Exploring the 'Nuclear Option' for This Crisis

Unless you’ve been living under a rock, you know that a housing boom enhanced by risky leverage has caused an implosion within our very financial system. What was first contained to the real estate and financial markets has now quickly spread into mainstream job losses.

While the panic may have subsided, the pain that people continue to feel is very real. Businesses continue to fail and the very health of some of the largest financial institutions still remains in doubt. There have been a lot of solutions proposed for getting ourselves out of this debt ridden mess, but most agree that it’s going to take some kind of investment to break the vicious downward spiral. Some argue that this investment should come from the government through stimulus spending, while others have argued that we need tax breaks and incentives for the market to properly function. Some say we should do nothing and let the market figure it out. There are even those who argue that the tax revenue from legalizing marijuana could be the solution to our problems.

While every argument has its pros and cons, even at $3 trillion dollars, I can’t help but wonder if these solutions are radical enough. Now bear with me, because I’m still trying to flesh out the impact that this kind of idea would have on the financial markets, but here is my own proposal for an economic recovery plan.

Eliminate the creation of any new derivative investment.

When you look at the cause of the financial crisis, it’s easy to blame real estate, but the reality is that it was over-leverage that created the tsunami after the quake. Because of the lax regulation surrounding CDOs and other leveraged investments, banks and institutional investors were able to create a side market where they could bet on the success or failure of the marketplace.

From '02-'07, the derivative market grew from $100 trillion to $516 trillion in size. When the bubble burst, this side market took the real market down with it. Considering that it was leverage that led us into this, forgive me if I can’t help but wonder how beneficial this stuff really is.

While derivatives do allow for businesses to hedge risks that they’ve taken, they are also used to speculate on everything from the price of gold to the weather in New York City. The problem is, that I don’t think they actually create jobs, at least not directly.

If a company wants to raise money so that they can hire staff, expand their business or just stay alive, they’ll typically either borrow the money (debt) or will sell off ownership in their company (equity). While there are many other ways to raise money, the important point is that the debt or equity that is created goes towards helping the business succeed.

When a big bank writes an option contract or an interest rate swap and links it to the price of something else, none of the money goes to the business or underlying asset that investors are betting on (or against for that matter.) Instead, the money raised is passed between investors and financiers depending upon the final result.

So what would happen if the captains of industry weren’t allowed to underwrite derivatives any longer? This $500 trillion market would be forced to find other investments. Instead of being able to borrow money and make 10 - 1 long shots, they’d have to invest in the real assets or buy that debt and equity off of the open market. Instead of a $3 trillion injection, we would see $500 trillion redistributed to businesses as more and more contracts expired.

Now I’ll be the first to admit that there are some serious risks to my proposal and that such a drastic action could potentially cause an even greater collapse. I’ll also concede that any possible attempts at banning derivatives would have so many loopholes that it wouldn’t be effective. I won’t even pretend to know how the financial behemoths would react if they lost access to these types of investments. Certainly a few of them would likely go under. I’m also not sure what type of contraction effect something like this could have on the money supply.

The last thing we’d want is for people to have to pay back $500,000 mortgages earning 1980s-level wages. Yet despite all these misgivings, I can’t help but wonder how important this extra layer of investment really is. By not allowing derivative investments, it would remove a middleman from the finance system and allow private money to go directly to job creation.

The cure may end up being worse than the disease, but if we end up finding ourselves in the Great Depression 2.0, I think that the nuclear option should be left on the table.

Comments

[Tatertot:]

I think your statement "While derivatives do allow for businesses to hedge risks that they’ve taken..." is enough of a reason for derivatives to remain as an investment. Maybe there should be more regulation, and for certain derivatives I would whole-heartedly agree, but to completely eliminate them is drastic overkill. Your proposal would ban the creation of option contracts, futures contracts, mortgage backed securities (and while they have their faults, imagine what would have happened had all the risk of default been with the banks), or any of the other derivatives useful for managing risk. With no way to distribute risk, I suspect we would see a seizure of the market much more violent than we've seen. Maybe it's called the "nuclear option" for a reason...

