How Farmers caused the Great Recession
One of the subjects I find most interesting in finance is the fact that humans can’t seem to shake their irrational exuberance. The first time I experienced the phenomenon was when I worked in the Tech industry in the late 1990s. Everyone thought they were going to be the next dot com millionaire. People jumped into the stock market and bought every tech stock they could get their hands on. People rode the wave up and soon found they were millionaires. Millionaires on paper only.
As the market crashed down, people’s accounts flatlined. Irrational exuberance stuck again. The belief that the market can only go up has been disproven time and time again. Four hundred years ago, the irrational exuberance of the time was over tulips. In the 1630s, people in the Netherlands rode an economic bubble based on, you guessed it, tulips (1). Tulip bulbs often exchanged hands hundreds of times a day, and the prices for bulbs skyrocketed.
I started to explore the psychology of market panics, recessions, depressions and crashes in 2007. Many economists were already raising the alarm. I was working for a large investment company’s institutional trading platform at the time (NSCC). During a typical day, I would move hundreds of million dollars between firms. On my busiest day, I moved $1.8 billion. This gave me a sky high view of a crashing economy.
I read through hundreds of books during the collapse, with many focused on the cause of recessions. Several questions came to mind. Why do these bubbles keep happening? How long has this cycle been repeating itself? Why aren’t more people listening to the expert’s warnings? What is the average investor supposed to do during these cycles?
You probably have a question of your own right now. What do tulips have to do with famers causing the Great Recession? It turns out, the same market forces were at work. And farmers are the reason.
Not all economic downturns are caused by the same thing. There are countless reasons behind them. Economists and financial advisors do not have a way to be certain a downturn is coming. What we do have is history. Quite a bit of it, in fact. In the midst of the Great Recession, authors Carmen Reinhart and Kenneth Rogoff put their work, “This Time is Different: Eight Centuries of Financial Folly.” As the title suggests, economists have 800 years of financial information available (2). Mark Twain used to say “History doesn’t repeat itself, but it often rhymes.”
With eight centuries of available economic data, it’s plain to see that investors are not rational. It’s also easy to point out all the times that history has rhymed. The culprit behind the 2008 financial crisis was option trading. Option trading helped collapse the tulip market 400 years ago… it’s bound to cause future crashes as well.
The Farmer and the Baker
The farmer would plant his crop of wheat in early spring. Most years, he could expect good sun and rain to provide a good yield. Some years, the crops would flourish, and he’d find himself with an overabundance of wheat. Other years, floods or drought would devastate the crops, leaving the farmer with little to show for his work.
The basic laws of supply and demand come into play here. Most years, the crop could be sold at a consistent price. When the year provided an abundant crop, the price of wheat would plummet due to the large supply. During bad years, scarcity caused the prices to skyrocket. When planting the seeds, there was no way of knowing how much he would be paid that fall.
This led to problems for the baker. Come fall, when the harvest was made, there was no way to know what the price of wheat would be. Would the crop fail and prices skyrocket? Would there be an abundance of wheat? No one knew. To solve this problem, futures and options were crafted.
From Ancient History to Modern Finance
In Aristotle’s Politics, the tale of Thales of Miletus is told (3). He was a philosopher and mathematician who became quite wealthy after he purchased the rights for use of olive presses prior to an abundant harvest. This tale shows us that the fundamental concept of options and futures trading date as far back as 350 B.C.
Futures trading came first. Futures are a contract to buy or sell a physical commodity, such as wheat. The price is agreed upon at the beginning of the contract. On the date the contract expires, the seller delivers the product and the buyer pays the agreed upon amount. This allows the farmer to know in spring how much the crop would be worth come fall. The baker would know how much his expenses would be in the fall.
The Tulipmania of the 1630s was driven, in part, by futures trading. People purchased contacts to buy tulips at a future price. In 1635, a single tulip bulb sold for 2,500 florins. The average annual wage of a skilled worker was around 150 florins. People in the bubble only saw the potential for growth. If it cost 2,500 florins today, it might rise as high as 3,500 florins by next year. To get in on the gravy train, people bought future contracts.
The thinking would have almost been sound… except for the fact history had already shown otherwise. The bulb is worth 2,500 florins now, so I’ll buy the contract to buy bulbs on some future date with the hope of selling it for far more. That’s not what happened though.
When the bubble burst in 1637, some people were left holding contacts requiring them to purchase tulips at prices ten times higher than what was available in a market. Others found themselves proud owners of tulip bulbs worth thousands less than they originally paid.
How to value an option – Black-Scholes Option Trading Model
Futures contracts became standardized in the U.S. long before options rose to prominence. America was primarily an agricultural society, so this makes sense. An option is different than a futures contract because the owner of the option has the right to purchase a product, but is not required to do so. Options were typically behind the seen contracts, and they didn’t gain much popularity until the 1960s. Part of that might have been due to the complicated nature of option trading. In 1973, two economists published an article that would become the theoretical basis for pricing options over time. The Black-Scholes model eventually earned the authors the Nobel Prize in Economic Science. Here’s the formula they came up with:
Enter Wall Street
Wall Street rarely misses an opportunity to make a quick buck off of a sucker. The more convoluted and complicated the product, the better the chance is the buyer won’t look much into it. The salesmen love being able to have a PhD drone on in front of clients. They promise little to know risk for amazing returns. These salesmen are good. Too good.
