14. Financial Arms Race

Over time, seduced by their allure, dealers began trading derivatives, risking their own money. Like narcotic dealers, they discovered the pleasure of their illicit, highly addictive products. They had not heard the warning of the seventeenth-century French author François de La Rochefoucauld: “We are so accustomed to disguise ourselves to others that in the end we become disguised to ourselves.”

Derivative professionals, especially quants, were taken in by an elegant vision of a scientific and mathematically precise vision of risk. As the English author G.K. Chesterton wrote: “The real trouble with this world [is that].... It looks just a little more mathematical and regular than it is; its exactitude is obvious but its inexactitude is hidden; its wildness lies in wait.”¹

Shock-Gen

Société Générale (SG or Soc-Gen) was the crème de la crème of French banking, synonymous with complex, state-of-the-art derivatives. On January 24, 2008 the French bank announced losses of €5.9 billion from trading equity derivatives. The Financial Times Lex Column rechristened the bank ShockGen.

Jerome Kerviel, a junior SG trader, used derivative contracts to take positions on stocks, trading in equity indexes like Dow Jones Eurostoxx 50, Germany’s DAX, and London’s FTSE 100 indexes. Kerviel’s job was to buy from and sell to clients, offsetting positions with other banks to minimize risk. It turned out that Kerviel had not matched the positions, creating fictitious trades to hide purchases of €50 billion of shares.

La Défense, the nouveau, très moderne Paris business district bordering a graveyard, where SG is based, is named after an 1884 statue commemorating the soldiers who defended Paris during the Franco-Prussian War. In damage control mode, SG’s public relations defended the bank with the same determination. Kerviel was a “super villain” with an “extraordinary talent for dissimulation.” Using his knowledge of SG’s operations, he carefully hid the positions using derivatives and falsified documents. The bank’s version lost credibility as the facts emerged.

SG had not detected the huge positions because the bank focused on the net position, the difference between bought and sold positions. Kerviel’s positions escaped detection because the fictitious portfolio of trades balanced the real transactions, giving the impression there was no net position and therefore no risk. The positions required SG to lodge cash to support transactions. SG had not noticed the size of the margin calls. Eurex, the European derivative exchange, actually sent detailed data that allowed the bank to tie specific positions and cash movements to individual traders. SG had not reconciled the information.

Between June 2006 and January 2008, on more than 90 occasions, there were internal queries about Kerviel’s trading. The trader’s explanation of anomalies was accepted without further investigations, despite oddities like products scheduled to mature on days when the market was closed. Eurex queried Kerviel’s trading in late 2007. SG responded, but considered the queries “technical.” Daniel Bouton, SG’s chief executive, admitted that the bank’s derivatives business designed to run at 80 mph was actually doing 130.

Evil Kerviel

Whenever a bank loses a large sum trading, it is always blamed on a rogue trader. In 1995, Nick Leeson of Barings lost £860 million ($1.4 billion) in equity trading. In 1996 Yasuo Hamanaka of Japan’s Sumitomo lost $1.8 billion in copper trading. In 2006, Brian Hunter and hedge fund Amaranth lost $6 billion in natural gas trading. Recycled French homilies could not explain the largest derivative trading loss in history.

Banks do not want to admit that risk taking and profits from speculation are part and parcel of modern finance. In 2007, around 35 percent of the profits of SG’s corporate and investment bank came from trading, both with clients and on the bank’s own account. Like competitors, SG encouraged and allowed aggressive risk taking and competition between traders.

In 2004, the National Australia Bank (NAB) lost hundreds of millions in currency trading. Sentencing two former traders, Judge Geoff Chettle identified a culture in which traders were seemingly “invincible.” The NAB team described themselves in Olympian terms—BOAT or Best of All Time. The judge identified “a culture of profit-driven morality...you [had] to take risks in order to achieve the projections and targets set for your desk. To further your career, you had to succeed.”²

Like Leeson, Kerviel was an unlikely rogue. Unlike the bulk of SG traders who were graduates of France’s prestigious grande écoles in quantitative disciplines, Kerviel studied at second-tier universities in Nantes and Lyon. Like Leeson, Kerviel joined SG in a support role, making the rare transition from back office to a junior trader in 2005.

