Thursday, 28 July 2011

History repeating itself?

The macro-economics of August 2011 looks much the same as August 1971, but have we learnt anything about the markets over the past forty years?

Following the 1929 Crash and the consequent world-wide Depression governments around the world had devalued their currencies in order to make their products more competitive in foreign markets. These ‘beggar-thy-neighbour’ policies created a deflationary spiral that magnified the effects of the Crash. In 1944 the Allied powers met at Bretton–Woods, in New Hampshire, and agreed to fix the gold price of the main currencies, the US$ was fixed to gold at $35/oz, while other currencies were pegged to the dollar with the pound sterling being set at $4.03. Bretton–Woods also established the International Monetary Fund and World Bank.

By the late 1960s the Bretton–Woods system was beginning to creak as the Germans and Japanese exported to the Americans,while the U.S. poured money into th e war in Vietnam. As gold was sucked out of the U.S. the system began to look untenable. In 1971, foreign governments demanded that the U.S. honour its “promise to pay” and convert their dollar notes into gold, in July Switzerland converted $ 50 million into gold. There was an arbitrage, buy gold with dollars and then sell the gold for Deutsche Marks. On August 15, 1971 the U.S. President, Nixon, responded to these activities by abandoning the gold-standard, the “promise to pay”. Bretton Woods collapsed and foreign exchange rates stopped being

As a consequence of the collapse of the Bretton–Woods system of exchange rates central banks  were forced to change the interest rates more frequently. In simplistic terms, the level of interest rates has two effects. If rates are low people will borrow from banks, who will create money for the economy and this may generate inflation which devalues a currency. If interest rates are high, and the currency stable, foreign investors will like to deposit their spare cash in banks paying the high rates of interest, raising demand for the currency. After 1972 interest rate policy became a key lever that governments had to control their economies. In the 27 years between 1945 and autumn 1972, when Bretton–Woods collapsed, the Bank of England changed its lending rate 43 times, in the 27 years after 1972, it changed them 223 times, about every 45 days. Finance had moved from a world of deterministic control to one of stochastic control, and people had to think more carefully about controlling their financial risks.

Business responded to this change in the economic environment by returning to the derivatives markets, using them to provide the tools to hedge the risks, whether as a borrower or a lender, of the fluctuating the interest rates. In the same year that Bretton-Woods collapsed, Nixon appointed William Casey, a spy and tax lawyer, as director of the Securities and Exchange Commission (SEC) and the path for the the derivatives exchanges was opened. A currency future had been created in New York in 1970, but had foundered. However when, on May 16, 1972, the Merc began trading futures on seven currencies the market for FX risk management was there and the Merc was rescued from the doldrums of the  1960s.

While futures or forward contracts, firm agreements to buy or sell an asset at a fixed price in the  future, existed in an ethical and legal limbo, option contracts, contracts that gave the holder the right, but not the obligation, to trade were closer to the devil. As late as the 1960s officials of the SEC had compared options to thalidomide and marijuana and claimed that there had never been a case of market manipulation that did not involve options [MacKenzie2008, p 149]. Casey, and the SEC, cleared the Chicago Board of Options Exchange and it opened on April 26, 1973. Within days, the Journal of Political Economy, the house journal of the Chicago economists, published a paper, The Pricing of Options and Corporate Liabilities by Myron Scholes and Fischer Black.

The CBOT launched the first interest rate derivative in 1975, where the underlying was linked to  mortgages, in 1976 the Merc introduced a future on 30-day U.S. Government Treasury bills, and CBOT launched a future on 30-year U.S. Treasury bonds in 1978. The London International Financial Futures Exchange opened in 1982 and in 1984 the equivalent of a stock–market index for interest rates, the London Interbank Offered Rate, LIBOR, began to be published, and futures, known, confusingly, as Eurodollar futures, began to be traded on the Merc based on this index.

