…vanity of vanities; all is vanity (Ecclesiastes 1:2b).
Economic historians will be analyzing America’s early 21st century credit crisis till Jesus returns. As a veteran of the early days of these financial wars, it appears to me that the primary reason will be, “greed exceeded fear,” and the secondary reason will be a.) Misguided government policy initiatives—home mortgages for folks who really could not afford them, called “sub-prime,” combined with private innovation that outran the understanding of management and government regulators. No one with a nodding acquaintance of the situation will doubt, with 20/20 hindsight, that it could have been avoided, and though it will not be the end of America as we know it, it will create a large class of former millionaires. Here’s a brief history lesson not learned by the innovators, regulators and legislators that would significantly suppress the flames of a future global bonfire.
With the Breton Woods agreement in 1971 the dollar went off the gold standard—fixed exchange rates—and central bankers let market forces (theoretically, but with intervention from time to time) determine foreign exchange rates. Leo Melamed and some creative guys in the commodity futures trading pits of the Chicago Mercantile Exchange decided the world was ripe for futures trading in the ultimate commodity—money. I was a fighter pilot fresh out of the US Air Force, looking for something to match the adrenaline high of dancing the wild blue in a supersonic angel during the Vietnam War. The idea, as Leo presented it, of trading foreign exchange futures in Chicago’s 100-year-old commodity futures trading pits captured my imagination and I went to work for the Chicago Mercantile Exchange.
With a great deal of ballyhoo by the Chicago traders, and righteous indignation and incredulity by New York and London bankers, some of whom literally laughed Leo and me out of their opulent offices, foreign exchange futures trading began in the ignominious commodity trading pits in May, 1972, cheek by jowl, as it were, with pork belly futures. A few years later, as a Director of The Exchange, I chaired the committee that designed one of the world’s first two financial derivatives contracts—Treasury Bill futures. (I just called the meetings to order and some financial geniuses handled the heavy creativity.) The rest is trillion dollar history. Why, you may ask, would I be confessing this with blood up to the horses’ bridles on Wall Street and your IRA in the tank caused by second and third generation financial derivatives trading?
Here’s the lesson. Shortly after financial derivatives trading began in Chicago, the New York City masters of the universe smelled the money, quit laughing and joined their unholy brethren, fraternizing with the very unwashed country bumpkins they had scorned in Chicago’s futures trading pits—sweet revenge for Leo and me. They stood sweating, shouting, shoving, spitting, and on occasion, biting one another, in the wildest, most archaic, yet most unfettered arena of capitalism left in this world, but they saw it as a bit below their dignity. They took the concept back to the high rise hubris-filled trading rooms of Wall Street (not unlike a fighter squadron operations room in terms of egomania) and created all kinds of new financial derivatives based on home mortgages, so exotic, it turns out, that even their own management and regulators did not understand them.
In their hurry to get out of corn country they forgot (or, sarcasm aside, considered and discarded) the most important part of the mechanism—the exchange clearinghouse—and today we see the catastrophic result, a global bonfire that has vaporized vanity, careers, and many billions of dollars. It was those exotic second and third generation derivatives based on basic home mortgages, using (insane!) leverage of 30 and 40 to 1 without the protection of a clearinghouse, that hugely magnified the problems caused by foreclosures (primarily the sub-prime mortgages), even though the defaulted mortgages represent a single digit percentage of all mortgages outstanding in America. The Wall Street Journal reported Sept. 20, 2008 that as of the end of August 24.8% of sub-prime mortgages, most of which were originated in 2006 and 2007, were at least 30 days past due, though that represented only 6.6% of all mortgages outstanding, up from 5.8% at the end of June and 4.5% a year earlier.
A clearinghouse standing as the guarantor for all derivatives trades, marking all transactions to the market daily and settling with cold hard cash from both parties to every transaction, would have removed the domino effect of a major financial institution failure. (And it is beneficial for other important reasons, such as transparency of transactions and a real time view of the size of the market.) This clearinghouse mechanism is not new. It has been used in Chicago since the Board of Trade began trading in agricultural commodity futures in the middle of the 19th century. Back in March of this year, with the napalm blast of the Wall Street’s Bear Stearns’ multi-billion dollar immolation, some regulator suggested that maybe a clearinghouse for such trading would be worth looking into, but the idea apparently got lost in the ashes. Now, 6 months later, more of the mighty financial institutions have fallen, been bought out at pennies on the dollar of their intrinsic value, or become wards of the American taxpayers. God willing, with some good management, the taxpayers could turn a tidy profit for all the risk that has been foisted upon them from innovation and legislation run amok.
Meanwhile the Chicago financial derivative traders and their clearinghouse system continue to run a thriving financial behemoth with the merger of the Chicago Mercantile Exchange, the Board of Trade and NYMEX under the name of CME Group, an integral part of the world’s financial system. Someone in authority on Wall Street needs to wipe the blood out of his eyes, come in off the ledge and go relearn some lessons from those unwashed heartland country bumpkins.
Or, if the money’s all gone and hope with it, they are welcome to come on out to Colorado Springs and we’ll talk about more important matters.
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JD Wetterling is a former Director of the Chicago Mercantile Exchange (now CME Group), and Chairman of its Finance Committee and Interest Rate Futures Committee. He’s now a PCA elder and author (www.jdwetterling.com) living in Colorado Springs, Colo.