Despite his job entailing low risk, Kerviel started taking positions to bet on the movements in shares. Kerviel claimed that unauthorized trading was widespread and tolerated when it made money. In late December 2007, his positions showed profits of $2 billion, before the markets turned and the gains became losses.

Kerviel was not greedy, hoping only for a modest €300,000 bonus. But he wanted recognition as an exceptional trader: “This will show the power of Kerviel.”³ Kerviel admitted: “You lose a sense of the sums involved in this type of work. You get desensitized.”⁴

Soldier Monks

ShockGen damaged French banking’s image of cutting-edge quantitative finance. In May 2007, Christian Noyer, the governor of the Banque de France, praised French banks’ derivative skills: “French expertise in this field is founded on a solid teaching in math and finance, the key to excellency in financial fields, and on an important hive of university-level talents.”⁵

At SG Antoine Paille built the derivative business in the 1980s, drawing on the skills of highly trained engineers and mathematicians from the grande écoles. SG’s reputation was for complex derivatives, especially in stocks and currencies. There was no insurance or guarantee structure that they would not price or trade. Like the devout and disciplined monks who fought in the Crusades, Paille’s traders—les moines-soldats—personified innovation, skill, confidence, and arrogance.

The French grande écoles propound a system based on the work of René Descartes, the seventeenth-century French mathematician and philosopher. SG’s traders believed in the Cartesian system—an ordered world where models can be built to understand and predict outcomes. Kerviel circumvented sophisticated systems with crude, simple strategies. SG’s vaunted risk management systems and risk managers did not detect the unhedged €50 billion exposure to European markets. Foreigners joked that, as a result of ShockGen, France finally achieved a world record in finance.

Kerviel emerged as a heroic figure—the Che Guevara of finance or the James Bond of SocGen. Some called for Kerviel to be awarded the Nobel Prize for economics. There were Kerviel T-shirts. The social-networking site Facebook hosted groups dedicated to the support of Kerviel. Kerviel went on to publish his own book, L’engrenage, Mémoires d’un trader.

Mystère Kerviel

In 2010, Kerviel appeared in a French court charged with breach of trust, computer abuse, and forgery. The judge’s first question was: “Tell me who you are—who is Mr. Kerviel?”⁶

The trial featured France’s two best-known lawyers—Olivier Metzner defending Kerviel and Jean Veil for SG. Metzner noted: “When it is a case of a man against the system, I defend the man and not the system.”⁷

Daniel Bouton, who resigned as SG’s CEO, testified that the trading scandal was a “catastrophe” and a “hurricane” that nearly destroyed the bank. Bouton spoke of his “formidable anger” at learning of the “monstrous” bets and losses: “It is not the business of a bank to risk its very existence.” Bouton rejected claims that SG knew of the positions taken by the “evil genius”: “I cannot believe for one second any of Jérôme Kerviel’s supervisors were aware. I’m sorry, my dear fellow.”⁸ Jean-Pierre Mustier, the former head of SG’s investment bank, told the court that traders were encouraged not to take risks but to “know how” to take risks.⁹ SG’s failure was in creating an environment of “too much trust.”¹⁰

Summing up, Olivier Metzner told the Paris courtroom that Kerviel was a young man “formed—deformed—by Société Générale.” He was a 33-year-old country boy from Brittany who entered a “virtual” world where “numbers had no meaning.” Turning the judge’s first question around, Metzner asked: “Who are you, Société Générale? Who are you? How do you create men like this?” It echoed the testimony of another SG employee Nicolas Huc-Morel: “There is no ‘Kerviel mystery.’ The mystery is rather Société Générale. How could the bank allow [such] massive positions to be taken? How could Mr. Kerviel’s superiors not have known?”¹¹

