Lehman Brothers and the Tentacles of Loosely Connected Derivatives
By Dr. Arch (Keith) Barnes – March 1, 2011
Ever been fishing? Well, even if you haven’t you can readily grasp two things very readily: you cannot know for sure that there are fish down in the murky depths. Even if there are, and you can see them on your hi-tech fish-finder, you cannot know for certain that the bait you have is going to attract them. Well, the good news is that unless you have flown in (as I once did) to some remote location at great expense, you won’t lose all that much… some time, maybe, and some boat rental money. No big deal, right?
A few decades back, the already turbid waters of investments were made substantially more murky by the rapid expansion of something called derivatives. Unlike the mathematical concept of derivatives, however ─ which can be seen and dealt with by those adept at calculus ─ the foggy, complex and disconnected world of investments based on derivatives is, at best, accessible to investors through elastic and easily broken strings. Very risky, very hard to influence, impossible to read and to assess. The potential losses are enormous… as we have seen.
Okay, enough of metaphor and parody. Here’s the thing: by the time Lehman Brothers filed for bankruptcy more than a year ago, there were nearly seventy trillion US dollars invested in financial derivatives world-wide. That, folks, was roughly the total net worth of all Americans! Lehman was as heavily into it as anyone, and a large portion of their total “assets” of six hundred billion dollars were swimming in the murk (sorry, I’m back to fishing again).
Oh, did I mention that I personally held a number of Lehman bonds. I bought them for two decidedly unsophisticated reasons: First, Lehman was “solid.” Looking back, now, that one makes me chuckle. Second, these bonds paid a nifty interest rate. How could I lose? I lost because of greed and blindness. I liked the rate of return I was getting and this induced me into an apathetic state in which I was not even willing to see… though I’m certain I would not have seen through the tangled web created by derivatives on derivatives. Furthermore, the leverage of most such derivatives, and the fact that many are at the dirty end of the stick of events, conditions, variables and other shaky factors would have made my attempts to assess the risks impossible without an omnipotent crystal ball.
So, like many others, I lost a chunk of money. No, I am not pointing the finger of blame at anyone but myself. On this issue, unlike the subsequent real estate collapse, my losses were not largely caused by wrong-headed government meddling, or even Madoff-like skullduggery. There may well have been considerable greed, a fair measure of stupidity and incompetence inside the Lehman operations, but such weaknesses are everywhere. In the case of Lehman, however, the complexities of the multiple level derivative extensions, and the size of the organization itself, and its networks, even the brightest and best minds would be virtually impotent.
Now that the dust has settled on this fiasco, or nearly so, what can be done? Well, for investors of all kinds this failure served one useful purpose: it reminded us that investments are risky. The less connection between the money invested and something tangible, the greater that risk. Act accordingly. For those who attempt to be devilishly creative, inventing ways to “make book” on horse races in which you do not control the horses, their feed, their training, their bloodlines… Oops, we have gone from fishing to the Sport of Kings! Well, there will always be such people, especially when they are able to play the game with other people’s money. I have no advice for them, except to say, “What would your mother say?”
Do we need the heavy hand of government regulation? Of course we do, but where in government is there the capability to assess the threats and risks and devise fair and even-handed standards and controls in such complex and expansive systems? Not, as we have seen, in the Senate or House committees who purport to be watchdogs on our behalf. Perhaps, and this is merely a suggestion, we need a sort of grading system for all investments based on the risks. Rather like the movie rating system employed by the Motion Picture Association. Wait, already we have Moody’s, Standard and Poor and other credit rating organizations. They failed miserably.
An independent panel of experts, perhaps, overseen and funded by the federal government… wait, once again we already have such a body, sort of. It is called the Securities and Exchange Commission. But the SEC is not sufficiently independent of the government. They should be funded by fees paid by all investment firms and audited regularly of course, but our government is incapable, they have proved it time and again. And for goodness sake take those show-boat Senate inquisitions of the television. They merely provide a stage for the pontificators and the finger-wagging self-righteous. Anyway, no amount of government regulation short of the elimination of private property rights will prevent people from taking risks with their money. That particular form of hell is not an option, not for America. Instead we should realize that in a complex world there are those who are entrepreneurial and others who are risk-averse. There are creative honest people and some who are creatively larcenous. Prosecute and punish heavily those who steal or are criminally negligent. Risk-takers will lose money in such an environment. Those who take no risks will remain in their comfort zone. T’was ever thus.