It was not only the capital markets that were transformed in the 1970s. Up until 1973 the price  of oil was set by the Railroad Commission of Texas, who controlled the oil production in Texas, and hence the oil price in the U.S., which as the world’s main oil consumer, effectively set the world price. Following the collapse of Bretton–Woods, the U.S. dollar’s value fell and as a consequence, the real income non-U.S. oil producers fell, and the Organisation of Oil Producing and Exporting Companies, OPEC, began to price their oil in gold and agree production quotas, setting the global–price. In 1973 the Middle-Eastern members of OPEC imposed an embargo on the west, following the defeat of the Syrian–Egyptian attack on Israel, and cut production, forcing the price of oil up. This, in-turn, prompted the development of alternative oil–provinces, notably the North Sea between the U.K. and Norway, which had been
previously un-economic. When this extra production hit the market, in the 1980s, just as demand fell, as consumers cut back consumption in response to higher-prices, and Iran and Iraq exceeded their quotas to fund their war (1980–1988), prices collapsed along with OPEC’s cohesiveness. In 1985 OPEC’s price-setting mechanism was abandoned, and another key economic input became a stochastic process, and in response, in 1988, the London based International Petroleum Exchange introduced the Brent oil futures  contract. 

Behind Black Monday, the failures of LTCM and The Equitable and the Credit Crisis of 2007–2008 is the fact that the financial world became stochastic in the aftermath of the collapse of Bretton–Woods,. The derivative markets did not spontaneously appear, they developed in response to the increased uncertainty in key economic drivers.

The world of 1980 was very different to that between 1918 and 1970 when exchange, rates,  interest  rates and commodity prices were being controlled by the great and the good. One view might be that the  abandonment of Bretton–Woods had lead to the chaos of 1970s stagflation, another is that Bretton–Woods shattered under the strains of trying to confine the economy to a specific path. The derivative markets emerged in response to freeing the economy, the deterministic  policies created impossible stresses in the global economy, and derivatives enabled risk–management in the resulting uncertainty.

The derivative markets were fundamentally different from the stock-markets, where decisions were made based on an investor’s judgement of the market fundamentals, and the core skills where in understanding economics and a company’s balance sheet, finance. The derivative markets were concerned with comparing the price differences between similar assets across different markets. It was not about the study of objects, but the relations between objects, and the derivative markets needed mathematical skills. In the aftermath of Black Monday significant numbers of applied mathematicians, physicists and engineers began working in the derivative markets, the ‘quants’ had  arrived.

The events of August 2011 are not so different to those of August 1971, but then again these  events are not so different to those of the 1690s!

Trading in stocks did not take off in England until after the Glorious Revolution of 1688. It is  often assumed that this was because, as Geoffrey Poitras puts it, “William III was accompanied by an influx of Dutch persons and practises”. However a market does not create itself and, according to Anne Murphy, a historian who has worked as a currency trader, the root cause of the explosion of stock-market trading, and the accompanying boom, was the Nine Years War [Murphy2009, p 10–14], [Poitras2000, pp 281–285]. Murphy points to a contemporary account written by John Houghton in 1694
a great many Stocks have arisen since the war with France; for Trade being obstructed at Sea; few that had money were willing it should lie idle [Murphy2009, quoting on p 12]
It was not just the shortage of opportunities to participate in regular trade that stimulated the  boom. England had grown wealthy under Charles II and alongside the increase in wealth was a growth in the financial services industry, involving life insurance and annuities, general insurance and the trade in the shares of the handful of joint-stock companies that existed at the time, such as the East India, Hudson Bay and Royal Africa [Murphy2009, p 12–19]. Evidence of this growth in financial services is provided by the 1673 Act of Common Council that looked to put an end to “usurious contracts, false Chevelance, and other crafty deceits” [Murphy2009, p 83].

The additional risks of sea trade resulting from the war with France, and the actions of privateers  meant that merchants looked for domestic investment opportunities and the number of joint-stock companies exploded, and with more companies came a more active stock market. John Houghton describes how the market worked
The manner of managing Trade is this; the Monied Man goes amongst the Brokers  (which are chiefly upon the Exchange [Alley], and at Jonathan’s Coffee House [the origins of the London Stock Exchange], sometimes at Garraway’s and at some other Coffee Houses) and asks how Stocks go? and upon Information, bids the Broker to buy or sell so many Shares of such and such Stocks if he can, at such  and such Prizes [Poitras2000, quoting on p 288].
Brokers put buyers and sellers in touch with each other, for a commission but without actually  taking possession of any asset. Alongside the monied men and brokers were the stock-jobbers or dealers, the speculators, providing liquidity in the market and trying to turn a profit from their trading. This dual-system, separating brokers from stock-jobbers, existed in London up until the ‘Big Bang’ of 1987.