Feb 12 08:10 AM

[Dirk McCoy:]

There's not really $500 Trillion of cash waiting to flow out of derivatives. This is the nominal value of the "insurance" on credit defaults, including "insurance" on the "insurance", and once you eliminate all the double accounting, the real monetary impact is the principle- I'm guessing that's less than 10%. There may be some slight wealth effect associated as well (look how much insurance I have!), but if you eliminate CDOs and CDSs, all you'd really be doing is killing off insurance.

While you may argue this makes perfect sense since the capacity to pay off the insurance is nowhere near the nominal value, it's also true that none of the insurance companies could pay claims if a national hurricane hit everyone's house. The timing and magnitude of the Fed's rate increases between 2004 and 2006 set off a financial tsunami- maybe we should be more worried about preventing that.

Feb 12 08:26 AM

[Tom Armistead:]

The spread of derivatives is analogous to the spread of nuclear weapons.

Trouble occured when derivative proliferation put CDS in the arsenal of hege funds. Like naughty children with a new toy, they nuked every financial in sight.

CDS are insurance and should be regulated as such, with a requirement of insurable interest for the buyer and capital adequacy for the seller.

By placing this limit on proliferation, we will avoid the financial nuclear winter.

Feb 12 08:27 AM

[Davis Freeberg:]

You certainly raise a good point. To a certain extent my proposal is a little bit tongue in cheek. More then anything I was hoping to get a better extent of what would happen if we did end option and CDO trading. Would the market see it as a stimulus for the underlying assets or would the impact be so devastating that it would put all banks out of business? I don't know the answer and I'm not convinced 100% that either would necessarily occur, but appreciate your take on the idea.

Feb 12 10:22 AM

[Nick Waddell:]

Davis,

Your proposal may be tongue in cheek, but I think it is the kind of creative thinking we need to engage in right now. I wonder if Econ students today realize and appreciate the kind of living experiment we are in the midst of.

Feb 12 12:10 PM

[out-off-the...:]

as said above premium much less than notional, maybe 10% right. On top of that you need nett all the trades, so real investement in derivatives is much much smaller..., not such a nuclear bomb after all.
FYI you cannot stop this, take forward contracts have been existing since the Egyptians...

Feb 12 12:18 PM

[mr freddo:]

The derivative market has to be regulated, run off of an exchange, and be transparent. Anyone providing default insurance must prove, like other insurance companies, that they have the assets to pay in the event of a default. Naked swaps should be banned. Buying insurance on a bond you don't own gives short players a powerful reason to drive a company out of business so they can collect.

We created this crazy casino out of our financial markets where the value of the casino bets (derivatives) far outweighs the value of the underlying assets.

This "sophisticated" system has not served us well. Let's get back to making investments in well run companies with world class products rather than making bets on the weather in NYC.

Feb 12 12:27 PM

[infp:]

Apparently markets cannot regulate themselves.

Feb 12 12:29 PM

[Erez Attiya:]

Your article is not correct at all, although you has a point there. Look, derivatives market is good and it actually made work places and (you won't believe it) real people works in this market. The problem comes from the place that this market wasn't regulated at all (well almost, but not even close to the other markets). Think about that no financier could make any idiotic derivation without an authorization from the regulator (SEC, etc.). If we had a serious regulator, it wouldn't let the market come to the place it is staying at now. Every mathematical development that can lead to smarter financial actions (like more sophisticated derivatives), is blessed, but the regulator need to (at least) approve it (or not) but absolutely not letting the bankers in WS to whatever they want without censorship. I promise you that when this turbulence will over and we all will get smarter (including the regulators) we will be able to enjoy a sophisticated markets, with a lot of opportunities to make profits, but in much safer financial environment.

Feb 12 12:40 PM

[levin70:]

The killing of all derivative contracts argument is just silly. Posting this makes anything you say immediately be written off as delusional. However, a better discussion was started above, that has also been discussed by David Merkel, in regards to who should be able to purchase a CDS contract. David Merkel's argument was the analogy used above to regard the CDS contract much like a life insurance contract and that there are good reasons that third parties can't buy life insurance contracts (the obvious incentive to kill the contract party).

