HOLOGRAPHIC IMAGE OF AN EMPTY PAPER BAG: FTX Meltdown is the natural outgrowth of allowing trading in unregulated securities sold as “derivatives”

Alan Greenspan admitted (after the 2008 crash) that he and the rest of the Federal Reserve had made a huge mistake in failing to regulate the creation, sales, and trading of derivatives that were only tenuously linked to the lending marketplace. The securities had no value or known attributes, but Greenspan was operating under the Milton Friedman doctrine that free market actions would make any necessary corrections.

This was ideology at its worst.

He wasn’t wrong about how free markets operate. He was wrong in assuming that the market in these falsely labeled lending derivatives was free. He also assumed that such “derivatives” literally derived their value from some underlying asset that was legally owned by the issuer of these unregulated securities (unregulated because Bill Clinton signed the Republican bill into law without anyone realizing that they were letting the tigers out of the cage).

The derivative marketplace was not and is not free, and thus no free market forces were applied. It was strictly controlled, with no competition or other factors that could have effectuated a return to reality. The crypto meltdown at FTX also involved similar derivatives that were offered as having the value “because we say so.”

That works until it doesn’t.

In the mid-1990’s I knew many brokers who were getting rich selling and trading derivatives. They used the word “derivative” like it was a religious icon. That was because they were making 3-4 times their previous annual income with bonuses from the brokerage house where they worked.

There is nothing magical about a derivative. All securities (regulated and unregulated) are derivatives (or they are supposed to have a legally recognized derivative value to be legal). They derive their value from some asset that exists in real life. Perhaps a business or investment. The asset is owned by the security issuer, which then reduces its declared ownership by the amount of ownership purchased. It really is that simple.

But all derivatives sold in the crypto markets were based solely on gambling — the subject being future market conditions — i.e., demand for more crypto. This is like the meme stocks with no rhyme or reason during the pandemic. Stocks were run up in price because of demand derived from boredom.

“Derivatives” referenced in the lending marketplace suffered from the same fatal defect. They were pure crap — worse than junk bonds.

So when I mentioned to my friends on Wall Street nearly 30 years ago that they were selling crap, they responded that they were selling it because people were buying it. And that financed mansions and the expansion of mansions. They didn’t know what to do with all that money. They also didn’t fully appreciate the fact that the “certificates” they were selling were both underwritten and issued by the same entity — an investment bank bookrunner. There was no asset.

So to the investment bank, it was free money that they could spread around a little to other securities brokers and all the way down the line paying pizza delivery guys $1 million per year. But eventually, like FTX and the 2008 crash, there is a reckoning. The interesting and dismaying development with certificates that were falsely claimed to be “mortgage-backed” and falsely claimed to be “bonds” is that instead of disappearing, they are flourishing.

As soon as the Fed decided to “save the banks” by buying the wrongfully labeled MBS, the market appeared to be real instead of closed (which it was). Maybe the same thing will happen with crypto and even meme stocks. But I think that history shows that when all the mania dies down, people gravitate to fundamental values rather than the hype, the sizzle, and the holographic image of an empty paper bag.

2 Responses

  1. Great article Neil, keep ‘em coming

  2. Excellent article Neil! Thanks

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