In 1719 Daniel Defoe published Robinson Crusoe and wrote an article The Anatomy of Exchange  Alley in which he described stockjobbing as
a trade founded in fraud, born of deceit, and nourished by trick, cheat, wheedle,  forgeries, falsehoods, and all sorts of delusions; coining false news, this way good, this way bad; whispering imaginary terrors, frights hopes, expectations, and then preying upon the weakness of those whose imaginations they have wrought upon [Poitras2000, quoted in p 290]
An observation, mentioned by Defoe but more explicitly stated by Thomas Mortimer in 1761, concerned  the type of person involved in stockjobbing. Mortimer makes the point that there are three types of stock-jobber, firstly foreigners, secondly gentry, merchants and tradesmen, and finally, and “by far the greatest number”, people
with very little, and often, no property at all in the funds, who job in them on  credit, and transact more business in several government securities in one hour, without having a shilling of property in any of them, than the real proprietors of thousand transact in several years. [Poitras2000, quoted in p 291]
It was not only stocks that were being traded in the first half of the 1690s. Murphy estimates  that around 40% of the trades between 1692 and 1695 were in stock options, that were being traded in order to manage the risks of stock trading. [Murphy2009, p 24–30] Evidence of the widespread use of options comes in 1720 when Colley Cibber, who would become Poet Laureate in 1730,, wrote a play, The Refusal (‘The Option’), describing the action in Exchange  Alley
There you’ll see a duke dangling after a director; here a peer and ‘prentice haggling  for an eighth; there a Jew and a parson making up the differences; there a young woman of quality buying bears of a Quaker; and there an old one selling refusals to a lieutenant of grenadiers [Ackroyd2001, p 308]
Clearly, in 1720 the public were familiar with the trading of derivatives, pretty much everyone was  involved, and social, religious and political differences were forgotten in the markets.

The stock market boom that started in the late 1680s had gone bust by the middle of the next decade. At the time it was popular to blame stock-jobbers for destabilising the economy by either ramping worthless stock or undermining a going concern (depending on your point of view) [Murphy2009, p 33], while, more fundamentally, the stock market was attacked for turning “men away from honest and beneficial trades” [Murphy2009, p 68]. More rational explanations were that many of the joint-stock companies were mis-managed and the government’s need for cash sucked funds out of the market, causing prices to collapse [Murphy2009, p 35].

Anyone born before 1970, unless they have actually worked in the markets, find it difficult to  understand the changes in the financial environment that had occurred after the collapse of Bretton–Woods. Derivatives would not start appearing on undergraduate courses in universities until the mid 1990s, and even then, for many of the lecturers in economics and finance educated in the post-war deterministic economies, they would be unfamiliar beasts. This meant that at the turn of the century there was a dire shortage of people with the skills to understand the complex world of derivatives [Tett2009, p 68], which required a unique grasp of financial theory, market practises, applied mathematics, probability and

At the same time, some banks chose business managers as their chief executives, such as Fred  Goodwin at the Royal Bank of Scotland or Andy Hornby at Halifax–Bank of Scotland, rather than ‘bankers’ bought up on the basic process, and the uncertainties, of converting credit into cash. The consequence of this was that some banks focused on efficient profit generation, the allocation of scarce resources, at the expense of monitoring the risks of their activities, managing an uncertain world. This manifested itself by firms buying in expertise, in the form of ‘black–box’ software systems to value the CDOs combined with external (or internal) consultants for advice. Some banks were not only out–sourcing their call centres, but their brains as well.

In the lead–up to the Crisis of 2007–2008, RBS sponsored sports-stars to the tune of 200  million pounds, in the same period they invested nothing in mathematics. J.P. Morgan was different, they developed, in–house, Value at Risk, CreditMetrics and employed David Li as he thought about using copulas to price CDOs. The quants that that they employed were able to develop these tools because they had a deep understanding of the markets and mathematics, and critically, how and where the mathematical models were weak and needed to be augmented. Not only did J.P. Morgan recognise the need for these skills, a feature shared by all the serious investment banks, but in disseminating their models they advertised
that their expertise was a fundamental component of “first class banking in a first class  way”.