Kerviel maintained that his superiors were aware of his risk taking. Metzner claimed: “It is not a man at fault here but a system.” Kerviel revealed the ambiguity in the relationship between traders and banks that employ them: “I’ve said it, and I repeat it: It’s in my mandate when I’m making money, it’s no longer there when I’m losing it.”¹²

On Tuesday, October 5, 2010 Jérôme Kerviel was convicted of breach of trust and other crimes and sentenced to 5 years in prison and ordered to pay SG €4.9 billion. The impossible level of damages made the French court the “laughing stock” of the world.¹³ SG indicated that the damage award was symbolic. Based on his salary as a computer security consultant, it would take Kerviel 177,000 years to pay.

The damages left Kerviel bankrupt and crippled for life, unable to make trouble for the French establishment: “a token ball and chain attached to him for the rest of his life. The €4.9 billion fine is a little illusory as it makes little difference whether one drowns in 10 feet of water or two miles.”¹⁴ The French court’s decision also made it difficult for related American class action lawsuits to be pursued against SG, its directors and management.

When ShockGen’s losses were revealed, Christian Noyer told reporters he was “totally serene.” About 8 months later, Noyer’s American peers were anything but calm as AIG, the world’s largest company, found itself in serious financial difficulty from a toxic combination of derivatives, model failure, and an old-fashioned need for cash.

Risk Is Our Business

Cornelius Van der Starr founded AIG in 1919 in Shanghai, China. Under Maurice R. “Hank” Greenberg, Starr’s successor and CEO for 37 years, AIG became one of the largest underwriters of commercial and industrial insurance in the world, with $110 billion in revenues and $1 trillion in assets.

AIG’s marketing boasted that “the biggest risk is not taking one.” In September 2008, AIG’s poor risk management required a government rescue, with an initial $85 billion line of credit.

AIG’s problems related to AIG Financial Products (FP), a specialist derivative trading operation, the brainchild of former Drexel Burnham Lambert trader Howard Sosin. Restricted by Drexel’s low credit ratings, he saw the opportunity to create a derivatives business using AIG’s AAA credit rating and large balance sheet.

Fortuitously, Greenberg was looking to expand outside insurance at the time. Aware of the risk of the complex joint venture, Sosin negotiated the arrangements carefully. As his legal advisor put it: “let us plan your divorce while we’re planning your marriage.”¹⁵ Sosin got autonomy and a generous financial share of the business. AIG got 65 percent of earnings, while Sosin’s team received 35 percent.

Initially, FP focused on traditional derivatives, interest rate, and currency swaps. FP focused on long-dated transactions, up to 30 years, taking advantage of AIG’s AAA status. In July 1987, FP completed a $1 billion swap with the Republic of Italy, ten times a typical trade at the time, earning $3 million. In its first 6 months of operation, FP made around $60 million, establishing itself as the go-to shop for complex, long-dated derivatives.

FP became a beautiful money-making engine, contributing more than $5 billion to AIG’s pretax income. Sosin was well rewarded. Even a company lawyer received a $25 million bonus at the end of 1 year.

The autocratic Greenberg mistrusted the equally autocratic Sosin’s independence. Sosin resented Greenberg’s interference in operations that AIG did not understand. The central issue was the calculation of FP’s profits.

Derivative transactions are accounted for on a mark-to-market (MtM) basis—the current market price of the instrument. MtM accounting allows earnings to be recognized up front, even if the deal has a life of 30 years. As derivatives trade privately, market prices for specific transactions are not directly available. Derivative profits are mark-to-model or mark-to-myself rather than mark-to-market. Model variations and small differences in input can result in large changes in values for some products. Investment blogger Nicholas Vardy compared mathematical models to bikinis: “What they reveal is suggestive; but what they conceal is vital.”¹⁶

As there is no real market for long-term, complex deals, Sosin and FP were the market. Trading was illiquid. In the words of the trader: “I would take your time and have your cup of coffee.”¹⁷ FP’s deals created the quotes against which their transactions were valued. FP and Sosin received theoretical profits up front based on models while AIG remained at risk over the life of the transaction. FP had access to AIG’s credit ratings and capital, largely rent-free. Sosin and FP had powerful incentives to chase short-term profits, leaving AIG with potential future losses.

