Think Twice Finance

The Subprime Mortgage Crisis, Part 2: The Birth of Derivatives.

The single best piece of luck I ever had was to write a couple articles about what was then a gleam in the eye of a couple dozen people in the world, Standard and Poors futures and CPI (Inflation) futures.

I learned more about risk and about the human condition in the next two years than I have learned before or after. My articles were essentially descriptive – they explained some alternative ways these contracts could be used to modify risk profiles of individual portfolios. However, they were basically supportive of the idea since it introduced desirable possibilities for investors, it seemed. At the time, as with test tube babies, it was a new and radical idea and so, to the world’s reactionaries, undoubtedly bad.

I was pleased when I was asked by the Commodity Futures Trading Commission, the regulator of futures markets, to testify in hearings concerning a related contract, the proposed Dow Jones Futures contract. It was then that I learned one of life’s unpleasant truths. Although I was not alone among Fed economists in my interest in seeing what could be done with financial futures, my then employer, The Federal Reserve, was more reactionary. I was told that one of the Governors was testifying on the same subject, and there was a desire that he be the only witness for the Federal Reserve on that day, as our testimonies were in conflict.

I left the Fed, took a job writing futures contracts for the Chicago Mercantile Exchange, and never looked back. The process of getting financial futures off the ground was a war. The adversary was the bank regulators, and the war was fought and won over a twenty year period at an untold cost in terms of lost opportunity, as the time spent overcoming the regulatory resistance to change could have been spent managing the change instead.

The history of the development of derivatives has as its high point the development of financial futures; its low, the regulatory push to sustain Mortgage Conduits. It is a story of struggle between forces for change and forces of reaction. Ironically perhaps, derivatives begin the story as an positive creative force, useful in addressing the risks of financial institutions – and end the story as a method of hiding the banks’ assumption of undue risk.

The first battle in the war over futures was a battle for the survival of futures contracts themselves. The Treasury and the Federal Reserve launched a joint study of futures markets, which asked the question, “Do futures pose a danger to monetary policy?” An answer in the affirmative would have put an end to the markets. Futures had friends in the Economics profession, including Milton Friedman and a number of influential economists at the Federal Reserve, and as a result the study basically was supportive of the financial experiment, although there was a feeling that the forces of reaction to futures within the relevant government agencies were far from silenced when a positive study was released to the relief of the futures industry.