However, just as powerful arguments have been brought forth to allow third party purchasing of CDS contracts, most noticibly price discovery leads to an efficient market. This argument was made in context of putting CDS contracts onto a regulated market (CME, ICE, whatever) with appropriate regulatory controls (including margin reqs).

Its an argument that I would hope commentators here would expand upon.

Kind Regards

Feb 12 12:57 PM

[Davis Freeberg:]

You may think my argument silly and delusional and you're free to write me off, but this post was more about generating a discussion around the impact of such an extreme move, then a serious argument for nuking all derivatives. Clearly killing off all options would never happen, in part because the financial services industry would make sure it never happened if the idea did take root, but also in part because there are legitimate needs for investors to protect themselves. What I am hoping for, is to generate a discussion around A.) are these contracts good for the market given what we've learned about leverage. Why should we even give someone a bazooka, when a hand gun can get the job done and bring more capital to real businesses and assets? How should these devices be regulated to reduce speculation while allowing investors to hedge? B.) If we did take such a drastic step and hit that little red button, what would be the impact on the economy, the banks, and the monetary system. As some have pointed out, maybe it wouldn't be $500 trillion injected into the real economy, but something closer to $50 trillion based on notational amounts and what not. Still sounds like a lot of stimulus to me. C.) Generate a discussion around CDS and options and whether there are things that we should be considering to introduce safeguards. From the start of the financial crisis, there's been a lot of discussion about how bad CDO's are, yet we still haven't seen any regulations protecting investors. I understand if you want to write me off as naive, but understand that my idea is less of a magic bullet and more of an academic exercise.

Feb 12 01:28 PM

[Income Tax:]

I think it just takes time to get over the crisis, all dramatic move will probably cause more complication. And the time cures all.

Feb 12 01:47 PM

[Alan Young:]

I don't think your idea is too radical at all; in fact, it seems like common sense. You needn't be so apologetic.

Feb 12 01:48 PM

[TomOfTheNorth:]

As long as we're at it, let's get rid of peanuts too. We should eliminate the possibility that a producer could EVER slip salmonella tainted product into our food chain (oops - too late).

Davis, the impetus for this crisis was leveraged debt. How about we say to the banks "Now fellas, going forward, let's try & keep it under 40-1. Waddya say?"

Your proposal isn't a nuclear option, it's more like a supernova. What do you think would happen to the hundreds of trillions (perhaps tens of trillions after netting but who knows) on the books if they're subjected to a liquidation mandate? Yikes!

The current Administration's version of the nuclear option is nationalization and (IMO) they're eventually going to have to launch.

Feb 12 01:49 PM

[Anandakos:]

Mr. Armistead,

Bingo. Very well said!

This is a perfect template for necessary derivative regulation: the purchaser of derivative insurance should have a verifiable potential loss for which the derivative provides nominal protection. And the seller of that protection should have verifiable capital proportional to the risk insured.

I would add that such contracts should not be transferable by the issuer without approval by the purchaser. And the purchaser should not be able to obtain multiple policies totaling coverage in excess of the verifiable potential loss. The purchaser should be free to obtain multiple partial coverage contracts in order to widen the insurance base if desired, but the total value could not exceed that of the potential loss.

This is insurance 101. CDS's as now marketed have enormous perverse incentives, not least of which is that parties C, D and so on can bet on the failure of a debt between parties A and B. That is NOTHING more than standing by a craps table and betting against the roller.

On Feb 12 08:27 AM Tom Armistead wrote:

> The spread of derivatives is analogous to the spread of nuclear weapons.
>
>
> Trouble occured when derivative proliferation put CDS in the arsenal
> of hege funds. Like naughty children with a new toy, they nuked
> every financial in sight.
>
> CDS are insurance and should be regulated as such, with a requirement
> of insurable interest for the buyer and capital adequacy for the
> seller.
>
> By placing this limit on proliferation, we will avoid the financial
> nuclear winter.

Feb 12 01:53 PM

[Crocodilian:]

"Nuclear option" is exactly the wrong metaphor.

