morgan Stanley Consumer index have declined about 2% so far. The transports have been hit hard, declining about 4% and the small cap Russell 2000 continues to struggle, dropping about 3%. In a development that must be disconcerting for the bulls, both major leadership groups, financials and technology, trade poorly. So far this week, the NASDAQ 100 and Morgan Stanley High Tech index have declined about 2%, the semiconductors 4% and the Street.com Internet index 5%. The S&P Bank index has declined 3%, and the Bloomberg Wall Street index has been hit for 4%. The bond market continues to trade unimpressively, as does the dollar. The fact that both the dollar and Treasuries are not trading better is particularly interesting considering one would have expected some"safe-haven" buying because of the developing crisis in Kosovo.

Last week, Mr. Greenspan spoke before the Futures Industry Association where the topic of his speech was financial derivatives. He began his speech stating "By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives." He goes on to say that the total amount of derivatives globally now likely approaches $80 trillion. For US commercial banks, alone, the number is $33 trillion, which compares to total commercial bank equity of about $460 billion. Derivative positions have grown since 1990 at a 20% compound rate. And while it would have been reasonable to expect a more cautious approach to derivatives after the recent debacles in Asia and Russia, our banks have shown anything but caution. US banks have expanded total derivative positions by 30% the past year. This is appalling and it is simply unthinkable that Mr. Greenspan remains such a devoted proponent of derivatives. All the same, Mr. Greenspan explains, "The reason that growth has continued despite adversity, or perhaps because of it, is that these new financial instruments are an increasingly important vehicle for unbundling risk." Later, he adds, "In short, the value added of derivatives themselves derives from their ability to enhance the process of wealth creation." Mr. Greenspan also makes the claim that "derivatives are mainly a zero sum game: One counterparty's market loss is the other counterparty's market gain."

We are afraid that Mr. Greenspan is completely mistaken about derivatives. In past speeches, he has even gone so far as to make the claim that derivatives have increased the standard of living for citizens globally. We doubt too many government officials or citizens in Asia, Russia or Brazil would see derivatives in such a positive light. Indeed, derivatives were much a contributing factor to the currency crises in SE Asia, and later, Russia and Brazil. First, investment bankers created huge amounts of sophisticated derivative instruments involving Asian currencies and securities as part of the enormous increase of global capital that flooded into the region between 1993 and 1996. Wall Street derivative departments created very popular instruments to participate in the Asian Tiger "miracle". (For a great read, check out the book F.I.A.S.C.O. by Frank Portney) It became very fashionable in the US hedge fund industry to buy call options on SE Asian equity markets. It became commonplace, as well, to buy sophisticated derivatives that, for example, would allow the holder a big bet on Thailand debt securities with funds borrowed in Japan at low rates and through shorting the Japanese yen.

These derivative trades had all the appearance of "easy money", leveraging the interest rate differentials between various markets, until it became clear to some that the region's big financial and economic bubble was in jeopardy. Then, capital flight quickly led to currency pressure and, quickly, the breaking of currency pegs. These pegs had, for years, held many Asian currencies to the dollar and were critical to enticing foreign capital into these economies. But when investors wanted their money back, there was no one to take the other side of the trade and the pegs broke almost instantly. As always, markets work great during bull periods when money is coming in, but falter quickly when money wants to get out.

The derivative trades broke with the Asian currencies, as these highly leveraged speculations were but a house of cards that quickly collapsed. An unwinding of these derivative positions led to a wholesale dumping of the underlying currencies and securities, leaving markets frozen in illiquidity. In South Korea, where the Korean won traded with a 10% daily price change limit, this currency traded "limit down" four straight days as huge sell orders swamped the market and no buyers could be found. Throughout the region, derivative-related forced selling led to the virtual collapse of currencies, securities markets, financial systems and economies throughout the region. In Russia, foreign investors who were speculating aggressively in the Russian debt markets entered into derivative contracts with Russian banks to protect against a decline in the Ruble. When the Ruble collapsed, the Russian banks also collapsed and defaulted on their derivative obligations. It became one big derivative fiasco.

Importantly, many "hot money" speculators and institutional investors that came to the region were under the assumption that it would be possible to use derivatives to protect against loss; to use them as insurance. The belief was that when storm clouds approached, they would simply call their favorite Wall Street derivatives trader and buy puts to protect against loss. Importantly, this assumption of the easy and inexpensive availability of insurance changed behavior; investors took more risk then they would have, had derivatives not existed. In this regard, a good analogy would be the availability of inexpensive flood insurance leading to homeowners building expensive homes along a river, within the "100 year floodplain". Everything is great for awhile, as considerable building takes place along the river and insurance companies makes lots of easy money writing flood insurance. But, unfortunately, it is a disaster for all involved with the inevitable arrival of the wipeout flood.

A massive "flood" hit the emerging markets and it was truly an absolute wipeout. Derivatives had enticed imprudent behavior by investors and absolutely reckless behavior by speculators. Derivatives did not contribute to wealth creation, but, instead, exactly the opposite. They were a major factor leading to huge "hot money" flows, a complete distortion of risk perceptions and they certainly became a major factor behind the huge financial excesses and economic distortions that led to the region's terrible bubble and collapse. Unfortunately, we see all the same types of behavior in the US today. In Asia, when the crisis developed, market participants not only tried to dump their leveraged derivative positions, they also attempted to purchase derivatives as insurance, much like homeowners on a river trying to buy flood insurance after the heavy rains begin. This only exacerbated the crisis and led to a self-feeding meltdown.

What was not appreciated in Asia or Russia then, and what is certainly not understood in our market today, is that only individual market participants can hedge exposure with derivatives, not the entire market. If much of the market attempts to use derivatives for hedging, there is simply no one with the resources to take the other side of the trade. If no one takes the other side, the only way to hedge is to sell securities and, when the crisis begins, prices collapse as derivative-related selling simply overwhelms the market place. With about $14 trillion of stock market value in the US today, the market is too large for significant amounts of risk to be "unbundled", as Mr. Greenspan likes to say. Indeed, who has the resources to "insure" against a 25% market correction that would involve stock market losses of $3.5 trillion? The answer is no one.

Granted, derivatives have worked well in the US equity market so far, just as they appeared to work great in Asia and Russia during their respective bull markets. It's been like writing flood insurance during a long drought. However, derivatives are much a bull market phenomenon. They work splendidly when prices rise and their most favored use is for leveraged speculation. They don't work well at all and are, in fact, disastrous when a bear market strikes and the underlying derivative leverage is exposed. The panic is only further exacerbated by put buying for insurance purposes. Here, as was the case in SE Asia and Russia, they hold the potential to create a debacle. We mention derivatives today as we believe they will become a major issue going forward in the developing bear market.

It is our view that derivatives have come to have too much impact on our stock market. We suspect that huge amounts of hidden leverage exist through derivative speculations. Certainly, the Dow's run last week to 10,000 was much related to derivative trading and options expiration. It is certainly our belief that derivatives will be a major factor in the coming US stock market decline. Mr. Greenspan was Fed Chairman back in 1987 when portfolio insurance derivative strategies were a major force behind the crash. It is just shocking that he has become such a proponent of derivatives and believes that they actually reduce risk when it is patently obvious that a proliferation of derivative trading only greatly increases systemic risk. With the coming crisis it will become obvious that losses for our financial system and economy will be anything but "a zero sum game"!

by David Tice / Prudent Bear Fund
March 24, 1999

Copyright © 1999 by David Tice. All Rights Reserved.

Reprinted by USAGOLD with permission of Mr. Tice. No further reproduction without permission.

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