Every now and then in our business, a headline comes across the newswires that makes you do a double and triple take. A couple in my career were:
September 12, 2008
Headline: “AIG Asks NY Fed for $30 billion”
Reaction: “AIG needs how much? I guess we found the other side of all those subprime credit default swaps!”
December 11, 2008
Headline: “Prominent Trader (Bernard Madoff) Accused of Defrauding Clients up to $50 Billion”
Reaction: “Who is Bernie Madoff and how did he lose $50 billion when nobody on this trading desk has ever heard of him?”
Yesterday, when this headline came across the wires—“Pope Says Credit Default Swaps are Unethical”—at first I thought it was just some investor or regulator with the last name of Pope. Instead it was Pope Francis! Here is what the Pope had to say as reported by The Financial Times:
“It is obvious that the uncertainty surrounding these products makes them continuously less acceptable from the perspective of ethics respectful of the truth and the common good, because it transforms them into a ticking time bomb ready sooner or later to explode, poisoning the health of the markets. The spread of such a kind of contract without proper limits has encouraged the growth of a finance of chance, and of gambling on the failure of others, which is unacceptable from the ethical point of view.”
Wow! Blythe Masters of JP Morgan fame has allowed the myth that she created credit default swaps to circulate unopposed for a couple of decades. Now she may want to reconsider! While I’m not sure if I fully agree with the Pope, as I think he is a little late to the argument (not his fault, since he only became Pope five years ago), he challenges us to think about financial engineering, including central bank financial engineering. There was a time when many financial market participants believed that derivatives like credit default swaps or total return swaps were magic. I remember in the early 2000s, when I was on a derivative desk. The mortgage desk was short of a particular Fannie Mae coupon, and they were getting squeezed really hard, losing a lot of money. The head of the mortgage desk picked probably the most junior guy to mosey on over to the derivative desk to ask us to do a total return swap on the security they were short. In other words, the mortgage desk wanted the derivative desk to make its problem and its risk disappear through the magic of derivatives. My boss looked at him and said, “Sure, abracadabra, the risk is gone!” The kid said, “Really?,” to which my boss countered, “No dummy, all you’re asking me to do is take your problem and make it my problem!”
The point is, many people believed that derivatives like credit default and total return swaps were a form of money magic; they weren’t. At some point, risk was transferred, and eventually somebody pays the piper. Central bank quantitative easing is another form of “money magic.” The Fed created trillions of dollars, bought trillions of mortgage-backed securities and treasury notes, effectively lowered key interest rates, and kept them extremely low for a decade. For investors, we have bathed in the warmth of this policy. However, there is a cost, and the bill is coming due. Quantitative Easing created large risk asset bubbles: emerging markets, high-yield bonds and loans, and interest rate duration to name a few. Now as the economy is beginning to run on all cylinders, inflation is rising and the Fed needs to remove “the magic.” So far, the rise in rates has been relatively orderly. Yesterday we pierced 3.1% on the ten-year Treasury note. It feels like we are going to continue to grind higher. One could argue that rates have to grind higher as another form of “magic;” supply-side fiscal stimulus in the form of tax cuts is adding record amounts of rate duration supply to the markets at a very rapid pace. At some point soon, the bubbles are going start popping.
We may need to get the Pope on our side as soon as possible!
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