What heals a hangover? Time

Is there some magic trick which heals it faster? Nope.

We need a "boring option" to deal with this crisis, a slow meticulous process where we evaluate what we have and what we owe, where we write down the excesses to economically realistic levels, and where we pay for it through decreased consumption. At the same time, we invest in long term projects which will increase the productivity of our society.

No nuclear option. Just time, transparency, price and investment. Markets need stability and predictability to function well-- they accommodate a few shocks, but clearly, we've thrown them too many, and important parts of the market are on life-support. Let's let them get more stable before we surprise them again.

Here's a basic rule of thumb: this crisis was at least a decade in the making (I'd date it back to the failure to let LTCM go bust). Is it reasonable to assume that a problem with such deep roots can be solved by any policy, tomorrow?

I say it isn't.

Pick the "boring option" over the "nuclear option".

Feb 12 01:59 PM

[Orlando:]

The argument made that says treatment of these obligations as a contract (insurance contract) is the most intreaguing and compelling for keeping and regulating them. However, if you eliminate this contract the potential for profit is so big that there will be offshore utilities offering derivatives within minutes of elimination forcing our risk off shore. The nuclear option does not exist physically in today's wireless world, in my opinion.

Feb 12 02:01 PM

[TomOfTheNorth:]

Davis, you sound so sensible here! Reading your radical post, I assumed you were speaking of OTC derivatives and took it seriously because (it's shocking, I know) the concept of abolishing them has previously dribbled out of some of our less-astute legislators. In any case, I see the discussion as misdirection from finding a solution to the crisis. The key to finding a solution rests with determining the problem. It's not housing, it's not derivatives - it's ridiculously, egregiously overextended debt. The solution is what it always was: pay your bills or go broke. Regrettably, we're going to do neither for the foreseeable future.


On Feb 12 01:28 PM Davis Freeberg wrote:

> You may think my argument silly and delusional and you're free to
> write me off, but this post was more about generating a discussion
> around the impact of such an extreme move, then a serious argument
> for nuking all derivatives. Clearly killing off all options would
> never happen, in part because the financial services industry would
> make sure it never happened if the idea did take root, but also in
> part because there are legitimate needs for investors to protect
> themselves. What I am hoping for, is to generate a discussion around
> A.) are these contracts good for the market given what we've learned
> about leverage. Why should we even give someone a bazooka, when a
> hand gun can get the job done and bring more capital to real businesses
> and assets? How should these devices be regulated to reduce speculation
> while allowing investors to hedge? B.) If we did take such a drastic
> step and hit that little red button, what would be the impact on
> the economy, the banks, and the monetary system. As some have pointed
> out, maybe it wouldn't be $500 trillion injected into the real economy,
> but something closer to $50 trillion based on notational amounts
> and what not. Still sounds like a lot of stimulus to me. C.) Generate
> a discussion around CDS and options and whether there are things
> that we should be considering to introduce safeguards. From the start
> of the financial crisis, there's been a lot of discussion about how
> bad CDO's are, yet we still haven't seen any regulations protecting
> investors. I understand if you want to write me off as naive, but
> understand that my idea is less of a magic bullet and more of an
> academic exercise.

Feb 12 02:05 PM

[Anandakos:]

Levin70,

Your argument about price discovery in the CDS market is a circular one. If one analyzes it, it assumes the necessity of a market in CDS's. But what purpose does a market in CDS's really serve? Well, "it provides price discovery for CDS transactions". Oh! Now I see.

If one accepts that the PURPOSE of a CDS is for lender A to spread some of the risk of its loan to borrower B by purchasing coverage from unrelated insuror C, where is there any need for an aftermarket? The contract is already written. Insuror C is on the hook for its payment to A if B defaults regardless of what happens until the contract expires unless it sells the contract to another party. But fi the purchaser of the contract, "D", has significantly smaller capital reserves than issuer C -- in whose capital adequacy and ratings A placed its trust when purchasing the contract -- that potentially deprives A of the coverage for which it has in good faith paid C. Insurors are forbidden from selling policies on to less capable hands; sellers of CDS insurance should also be so forbidden.