A few decades back, the already turbid waters of investments were made substantially more murky by the rapid expansion of something called derivatives. Unlike the mathematical concept of derivatives, however ─ which can be seen and dealt with by those adept at calculus ─ the foggy, complex and disconnected world of investments based on derivatives is, at best, accessible to investors through elastic and easily broken strings. Very risky, very hard to influence, impossible to read and to assess. The potential losses are enormous… as we have seen.
Okay, enough of metaphor and parody. Here’s the thing: by the time Lehman Brothers filed for bankruptcy more than a year ago, there were nearly seventy trillion US dollars invested in financial derivatives world-wide. That, folks, was roughly the total net worth of all Americans! Lehman was as heavily into it as anyone, and a large portion of their total “assets” of six hundred billion dollars were swimming in the murk (sorry, I’m back to fishing again).
Oh, did I mention that I personally held a number of Lehman bonds. I bought them for two decidedly unsophisticated reasons: First, Lehman was “solid.” Looking back, now, that one makes me chuckle. Second, these bonds paid a nifty interest rate. How could I lose? I lost because of greed and blindness. I liked the rate of return I was getting and this induced me into an apathetic state in which I was not even willing to see… though I’m certain I would not have seen through the tangled web created by derivatives on derivatives. Furthermore, the leverage of most such derivatives, and the fact that many are at the dirty end of the stick of events, conditions, variables and other shaky factors would have made my attempts to assess the risks impossible without an omnipotent crystal ball.
So, like many others, I lost a chunk of money. No, I am not pointing the finger of blame at anyone but myself. On this issue, unlike the subsequent real estate collapse, my losses were not largely caused by wrong-headed government meddling, or even Madoff-like skullduggery. There may well have been considerable greed, a fair measure of stupidity and incompetence inside the Lehman operations, but such weaknesses are everywhere. In the case of Lehman, however, the complexities of the multiple level derivative extensions, and the size of the organization itself, and its networks, even the brightest and best minds would be virtually impotent.
Now that the dust has settled on this fiasco, or nearly so, what can be done? Well, for investors of all kinds this failure served one useful purpose: it reminded us that investments are risky. The less connection between the money invested and something tangible, the greater that risk. Act accordingly. For those who attempt to be devilishly creative, inventing ways to “make book” on horse races in which you do not control the horses, their feed, their training, their bloodlines… Oops, we have gone from fishing to the Sport of Kings! Well, there will always be such people, especially when they are able to play the game with other people’s money. I have no advice for them, except to say, “What would your mother say?”
Do we need the heavy hand of government regulation? Of course we do, but where in government is there the capability to assess the threats and risks and devise fair and even-handed standards and controls in such complex and expansive systems? Not, as we have seen, in the Senate or House committees who purport to be watchdogs on our behalf. Perhaps, and this is merely a suggestion, we need a sort of grading system for all investments based on the risks. Rather like the movie rating system employed by the Motion Picture Association. Wait, already we have Moody’s, Standard and Poor and other credit rating organizations. They failed miserably.
An independent panel of experts, perhaps, overseen and funded by the federal government… wait, once again we already have such a body, sort of. It is called the Securities and Exchange Commission. But the SEC is not sufficiently independent of the government. They should be funded by fees paid by all investment firms and audited regularly of course, but our government is incapable, they have proved it time and again. And for goodness sake take those show-boat Senate inquisitions of the television. They merely provide a stage for the pontificators and the finger-wagging self-righteous. Anyway, no amount of government regulation short of the elimination of private property rights will prevent people from taking risks with their money. That particular form of hell is not an option, not for America. Instead we should realize that in a complex world there are those who are entrepreneurial and others who are risk-averse. There are creative honest people and some who are creatively larcenous. Prosecute and punish heavily those who steal or are criminally negligent. Risk-takers will lose money in such an environment. Those who take no risks will remain in their comfort zone. T’was ever thus.