The benefit of J.P. Morgan’s approach is described by Gillian Tett in her account of the Credit Crisis, Fool’s Gold. The background is it is 2005–2006 and J.P. Morgan’s shareholders are putting  the bank’s managers under intense pressure to mimic the revenues being reported by other  investment banks, who were actively investing in CDOs of MBS.
[The J.P. Morgan chief executive] made it clear that he wanted a mortgage  production line, so Winters had duly asked his staff to re–examine how to create a profitable business selling mortgage–based CDOs.
When they crunched the numbers, though, they ran into a problem. “There doesn’t seem to be a way to make money on these structures,” Brian Zeitlin, one of the bankers who worked in the CDO division reported. …
Reluctantly, Winters told the J.P. Morgan management should not open the spigots on its pipeline after all. The decision was greatly frustrating, though. The other banks were pushing JPMorgan Chase further and further down the league tables  largely due to the bonanza  from their mortgage pipelines. So were they just ignoring the risks? Or had they found some alchemy that made the economics of their
machines work? [Tett2009, pp 148–151]
The J.P. Morgan quants had taken the prices the traders were observing in the market and  reverse engineered them, just like they did with the Black–Scholes pricing formula, extracting the key parameter, ρ. When they told the traders that the basis of the prices in the market was ρ = 0.3, the traders could not believe it. A correlation of ρ = 0.3 implies that there is only a small linkage between defaults, reflecting the fact that if BP went bust it did not mean that Tesco would follow suite. But anyone who had seen an economic downturn would be familiar with whole streets being derelict, the correlation of mortgage defaults was unknown, but not insignificant.

There is another aspect to the approach taken by the banks that weathered the storms  of 2007–2008. While there is frequently the claim that the Credit Crisis was a global phenomenon, it was not. Asian banks were unaffected and British and American banks suffered far more than French or German banks. The explanation that banks were not as involved as RBS or Merrill Lynch is not a satisfactory answer (BNP Paribas, SocGen and Deutsche Bank were all heavily involved in credit derivatives. [FCIC2011, Fig  20.4, for example]). U.S. bankers have been known to suggest that the non Anglo-Saxon banks played fast and loose with accounting rules, not declaring their losses on credit derivatives. The response to this criticism from French mathematicians is typically Gallic, and Cartesian, “They thought the models were wrong before August 2007, they were  certain they were wrong after August 2007, so why should they post losses that they were certain were wrong.”. This point was highlighted by a quote that appeared in The  Economist magazine, in January 2008 in relation to a fraud at the French bank, SocGen
In common with other French banks, SocGen was also thought by many to take  an overly mathematical approach to risk. “ ‘It may work in practice but does it work in theory?’ is the stereotype of a French bank,” says one industry consultant. (‘No Defense’, The Economist, 31 January 2008.)

The bankers at J.P. Morgan, along with French risk–managers, kept in mind Hume’s observation  that “it is never contradictory to deny matter of fact”. Bankers, like all scientists, must use their intellect and constantly ask themselves the questions ‘why’ and ‘how’ to give them the foresight not to act recklessly.

The common thread linking financial crises since Bretton-Woods, Black Monday, the Equitable,  the super–portfolio that bought down LTCM, the tech–bubble of 2000 and the Credit Crisis was not the collapse of Bretton–Woods but the adoption of standardised approaches to finance. Had the majority of traders, bankers and regulators thought like mathematicians, or French risk managers, and asked themselves, in a Cartesian manner, “how do I know what I think I know is true?”, then the crises might have been avoided. Banning speculative trading in deriviatives is simplistic, and not the answer.


P. Ackroyd. London: The Biography. Vintage, 2001.

FCIC. The Financial Crisis Inquiry Report. Technical report, The National Commission
on the Causes of the Financial and Economic Crisis in the United States, 2011.

D. MacKenzie. An Engine, Not a Camera: How Financial Models Shape Markets. The
MIT Press, 2008.

A. L. Murphy. The Origins of English Financial Markets. Cambridge University Press,

G. Poitras. The Early History of Financial Economics, 1478–1776. Edward Elgar, 2000.

G. Tett. Fools’ Gold. Little Brown, 2009.

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