If C wants to hedge its exposure to B's default to A, C should sell its OWN coverage to D or E or Z in a new transparent contract.

Obviously there are situations when C itself gets into difficulties and that may also deprive A of the coverage for which it paid. If this happens for a reason other than malicious default by C, that's just part of the risk of any contract. And that is the reason why I would allow any purchaser to obtain multiple coverages of less than the at risk amount, but totaling no more than the at-risk amount.

On Feb 12 12:57 PM levin70 wrote:

> The killing of all derivative contracts argument is just silly.
> Posting this makes anything you say immediately be written off as
> delusional. However, a better discussion was started above, that
> has also been discussed by David Merkel, in regards to who should
> be able to purchase a CDS contract. David Merkel's argument was
> the analogy used above to regard the CDS contract much like a life
> insurance contract and that there are good reasons that third parties
> can't buy life insurance contracts (the obvious incentive to kill
> the contract party).
>
> However, just as powerful arguments have been brought forth to allow
> third party purchasing of CDS contracts, most noticibly price discovery
> leads to an efficient market. This argument was made in context
> of putting CDS contracts onto a regulated market (CME, ICE, whatever)
> with appropriate regulatory controls (including margin reqs).

>
>
> Its an argument that I would hope commentators here would expand
> upon.
>
> Kind Regards

Feb 12 02:17 PM

[Anandakos:]

Orlando,

I don't think you're right. If CDS contracts are regulated as I've described immediately above, they still will have value for purchaser A and seller C so transactions would continue. In fact, regulated transactions priced in dollars would have MUCH HIGHER value for purchaser A than would unregulated transactions priced in another currency. So I don't think that the US market for CDS would be much affected at all.

Now, it's true that the Wall Street market for Euro- or Yen- or Renminbi-denominated CDS would move offshore. But do we in the US really want our financial system placed at risk of defaults in debts issued in countries we don't regulate and in other currencies? I don't think we do just to generate more rent-seeking jobs in New York.

On Feb 12 02:01 PM Orlando wrote:

> The argument made that says treatment of these obligations as a contract
> (insurance contract) is the most intreaguing and compelling for keeping
> and regulating them. However, if you eliminate this contract the
> potential for profit is so big that there will be offshore utilities
> offering derivatives within minutes of elimination forcing our risk
> off shore. The nuclear option does not exist physically in today's
> wireless world, in my opinion.

Feb 12 02:27 PM

[TomOfTheNorth:]

On Feb 12 01:59 PM Crocodilian wrote:

> "Nuclear option" is exactly the wrong metaphor.
>
> What heals a hangover? Time
>


Croc -

I go with Bloody Mary's! Maybe if we could just get the govt in a bar and get them all jacked-up, we could make some headway.....

Feb 12 02:28 PM

[US Out of K...:]

I think we should end all U.S. military support in the Korean peninsula.

It would help out our auto industry because we wouldn't have to compete with the cheap South Korean imports. The South Koreans buy nothing from us.

Obviously we should pull out all U.S. troops first. Then we can work with the Chinese and the Chinese can take care of Korea.

Korea is not our problem. They give us nothing and we give them too much.

Feb 12 02:57 PM

[gdg:]

Mr Freeberg,

I see the CDO's and CDS's as two different animals. I agree with the insurance assessment regarding the latter. You ought to have an insurable interest on one side and sufficient reserves to reasonably assure paying the claim in the event of a loss on the other. Otherwise, they amount to huge naked short positions without any margin limits, calls, or exchange oversight.

CDO's, as I understand them, were intended as a hedge or way to lay off the risk of sub-prime lending by collecting multiples of them from multiple (geographic) markets together in an sadly misjudged attempt at "diversification. Rather (in my simple mind) like owning small, mid-cap, and large cap domestic stock indexes and believing you own different asset classes when, in fact, the correlation of the whole is near 1.00. The consequences of the miscalculation, however, would have never been this bad if the trading of these derivitives would have required registration as a security and occured only on a public exchange. That, hopefully, would have led to reasonable content disclosures and sensible margin requirements.