Warren Buffett inherited Gen Re Securities, a smaller operation modeled on FP, when Berkshire Hathaway bought General Reinsurance. Buffett told shareholders that derivatives were like hell: “easy to enter and almost impossible to exit.”¹⁸ One contract was for 100 years.

Buffett discovered valuation problems:

Marking errors in the derivatives business have not been symmetrical. Almost invariably they...favored the trader who was eyeing a multimillion dollar bonus.... Only much later did shareholders learn that the reported earnings were a sham.¹⁹

Buffet’s feelings on Gen Re’s derivatives were like a Country and Western song: “I liked you better before I got to know you so well.”²⁰

In 1993, Greenberg terminated the agreement, forcing Sosin out. Many of the FP team stayed on, ensuring the continuation of the unit. Under the new agreement, AIG received 70 percent and the employees 30 percent of profits, but were forced to reinvest 50 percent of what they received in FP. At the time of its demise, employees had more than $500 million invested in FP.

In 2005, Sosin’s payout from AIG emerged in the course of his real divorce. His wife received a $40 million settlement—a $24 million payment, $3.6 million Manhattan apartment, $2 million Utah ski house, $800,000 home in Wallkill, NY, $6 million in brokerage accounts, eight cars and $2.9 million in jewelry. The settlement revealed that Howard Sosin had received $182 million from AIG upon termination.

Free Money

Around 1997, banks began using synthetic securitization to get risk off their books to reduce capital needs. The structure created the low-risk super senior tranche that banks wanted to sell off. After JP Morgan introduced the idea, FP began selling credit insurance, in the form of credit default swaps (CDS). Under the contract, AIG received a fee from the bank. In return, FP agreed to insure the bank against the small risk of loss on the super senior tranche. By 2008, FP had insured around $450 billion of this risk. AIG’s AAA rating and ability to take these risks more cheaply than a regulated bank made FP the go-to house now for super senior risk.

When FP entered into any contract on interest rates, currencies, equities, or commodities, it simultaneously entered into offsetting contracts to minimize its own risk. The focus was protecting AIG’s AAA credit rating. Greenberg warned Tom Savage, Sosin’s successor, that he would come after him “with a pitchfork” if FP endangered the AAA rating.²¹

Under the quantitatively trained Sosin and Savage, FP did not enter trades that “we can’t correctly model, value, provide hedges for, and account for.”²² Savage was skeptical about the credit business, especially valuing the risk. Joseph Cassano, Savage’s successor, was versed in accounting and credit but had limited quantitative skills.

Under CDS contracts, FP retained the risk unhedged. FP viewed the super senior risk like the catastrophe risk that AIG routinely insured—remote events unlikely to ever happen. In an investor presentation in May 2008, AIG pointed out the similarities between excess casualty insurance (catastrophe insurance) and FP’s super senior CDS portfolio.

FP relied on a model built by Yale Professor Gary Gorton, “guided by a few, very basic principles, which are designed to make them very robust and to introduce as little model risk as possible.”²³ The model used historical data to estimate the likelihood of losses on the insured portfolios of corporate debt and mortgages. Based on the models, the chance of losses on the super senior tranches that FP insured was remote: a one-in-a-million-year event. As Warrant Buffet quipped: “All I can say is, beware of geeks...bearing formulas.”²⁴

FP’s models convinced Cassano and AIG that they would never have to cover any losses, making hedging unnecessary. The payments to take on this risk amounted to free money. In a 2007 conference call with investors, Cassano argued: “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions.” AIG CEO Martin Sullivan added: “That’s why I am sleeping a little bit easier at night.”²⁵ AIG ignored German writer Ernst Jünger’s warning: “a half witted mathematician could cause more damage in a second than Frederick the Great in three Silesian campaigns.”