What Wall Street does to everyday folk is bad enough… but when they do it to each other, the results are epic. One of my favorite books of all times is, “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.” Author Satyajit Das delivers a comically sad insight into how Wall Street morphed an idea farmers have used for millennia into global collapse (4).
You have to understand that trading is binary. The person selling the product believes it will go down in value. The buyer believes otherwise. There’s no way to know who is right and who is wrong, but someone is leaving the room a loser. Wall Street traders believe they are the masters of the universe. There is no way they’re the loser. So when two (or more) Wall Street firms enter into a contract with each other, none of them think they’re holding the short straw.
Mathematics disagrees with them. Someone has to be the loser. Rather than face that reality, Wall Street chose to bury their head in the sand. The Black-Scholes option pricing model is a fine example of Wall Street placing their faith into the notion their fancy formulas magically predict the future. Sure Black-Scholes works, but only if:
- The options are European and can only be exercised at expiration
- No dividends are paid out during the life of the option
- Efficient markets (i.e., market movements cannot be predicted)
- No commissions
- The risk-free rate and volatility of the underlying are known and constant
- Follows a lognormal distribution; that is, returns on the underlying are normally distributed.
“Financial Weapons of Mass Destruction.”
This is what Warren Buffet called the derivatives. Future contracts are the most common type of derivative. Traders, businesses, and investors use them to limit losses on stocks or cap price increases on fuel. Wall Street has created a never ending array of options and future products. And this is how things went sour.
Bankers created ever more cunning ways to sell garbage. The Mortgage Backed Securities (MBS) pooled mortgages of hundreds of homeowners. The idea was to reduce risk through diversification. The idea was popular. The mortgage holders were broken up into tiers known as tranches. The top tranches were payers with the lowest credit risk. Wall Street sold these low risk products to everyone, including themselves. The idea was so popular that the products quickly sold out.
The only way to offer more MBS was to have more homeowners. You already know how this turns out. Many of the people who bought homes couldn’t afford the purchase. Of course, the banks knew this. So they covered these bad bets by selling something called a Credit Default Swap (CDS). So get this, your bank thinks it might have a bad bet. What do you do? You enter into a contract where another bank pays you if your loans fail. Think about that.
Tons of banks went out and bought knowingly bad MBS products, then insured them with CDS products with one another. Everyone had made the same insane bet on the real estate market and then doubled down on them. Just like the Black-Scholes model, the formulas these geniuses based their faith on were fiction. By the end of 2007, the outstanding CDS bets were worth$62.2 trillion. This is what happened next…
My favorite fact about the Great Recession is that the CDS was invented by a 25-year-old working at JP Morgan Chase. Blythe Masters was in her third year there when she invented the CDS. In recognition of her work, JP Morgan Chase made her the youngest female managing director in the firm’s history. She was 28. The big banks always reward a salesperson than can make them a dollar.
The Big Short
How is any of this possible… or even legal? Fundamentally, democracy is the reason. Capitalism is voting with your money. At the most basic level, options are votes about the future of finance. When properly used, derivatives like options and future contracts improve our economy. Shorting stocks is a great example of this process.
When someone puts time and effort into analyzing a company or the markets, they deserve to be rewarded. If you uncover something negative, you can short the stock and make a profit. Basically, you buy a contract to sell stock at its current price. If your research is correct, the stock price will fall and you can buy the stock for a lower price, then sell it to the contract owner for a profit. It’s a risky strategy, but if enough people believe the research, the market will correct the share price of the stock. That’s democracy in action on the stock market.
If you haven’t seen it already, take some time to watch the movie “The Big Short.” I read the book years before the movie, and I have to say that the movie did an excellent job of explaining an otherwise dull topic. There were groups of people who saw what damage was about to hit the global economy. The people went out and made huge bets against the big bank idiocrasy. They made a fortune when their research proved them correct. If the markets had listened to them, the economy might have been saved.
The book starts with a quote from Leo Tolstoy –
“The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he already, without a shadow of a doubt, what is laid before him.”
This is how Wall Street took a simple idea from farmers and collapsed the economy.
1. Mackay, C. (2004) . Extraordinary popular delusions and the madness of crowds. London. Harriman House
2. Reinhart, C., & Rogoff, K., (2009). This Time is Different: Eight Centuries of Financial Folly. Princeton, NJ. Princeton University Press
3: Aristotle,., Jowett, B., & Davis, H.W.C. (1920). Aristotle’s Politics. Oxford: At the Clarendon Press
4. Das, S. (2006). Traders, Guns & Money: Known and Unknowns in the Dazzling World of Derivatives. New York, NY. Financial Times.5. Lewis, M., (2010). The Big Short. New York, NY. W.W, Norton & Company, Inc.