The Best Thing About Being President of Harvard? Never Having to Admit a Mistake. Lawrence Summers & Derivatives
Thomas Sowell, who has a degree from Harvard in economics, said the best thing about having a Harvard degree was 'never again having to be impressed by someone with a degree from Harvard." In this article, Sowell's opinion of Harvard graduates will be extended to Harvard faculty in the person of Lawrence H. Summers.
Summers, who has a Harvard PhD in economics, served as Harvard president from 2001-2006, and is currently on the faculty as the Charles W. Eliot professor of economics. In addition to all his roles at Harvard, Summers has been active in government as well. He served as Deputy Treasury Secretary and Treasury Secretary in the Clinton Administration. Summers became Treasury Secretary on July 2, 1999 when he replaced another Harvard power-broker, Robert Rubin. (Rubin was off to Citigroup where he would make $115-million while Citigroup lost tens of billions.) (1) Later Summers would serve as President Obama's Director of the National Economic Council. Like few other people in the country, Lawrence Summers easily transitions between positions of great academic, financial and government power. This in spite of the fact that he has been proven spectacularly wrong in his area of (purely purported) expertise, economics.
Lawrence Summers and the Derivatives Controversy: May-July 1998
In May 1998 and under the leadership of Brooksley Born, the Commodities Futures and Trading Commission (CFTC) prepared their 'concept release' to consider regulating derivatives. Born wasn't a financier; she was a lawyer. However, much of her practice had involved financial derivatives. She had first hand experience with how complex and how large the derivatives market was becoming. She thought it made sense to look into whether derivatives should be treated in the same way other financial instruments, such as options and futures, were treated. Indeed, derivatives had been a growing source of concern among the more conservative members of the banking establishment for years.
However, for many in the banking establishment, derivatives were essentially the goose that laid golden eggs. What made the current regulatory environment so beneficial to these bankers was it allowed unlimited leverage on derivative products. As these bankers merely saw increased leverage from the standpoint of increased profits and not increased risk, this group of bankers would fight to prevent any regulation of derivatives. It was these members of the banking establishment that had the ear of Treasury Secretary Rubin. Some idea of the financial power behind the movement to oppose derivative regulation can be gleaned by the people called to testify against regulating derivatives. Not only was the Treasury department mobilized, but so too was the Federal Reserve (Alan Greenspan) and the Securities & Exchange Commission (Arthur Levitt).
The hearings on the CFTC's proposal were held in July 1998. In his July 1998 testimony, Summers gave two reasons for being skeptical of regulating derivatives (2);
- The parties to derivative contracts were largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies.
- Given the nature of the underlying assets involved...there would seem to be very little scope for market manipulation of the kind seen in traditional agricultural commodities.
The failure of the hedge fund Long Term Capital Management (LTCM) - coming less than two months after his July 1998 testimony - would show these two reasons to be completely wrong.
Reason 1: The Sophisticated Financial Institutions Argument - WRONG!
If any firm exemplified both the mind-numbing complexity and the enormous risk of derivatives it was LTCM. LTCM developed mathematical models to determine what prices should be. It used the result of the calculations to enter into derivatives contracts. Because the prices predicted by its model were often only slightly different than the prices which prevailed in the market, the only way for LTCM to make serious money was to use enormous amounts of leverage with its derivative trades. (In these trades, LTCM would essentially 'bet' that the market price would move toward the price predicted by its model.) For every $1 in capital, LTCM might borrow $30. With this amount of leverage, very small losses could wipe the firm out. Stripped of its mathematical complexity, the geniuses at LTCM thought they could make a fortune by picking up pennies in front of freight trains.
Some idea of the complexity - and the enormous intellectual arrogance - behind LTCMs mathematical models can be gleaned by a review of the educational background of some of LTCM's partners. Greg Hawkins, Larry Hillibrand, William Krasker, Robert Merton, David Mullins and Eric Rosenfield all had PhDs from MIT. Merton was also a professor at MIT and won the Nobel Prize in economics. Rosenfield and Mullins both taught at Harvard, and Mullins was also vice-chair of the Federal Reserve.
The presence of so many sophisticated and (supposedly) well-educated financiers in key positions with LTCM completely undermines Summers first reason for not wanting to regulate derivatives - 'sophisticated financial institutions who are able to protect themselves from counterparty risk.' Not only was LTCM comprised of sophisticated traders, so were all of LTCM's counterparties. LTCM's counterparties included the largest Wall Street banks. When LTCM was on the verge of failure, the Greenspan Fed felt forced to organize an enormous bailout of LTCM to protect these counterparties from LTCM's default. Not only did this bailout eviscerate Summers' first reason for being opposed to regulating derivatives, it also precipitated the largest mistake of the Greenspan era; the Fed's emergency rate cut of October 1998. (3)
Reason 2: The Derivative Markets Can't Be Manipulated Argument - WRONG!