Credit’s Fatal Attraction

FP’s model focused on the risk of loss if the insured securities defaulted, not changes in the value of the contracts over its life, especially unrealized MtM losses. Initially, FP insured corporate debt but subsequently began insuring complex securitized loans and mortgages. In 2005, FP was surprised to find that it had insured bundles of loans that were 95 percent U.S. subprime mortgages, rather than an assumed 10–20 percent. As the nineteenth century American humorist Josh Billings observed: “It is better to know nothing than to know what ain’t so.”

In 2007/8, the fall in values of subprime mortgages triggered large MtM losses on FP’s CDS portfolio. Credit risk spreads or margins rose, reflecting increased risk. Increased systemic risk pushed up default correlation (implying more defaults and losses if any borrower failed). In many cases, there were no actual losses. Where there were losses, losses did not threaten the super senior pieces that FP had insured. But the contracts showed substantial MtM losses. Responding to the altered market environment, the rating agencies downgraded the super senior tranches, triggering further losses.

To reassure banks, FP had agreed to post-cash collateral if the super senior tranches were downgraded, the current loss reached a threshold level, or AIG got downgraded below AA–. Now, as the insured super senior tranches showed losses, AIG was downgraded because of losses on the FP CDS portfolio and its investment portfolio, which was separately exposed to mortgage markets. One FP employee warned another: “the problem that we’re going to face is that we’re going to have just enormous downgrades on the stuff we got...we’re...f***ed basically.”²⁶

In November 2007, the CDS portfolio showed mark-to-market losses of $352 million. By December 2007, the losses increased to $1.1 billion. In May 2008, AIG announced a record quarterly loss of $7.8 billion, driven by write-downs of the value of the swaps. By August 2008, AIG estimated CDS losses at $8.5 billion. FP’s risk models still showed that there was a 99.85 percent chance that there would be no actual losses.

As MtM losses climbed, collateral calls flowed in. Goldman Sachs, who insured more than $20 billion of risk with AIG, demanded $1.5 billion in August 2007, and a further $3 billion in October. FP paid $450 million in August and a further $1.5 billion in October. By September 2008, AIG had posted in excess of $10 billion in collateral. FP suspected that trading partners were manipulating prices to increase losses and the collateral demanded. Commenting on the battles over collateral, Gary Gorton later seemed surprised: “It is difficult to convey the ferocity of the fights over collateral.”²⁷

Investigating differences between the FP’s prices and the collateral demanded by dealers, PwC, AIG auditors, identified serious problems in risk management. Former New York Federal Reserve president Gerald Corrigan, now a managing director at Goldman Sachs, had warned in 2007: “Anyone who thinks they understand this stuff is living in lala land.”²⁸

Lehman Brothers, whose operating principle was demonstrating smart risk management, filed for bankruptcy protection on 15 September 2008. Rating agencies reduced AIG’s credit ratings below AA on the same day. AIG now had to post $18 billion in further collateral to trading partners. In 2007 Gary Gorton wrote that “while financial intermediaries have changed in many ways, at root their problems remain the same. Indeed, the old problem of banking panics can reappear in new guises.”²⁹ Now, AIG simply did not have the cash.

FP dealt with a “global swath” of sovereigns, supranationals (like the World Bank), municipalities, banks, investment banks, insurance companies, pension funds, endowments, hedge funds, fund managers, and high-net-worth individuals. All major market participants were linked to each other by a complex network of contracts that few fully understood. In October 2008, Gorton wrote:

You have this very, very complicated chain of...risk, which made it very opaque about where the risk finally resided...the whole infrastructure of the financial market became kind of infected, because nobody knew exactly where the risk was.³⁰

If AIG failed, then the institutions that relied on it to insure its risk would have a problem, and then the institutions that relied on those institutions, and so on. The entire intricate structure would unravel if AIG failed to meet the collateral calls and filed for bankruptcy. The U.S. Government was forced to intervene to prevent the collapse of the global financial system, at an ultimate cost of around $180 billion.

