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The world according to Martin Mayer

Martin Mayer, a fellow at the Brookings Institution, is one of the world’s leading observers of the financial markets. He is the author of 32 books, including The Bankers, The Fate of the Dollar, The Money Bazaars, The Markets and others that have been widely acclaimed and translated into several languages. He is frequently called on to testify before congressional committees and was an expert witness in the Joseph Jett trial. Most recently, he has written extensively on issues involving risk reduction and the emerging markets.

Derivatives Strategy: Tell us about Mayer’s Laws of Derivatives.

Martin Mayer: There are three laws. The first is that when the whole is valued at less than the sum of the prices of its parts, some of the parts are overpriced. What this usually means is that you’ve separated out and sold the toxic waste, and you’ve found customers for the Z tranche.

I understand the argument that there are costs involved in breaking apart these instruments and that in fact you are catering to different markets, to people who want to buy something that is more exactly tailored to their needs. There is a reasonable case to be made that you can in fact take an instrument and break it into a number of different parts and that the different parts will sell—even in an honest market—for more than the total instrument.

But I’m still willing to stick with my law because there are ways that you can fiddle with these instruments. When I was on the housing commission for President Reagan, I was involved in the design of the REMIC. As everybody who’s dealt REMICs knows, you have to find the parts that are priced to make the division of the instruments profitable.

The second law states that when you segment value, you also segment liquidity. The second law is absolute. The very factors that allow you to sell the part for more mean that you’ve tailored the instrument to the needs of specific customers. And that means that in the end you have a smaller market for these parts than you might have for the instrument as a whole. That’s demonstrably true.

The third law involves the deconstruction of credit judgment. The rule holds that risk-shifting instruments will tend over time to shift risks to those less able to bear them, because “them as got want to keep and hedge, and them as ain’t got want to get and speculate.” It always turns out that you do business with firms that are B-rated and worse, because you can get the best prices out of them. So there’s an inherent instability in the tendency of credit judgment to deteriorate as you make money going down the credit scale.

I’ve worked on a fourth law, but haven’t come up with the right aphorism. That law will hold that the more abstract the instrument, the less it depends on real developments in real economies, and the more likely it is to be a vector of contagion. When you are comparing things that are extremely dissimilar, and when you have correlations without causes, you are creating the opportunity for contagion—and in a dynamic hedging environment you are indeed creating a virtual certainty of contagion.

DS: Let’s talk about liquidity, since that seems to be what brought Long-Term Capital Management to its knees.

MM: To me the most remarkable moment in the whole affair was when LTCM said last fall that it was disadvantaged because, unbeknownst to it, other firms were following the same strategy. If you don’t know what other people are doing, how can you have the slightest notion of what risks you are running?

If you go to the theater and there’s a nut running around shouting fire, you have to decide how close to the exit you’re going to sit on the basis of how many people are in the theater. But in this case, you don’t know how many people are in the theater. You are making the assumption that you can always get to the exit. And that, of course, is the central problem with dynamic hedging. In a world in which you have no notion of where the open interest is, you have no notion of the risk.

There are still lots of long-dated currency options and non-deliverable forwards on the Russian ruble out there that people are carrying at what they paid. They haven’t taken the losses yet. Even the one-year contracts are just beginning to come due now. There is some question about whether the banks intend to argue that they shouldn’t have to pay out money because the Russian default was an act of God. But until these contracts actually expire, nobody knows—and that’s not a good way to run the world.

DS: I suppose you’re saying that risk management can’t make sense if there’s no way to model liquidity. Is that one way of looking at it?

MM: You can’t even think about liquidity until you have some notion of how many people have the same positions as you have. If you’re following a strategy and you have no way of knowing whether other people are following the same strategy, how in God’s name can you even think about the risks of that strategy?

There is never going to be enough liquidity. Dynamic hedging implies that there will be liquidity whenever you need it. To my mind, this is the crucial failure of dynamic hedging.

DS: So hedging and diversification aren’t necessarily a way to get around risk.

MM: You did a Q&A with Nassim Taleb [December 1996/January 1997], who has a little story from real life in his book, Dynamic Hedging, in which the trader comes up with a conclusion that hedging increases your risk. When you are in a dynamic hedging world, hedging may increase your risk. Certainly other people’s hedging may increase your risk.