Going forward I would ban OTC trading of securities like these CDO's and call CDS's what they really are. I'd also prohibit (and enforce with serious jail time) the holding of such leveraged derivatives "off the books" by any publicly traded company.

That, however, doesn't tell us much about what (absent some serious ex post facto legislation) we can do about the hundreds of $trillions that are still hanging over the head of our entire finacial system. I'm sure it's a matter of my simplistic view of things financial, but if the CDO's are valued in many multiples of the underlying face value of the hard assets, musn't they overlap all over the place? And surely not everbody bet the same thing in the same direction, no? And if they're all fully (or mostly, anyway) assignable, why couldn't these guys (the major players anyway, including some of the big hedge fund positions) all get together under the watchful and competent eyes of Sheila Bain and trade offsetting CDS's? Couldn't they then, with SEC complicity, value their CDO's as discounted income streams and have much better and survivable balance sheets going forward? Other than something like that, I see no long term viable option but receivership.

It would take somebody smarter than me to assess the potential impacts, pro and con, of a ban such as you postulate. Nevertheless, I think it is folly to suffer through this mess and not address the causes of the meltdown, which are surely the over-leveraged CDO's and CDS's. In my view, your "nuclear" option, though, is probably stategic in yield, when a smaller tactical device or series of devices might serve your purposes with less fallout.

Feb 12 03:23 PM

[Larrysyr:]

There's always been an element of speculation (gambling) in financial instruments. This gives liquidity to the markets so that I (for instance) could sell my long-term paper today if I need or want the cash. Derivatives are just paper assets subject to speculation like any other paper asset, including plain old stocks and bonds.

We have a situation now where a lot of institutions and people overpaid for assets. These include purchasers of homes and mortgage-backed securities. My Economics professors would gasp at how inefficient the markets ended up being in pricing all this stuff.

But, really, so what? We don't close the supermarket because the steaks are too expensive. So, we shouldn't close the derivatives markets because a bunch of people couldn't figure out the proper price for the paper.

The real problem I see is that large institutions which provide essential public services got caught up in the speculation, and their losses translate into trouble for all of us. The big banks and insurance companies provide bedrock services that a modern economy cannot function without. (Hence, "Too big to fail.") Those services need to be insulated from the catastrophic losses suffered in speculative enterprises.

Our grandparents learned this in the 30s and enacted Glass-Steagall. Let speculators gamble. Keep bedrock services safe.

Feb 12 03:30 PM

[resoluteinv...:]

Imagine the prospect of a world in which the Financial Services Industry aided all other Businesses and Industries, and actively participated to help businesses succeed. It requires imagination, because in the current environment the Financial Services Industry exists as the 800lb. Gorilla, so to speak--it serves it's own ever expanding need for revenue and growth at the expense of nearly every business and individual it touches. Mathematical abstractions have been used to 'create' monetary value that just does not have any materials, goods, or even services as a basis. These are not "...smarter financial actions", as Mr. Attiya has characterized them, but only continuing attempts to play the system.

I support Mr. Freeberg and his premise. The Financial Services Industry is a valuable and necessary part of our existence, but abuses and systemic corruption must be stopped through laws and legislation. Perhaps this does suggest the elimination of Derivatives over time.
To those who will now suggest that Regulation will lead us down same path as Japan during their 'Lost Decade', I would suggest that we could instead learn from their mistakes and avoid that scenario, while still limiting the undue influence of the Financial Services Industry.

Feb 12 03:31 PM

[investor88:]

We should regulate properly the derivatives markets worldwide. It has grown to be a potential monster doing more harm than good. Proper regulation if it ever comes about will take decades to materialize.

Feb 13 02:30 AM

[axelrod608:]

I think of derivatives as IED's rather than nuclear weapons. Regardless of whether they masquerade as insurance or flat-out gambling they should be regulated by folks at least as knowledgeable and sophisticated as the folks who created them.

There are good, legitimate reasons why the insurance and gambling industries are regulated, And good, legitimate reasons why insurance companies cannot sell products before they are approved.

Are derivatives merely a corporate end-run to evade regulation ? I'm no expert, but that's what it looks like to me.

Feb 13 01:50 PM