The weekend after the AIG bailout, fans of UK soccer club Manchester United, sponsored by AIG, put a line through the company’s logo displayed on the front of the club’s shirt. In its place were the words “U.S. Treasury.”

Post-Modern Contradictions

In June 2009, the global derivative market totaled $605 trillion in notional amount, up from less than $10 trillion 20 years earlier. The volume compares to global GDP of $55–60 billion. As author Richard Duncan pointed out, the global derivatives market at its peak in June 2008 ($760 trillion) was equal to “everything produced on Earth during the previous 20 years.”³¹

Proponents argue that derivatives are used principally for hedging and arbitrage. They are essential to risk transfer, savings, investment, and lowering the cost of capital. But volumes of derivative products traded are inconsistent with hedging. In the credit derivatives market, at the peak, volumes were in excess of four times outstanding underlying bonds and loans. While they can be used for hedging, derivatives are now used extensively for speculation, manufacturing risk, and creating leverage.

Relatively simple derivative products, forwards or options, provide ample scope for hedging. Dealers argue that the proliferation of complex, opaque products was customer demand for “financial solutions.” In reality, derivatives are used to provide leverage to investors and corporations, increasing gains and losses for a particular event, such as a change in market prices of an asset, in accordance with customer requirements.

In 1999, Alan Greenspan remarked: “the profitability of derivative products has been a major factor in the dramatic rise in large banks’ noninterest earning...the value added of derivatives themselves derives from their ability to enhance the process of wealth creation.”³² The Fed chairman missed the true source of derivative profitability. Opaque and inefficiently priced financial products produced high profit margins.

Derivatives allow risk to be altered and reconstituted in infinite combinations and transferred between participants. In aggregate, the risk remains constant. Sometimes a risk is converted into a different, more dangerous exposure. The law of risk conservation means that risk in financial markets rarely decreases. Derivatives are powerful instruments but: “It’s like a hammer. You could use it to hammer in a nail with perfect precision. But you could also use it to pound someone’s brains out.”³³

Derivative Deconstruction

Academics, who created models to price derivatives, failed to make money trading when they tried to identify and buy undervalued options on stocks. The market knew things that the model did not. Wall Street’s PSDs, “poor, smart, and a deep desire to get rich,” turned derivatives into an extraordinary business. Rather than using derivatives to manage risks, dealers structured transactions to create risks, disguise true values, delay competition, and prevent clients from unbundling products. They reduced transparency and skewed the risk-reward relationship against the client.

In a January 2009 speech, Lord Adair Turner, chairman of UK’s Financial Services Authority, agreed:

Much of the structuring and trading activity involved in the complex version of securitized credit was not required to deliver credit intermediation efficiently, but achieved an economic rent extraction made possible by the opacity of margins and the asymmetry of information and knowledge between...users of financial services and producers...financial innovation which delivers no fundamental economic benefit, can for a time flourish and earn for the individuals and institutions which innovated very large returns.³⁴

Economist John Kay added: “There was never an economic rationale for structured products on the scale on which the financial services industry created them. They were the result of a frenetic search for commissions and bonuses.”³⁵

In the global financial crisis, Buffett’s label of “weapons of mass financial destruction” was literal. After it filed for bankruptcy protection, Lehman was found to own enough uranium cake to make a nuclear bomb. The investment bank acquired the uranium under a matured derivative contract.

Derivatives also created a false sense of security, encouraging greater risk taking. When the problems began, not only did derivatives fail to transfer risk, they increased the losses through leverage.