My colleague Barry Bosworth has stated a great truth—that diversification devalues knowledge. You figure that you can trust the law of large numbers to keep you from getting in trouble. But you can’t. That’s not the real world. In the real world, all of these correlations are going to disappear when there is a spike—and there will be spikes.

“If you’re following a strategy and you have no way of knowing whether other people are following the same strategy, how in God’s name can you even think about the risks of that strategy?”

That’s especially the case when you don’t know what you are doing. In the “emerging-markets” business, people are putting money into places they couldn’t find on a map. There is no way that’s going to reduce your risk.

DS: Do you think the Koreans who bought credit derivatives from JP Morgan knew what they were doing?

MM: That’s an interesting story. The Korean central bank put the country’s reserves into the hands of its commercial banks to increase the return on the reserves. One of the great worldwide problems that does not receive enough attention is that it’s quite expensive for third-world countries to hold dollar reserves, because their earnings on the dollar reserves are less than the interest rates in their own countries. That’s a burden and a continuing source of deficits. What the Koreans did was find all sorts of exotic derivatives, forward contracts, non-deliverable forwards, Ukrainian bonds, Brazilian Brady bonds and all sorts of other garbage into which they put their reserves—in order to yield sufficient interest income so that the Korean government would appear to be making money on its reserve.

That’s the secret of the JP Morgan lawsuit with the Korean banks. It was Korean Central Bank money that these guys pissed away. You had this incredible device—a Malaysian corporation formed to write instruments that would pay off according to the relative values of the Thai baht and Japanese yen, and designed solely for the purpose of selling these instruments to the Korean banks because the Korean Central Bank wanted to increase the return on its reserve.

Once you start to get into this sort of nonsense, serious problems can occur for everybody, because you are dealing in a world of thoroughly artificial instruments that have nothing to do with real production, real consumption, real trade or real anything. They are simply counters in a game. But when the players have to pay off, they have to pay off in real resources, and that sort of thing is extremely dangerous over time.

The comparative value of the Thai baht and the Japanese yen is a matter of importance to the Thais, and of some, but lesser, importance to the Japanese. But it should not be something that is a matter of importance to the Koreans. They should not be speculating in this stuff, and JP Morgan should not be encouraging them to do so. Until there is some recognition of this in the international community, publicly rather than privately, we are going to have repeats of September–October 1998, and one of these days we may not be able to get out of it.

DS: What role did you think over-the-counter derivatives played in the Asian crisis?

MM: Derivatives, shmarivatives. What do you call Brady bonds and futures contracts on Brady bonds? Derivatives are the vectors of contagion because they give you a way to compare and make money on changes in the relative values on the currencies that are not in any way competitive with each other. They are apples and oranges.

In October 1997, when the Brazilian real came under dramatic attack, nobody could figure out why. It turned out that in September ’97, between 20 percent and 25 percent of all the Brazilian Brady bonds were held by South Korean banks. The Brazilian Brady bonds had a large, liquid market because people were making a lot of money trading them and trading derivatives off of them. So when the South Korean banks got in trouble, the easiest thing for them to do was to sell Bradys. The bonds took a hit and the real took a hit. And that’s crazy.

It’s one thing to talk about a spillover effect with countries that are closely related to each other. It’s another thing to talk about contagion. There have been artificial links created between currencies because of the statistical correlation in their path behavior. That has nothing to do with anything. Correlations and causes can get mixed up anytime, but the notion that you put hard money on correlations where there is no—and can be no—causation other than the correlation itself is bad news.

DS: You’ve said before that you think derivatives dealers put demands on liquidity that exceed what the markets provide under conditions of stress.

MM: Absolutely. When things are going well, you get a great increase in the volume of trading because there is more stuff to trade. But when conditions are not going well, suddenly it all dries up. Liquidity dries up because banks panic, and banks panic with some reason. Anything that relates to call money markets is going to seize up when things spike. If the valuation of your instruments is highly dependent on the liquidity in the market that lets you sell your hedges, then you’re going to be stuck the way LTCM was stuck.

“The comparative value of the Thai baht and the Japanese yen is a matter of importance to the Thais, and of some, but lesser, importance to the Japanese. But it should not be a matter of importance to the Koreans.”

