The Bottom Line Blow Them Up or Burn Them Down

The founding father of pricing derivatives thinks the current way of doing business should be shut down completely.

There are those who say the present financial crisis was caused by a lack of transparency. One of the less transparent things today for suffering consumers and investors is the wisdom of their economic leaders.

In all the tumult surrounding the U.S. government's efforts to rescue and provide incentives, it's not at all clear which wise person will solve the crisis. The world economic leadership lacks a truly radical voice to present us with a completely different approach to dealing with the crisis and the global economy. All the prescriptions presented so far are nothing but old medicine, if not just home remedies.

The question of transparency was raised in a clear and scathing manner last week by none other than Myron Scholes, the Nobel Prize-winning economist. Scholes said derivatives products traded over the counter - not in an organized market - should be shut down completely. Speaking at a panel discussion at New York University's Stern School of Business, he said the "solution is really to blow up or burn" the over-the-counter market and start over.

Scholes included derivatives on stocks, interest rate swaps and credit default swaps in his list of what to move into regulated markets. CDSs, a sort of insurance policy against bond defaults, are the major cause of the collapse of insurance giant AIG.

Scholes, who won his Nobel for his work on pricing stock options and derivatives, is best known for the Black-Scholes Equation for such calculations. He also served for eight years as a director on the board of the CME Group, which operates the Chicago Mercantile Exchange, Chicago Board of Trade and New York Mercantile Exchange - the world's largest futures markets.

In many ways Scholes is the person who designed the model behind the pricing of the markets he now wants to blow up or burn down. He was also a partner in the infamous Long-Term Capital Management fund, a huge hedge fund that was in many ways responsible in 1998 for a mini-financial crisis that the U.S. Federal Reserve Board had to step in and fix.

Scholes has plenty of experience, deep understanding and even a personal interest in derivatives markets. You could say, perhaps, that he is the father of derivatives markets.

What Scholes has to say must certainly strike terror into the hearts of those sunk into these markets, even if it's not the same fear that struck them after these markets collapsed last year. Scholes recommends that regulators close down all these contracts at mid-market prices and start over by trading them afresh on a central market.

Compared to Scholes' simple words, closing down derivates markets is not so simple. Currently $531 trillion worth of over-the-counter derivatives contracts are outstanding - yes, that's $531,000,000,000,000. A huge chunk of this is non-negotiable due to the financial crisis, so closing them down would require regulatory intervention.

But Scholes' interesting idea is not so radical after all. In reality, it shows how distorted the concept of a "free market" has become in the past few years. The entity responsible for pricing and trading these derivatives was not the free market, but a long list (though probably not long enough) of financial institutions, and in particular banks' trading desks. These are the ones who traded directly with customers.

These traders had an interest in keeping the valuable derivatives far from the discerning eyes of the free market and its many players, in order to make as much profit as possible off them. The method of pricing the derivatives was complex enough to allow the trading desks to hide the risks involved. This lack of transparency is Scholes' main argument in his demand to rebuild the derivatives markets on regulated exchanges.

There was of course one wise man in Chelm who came out against derivatives, with or without transparency. Warren Buffett, the so-called Oracle from Omaha, wrote just last month in his annual letter to Berkshire Hathaway shareholders: "Derivatives are dangerous .... They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks. They allowed Fannie Mae and Freddie Mac to engage in massive misstatements of earnings for years .... Indeed, recent events demonstrate that certain big-name CEOs (or former CEOs) at major financial institutions were simply incapable of managing a business with a huge, complex book of derivatives. Include Charlie [Munger] and me in this hapless group."

Buffett writes to his shareholders: "Improved 'transparency' - a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks - won't cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can't audit these contracts, and regulators can't regulate them. When I read the pages of 'disclosure' in 10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don't know what is going on in their portfolios (and then I reach for some aspirin)."

Finally, as to his thoughts on pricing derivatives: "The Black-Scholes formula has approached the status of holy writ in finance .... If the formula is applied to extended time periods, however, it can produce absurd results. In fairness, Black and Scholes almost certainly understood this point well. But their devoted followers may be ignoring whatever caveats the two men attached when they first unveiled the formula."