In August 1998, when LTCM had just started to enter its death throes, some traders apparently became aware of LTCM's troubles and began to push the market against LTCM. Evidence of this is provided by a conversation LTCM's founder, John Meriwether, had with a former Salomon Brothers colleague, Vincent Mattone. In spite of not having worked with Meriwether for several years, Mattone remained a close personal friend of Meriwether - a rarity on Wall Street. The fact that Mattone nurtured, maintained and valued friendships wasn't the only thing that made him stand out on Wall Street.
Mattone was a throwback to the Wall Street of old; before the MIT PhDs thought they could reduce trading to a mathematical exercise, and before twenty-five year old Harvard art history majors thought they were ill-served when they only made $750,000 in a year. Mattone started at Salomon Brothers as a clerk at nineteen. He never earned a college degree and preferred pinky rings to Hermes silk ties. With little more than his wits and his work ethic, he worked his way up to very senior positions with both Salomon Brothers and, later, with Bear Stearns. Unlike the MIT PhDs and Harvard professors - whose ridiculous ideas formed the basis for LTCM's trading strategies - Mattone recognized that markets were human affairs, not scientific exercises. (4) In August 1998 Mattone asked Meriwether how much capital LTCM had lost. When told by Meriwether LTCM had lost 50% of its capital in the past few weeks, Mattone quickly concluded, 'You're finished....when you're down by half, people figure you can go down all the way. They're going to push the market against you." (5)
Recall that Summers believed 'little scope for market manipulation' existed with derivative trades! Vincent Mattone - who had forgotten more about market behavior than Summers would ever learn from a million Harvard PhDs - came to the opposite conclusion. The collapse of LTCM - which came very rapidly and in snowball fashion - proved Mattone correct and Summers wrong. Indeed, after LTCM collapsed, John Meriwether completely endorsed Mattone's assessment of the derivative market when he said,
"A hurricane is not more or less likely to occur because hurricane insurance has been written. In financial markets this is not true. The more people write hurricane insurance, the more likely it is that the disaster will happen because the people who know you sold hurricane insurance can make it happen." (6)
Concluding Remarks
LTCM's failure and the subsequent Fed bailout of LTCM came just two months after Summers' July 1998 testimony. In spite of completely undermining his two reasons for leaving derivatives unregulated, Summers never changed his obviously incorrect position on derivatives. In fact, in November 1999, Summers prepared a report on derivative regulation for the President's Working Group on Financial Markets. LTCM was only mentioned three times in the report! (7) The report was a total whitewash. Instead of detailing the exact manner in which the LTCM disaster had exposed the enormous danger derivative markets were rife with, and his complete ignorance of these dangers, Summers' report ignored the obvious lessons from LTCM. Instead, the report recommended providing derivative markets 'legal certainty' and removing 'legal obstacles' to the development of new derivative clearing systems. In doing so, the report paved the way for the much larger derivatives related debacle that would emerge from the 2008 financial crisis; the spectacular collapse and enormous bailout of AIG.
You know what real power is? Never having to explain a mistake. Lawrence Summers has that type of power in spades. Whatever you do, don't confuse that power with wisdom.
Peter Schmidt
Sugar Land, TX
July 26, 2020
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ENDNOTES:
(1) Not long after leaving Treasury, 18 OCT 99, Rubin would work for Citigroup. In a eight years he would be paid $115-million by Citigroup and then claim he didn't have any responsible for Citigroup's enormous losses because 'he wasn't senior management.' http://www.the92ers.com/dunce/robert-rubin
(2) Treasury Deputy Secretary Lawrence H. Summers Testimony Before the Senate Committee on Agriculture, Nutrition and Forestry on the CFTC Concept Release, July 30, 1998
https://www.treasury.gov/press-center/press-releases/Pages/rr2616.aspx
(3) http://www.the92ers.com/dunce/alan-greenspan
(4) In the movie "Trading Places," Eddie Murphy's character, Billy Ray Valentine - a Capricorn, demonstrated the same earthy knowledge of markets. Rather than purchasing pork bellies at the price recommended by the all-powerful Duke Brothers, Valentine recommended waiting for a lower price. He reasoned because it was so close to Christmas, traders caught on the wrong side of the trade in bellies would be in a panic to sell out of concern they wouldn't be able to buy their son the 'GI Joe with the kung-fu grip.'
https://www.youtube.com/watch?v=ruV7jp2QAq4
(5) Roger Lowenstein, When Genius Failed, Random House, NY, 2011, p. 156-157
(6) James Grant, Mr. Market Miscalculates, Axios, Mount Jackson, VA, 2008, p. 348
(7) Over-the-Counter Derivatives Markets and the Commodity Exchange Act, Report of the President's Working Group on Financial Markets, November 1999
https://home.treasury.gov/system/files/236/Over-the-Counter-Derivatives-Market-Commodity-Exchange-Act.pdf