What’s really happening is that the guys selling the hedging instruments are writing a form of insurance. It’s catastrophe insurance, but they don’t know it’s catastrophe insurance, so they have no way to price it that gives them accurate premiums for the risks. Nobody knows. The question is whether there shouldn’t be some regulator making sure that when the insurance doesn’t pay off, important players don’t go absolutely insane and bust. That’s got to be addressed.

DS: What would you do if you were the regulatory czar of the financial world?

MM: I would require an open registry of instruments and I would require transactions to go through clearinghouses. I think we are moving toward a world of renewed correspondent banking, and we’re going to have more payments done on a correspondent-banking chassis. An OTC derivatives contract is a correspondent-banking instrument and it’s going to get in trouble the way other correspondent-banking instruments do, because no correspondent bank knows what its respondent bank is doing outside the individual private relationship.

I want this stuff moved onto exchanges. I want the settlement to be done out in the open, and I want there to be a clearinghouse in which the clearinghouse itself has a registry of large-trader positions and open instruments.

Now, there are various ways to go about doing this. The Portuguese central bank requires a register of borrowers from Portuguese banks. They don’t tell you which bank wrote which loan. They simply tell you the total indebtedness of these organizations to Portuguese banks. That’s a public register. I think it would be helpful to have public registers of the total exposure of a banking system to borrowers. A registry of arge-trader positions is more controversial because questions can arise as to whether people can develop a strategy. But certainly a register of total open interest in certain kinds of contracts is possible, and I think this could probably be done through the Bank for International Settlements. The problem is that although the BIS really does believe in transparency, central banks really don’t believe in transparency.

DS: What do you think of the BIS’s recent decision to assess the credit risk on loans by reference to ratings?

MM: Banks are supposed to do information-intensive lending. The notion that the ratings agencies know what the risks are on loans better than the banks do—well, that’s really remarkable. It means that everybody has adjusted to a world in which banks are not going to hold loans in their portfolios. They are going to sell them off. And the ratings are important for the purpose of selling off the loans.

“ I want this stuff moved onto exchanges. I want the settlement to be done out in the open, and I want the clearinghouse itself to have a registry of large-trader positions and open instruments.”

If your risk component in lending is based on how easy it is going to be to sell what you bought, then the people at Moody’s, Fitch, and Standard & Poor’s are the people you want to listen to. But that denies the essence of the bank’s role in the financial market. They are supposed to know their borrowers and, increasingly, they don’t.

DS: Why is that the case?

MM: Our problem is that we’re moving away from a bank-dominated world in which banks had information that other people didn’t have and could set their course based on it. In this world, the regulators would value the portfolio and the market wouldn’t know what the portfolio was. A bank portfolio was a blind pool. When they were working properly, banks had deep silos of information about their borrowers, and the markets tapped into that to the extent that they could. The markets, on the other hand, work on shallow information that is available to everybody.

We’re moving from a world that was dominated by specific information in banks to a world dominated by much less profound but much more widespread information in markets. The clash between these two systems of valuing instruments is what makes for the instability that we can see all around us and that will increase. Banks are now making a lot of money, but there are certain assumptions in their bookkeeping that may prove not to be true.

DS: What role do credit derivatives play in all this?

MM: There’s obviously a real value in credit derivatives because they allow the farm-belt bank and the rust-belt bank to swap exposures. By diversifying, both of them have less risk. The reduction of their returns is minor because the cost of these contracts is minor.

The problem is that credit derivatives tend to be sold on a total-return basis. In some cases, you’re not swapping portfolios of loans. You’re gambling on the relative return of a risk-free instrument against an equity portfolio, a portfolio with junk bonds, a portfolio of foreign currencies or whatever, in which there is a larger risk.

What this means is that you can have a limited investment because you can pick up these risk-free instruments on borrowed money and then swap them on a total-return basis with a package of equities or junk bonds. Nobody knows what the hell is going on in these private deals, and nobody knows the volume of what is out there, including regulators. So nobody can have an informed opinion about what the dangers are. What has happened over and over again with these instruments is that people have assumed that there is measurable risk where in fact there is immeasurable uncertainty.

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