Jacques Derrida, the French philosopher, developed deconstruction, the pursuit of meaning, usually of a text, to expose its complex and sometimes unstable foundations. Deconstructing derivatives was “not a dismantling of the structure of a text, but a demonstration that it has already dismantled itself. Its apparently solid ground is no rock, but thin air.”³⁶

Piñata Parties

In 2010, concern shifted to sovereign debt, reflecting massive government spending to prevent the global economy from slipping into depression. Markets traded CDSs on sovereign nations. The specter of banks, some needing capital injections and liquidity support from governments to ensure survival, offering to insure other market participants against the risk of default by sovereign government (sometimes their own), was surreal.

Traders and derivatives need volatility to make their games profitable. Greece provided the first example of this new version of a piñata party, a tradition that originated among the Aztecs and Mayans in Mexico. A piñata is a brightly colored container, usually made from clay, cardboard, or papier-mâché. The container is beaten forcefully with poles and sticks, so that it breaks and the contents spill out to signify abundance or favors from the gods. In the financial version of a piñata party, a company or country was singled out. Traders grabbed their sticks and beat it until it broke apart.

Greece was running unsustainable budget deficits and was overly indebted. Greek public debt statistics were fudged with derivatives. Initially, banks and investors with exposure to Greek debt purchased credit insurance on Greece in the form of CDSs. They paid premiums to investors willing to earn a return for accepting the risk that the country might default. As the supply of CDS contracts was not restricted by the amount of Greek debt, hedge funds and other rubber-necked financial accident voyeurs joined the party, looking to make profits. Dealers in CDSs made large spreads from standing in between the buyers and sellers.

As with all insurance, higher risks mean higher premiums. The CDS markets became a visible benchmark of Greece’s problems. The price of insurance was not anchored to the real underlying risk or the public finances of Greece. Traders were not interested in whether Greece was likely to default or in protecting themselves from this risk. They just kept beating the Greek piñata. Traders pushed around the thinly traded insurance contracts, making money from the volatility. Price movements triggered collateral requirements, causing further problems. Eventually, the EU agreed to bail out Greece, with help from the International Monetary Fund.

The financial piñata was stuffed with money rather than divine favors. Pension funds earned premiums from selling insurance, hedge funds made trading profits or losses, and banks earned fees. Everybody had fun except the inhabitants of the country, whose economy was decimated.³⁷

The contagion effect provided further opportunity for traders. Volatile markets are like natural catastrophes—highly destructive and entirely indiscriminate in inflicting damage on anything in their path. The process was repeated in rapid succession with Ireland, Portugal, and Spain.

In the CDS market, traders holding insurance policies without owning the underlying bonds had a perverse incentive to ensure the default or, at least, a deterioration in the financial condition of the underlying companies and countries. This was nothing “much more than a floating craps game in an alley off Wall Street.”³⁸

Derivatives were now central to this world of speculation. Derivatives possessed the “violence of abstraction”:

Derivatives [must] be capable of computing all concrete risks...on a single metric. They must...translate concrete risks into quantities of abstract risk...the crisis of value measurement is expressed in the first instance in markets for financial instruments, like derivatives...it is at root a classic case of a crisis of value measurement, caused by collapses in value brought on by over-accumulation, falling profits, and unsustainable build-ups in fictitious capitals.³⁹

Economist Jagdish Bhagwati contrasted the “destructive creation” of financial innovation and the “creative destruction” of industrial innovation in the real economy.

The promise of derivatives was the measurement and management of risk. In 2009, Alan Greenspan, once an ardent advocate of all things derivative, elliptically noted: “A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year.”⁴⁰

If the Mirrored Room by Lucas Samaras is the ultimate symbol for extreme money, then derivatives are the ultimate, universal financial instrument for manipulating that world, creating, and chasing endless reflections of real things. In a thoroughly post-modern contradiction, far from reducing risk, derivatives increase risk, often with catastrophic consequences.