Podcast Write-Up #6: Forward Guidance w/ Dr. Richard Sandor
A chat with the father of derivatives
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Release date: 09.09.2022
Richard is known as the “father of financial derivatives”, he created the world's first interest rate futures contract.
Q: Tell us about the circumstances and the reason why you created that futures contract.
Richard responds he was teaching as a professor in the 1960s, and he was trading equities and agricultural commodities. The only debt that was outstanding was in the mortgage market. He wondered if you could turn interest rates into a commodity, and he experimented with a portfolio of an S&L that had about 18.000 loans in it. It was impossible to homogenize that because of redlining and other reasons. He picked up the idea again in the 1970s after Ginni Mae was established.
Here's the description of Ginnie Mae from Wikipedia:
The Government National Mortgage Association (GNMA), or Ginnie Mae, is a government-owned corporation of the United States Federal Government. It was founded in 1968 and works to expand affordable housing by guaranteeing housing loans (mortgages) thereby lowering financing costs such as interest rates for those loans. It does that through guaranteeing to investors the on-time payment of mortgage-backed securities (MBS) even if homeowners default on the underlying mortgages and the homes are foreclosed upon.
At that time, the president of Freddie Mac, Tom Bomar, got in touch with Richard because he was concerned that Freddie Mac owned about $900 million worth of mortgages, which it wasn't supposed to do and which was tiny relative to the size it holds now. Richard was asked to develop a hedging mechanism for a new secondary market. He started a job as chief economist at the CBOT to work on Financial Futures and an insurance derivatives market.
Here's the description of Freddie Mac from Wikipedia:
The Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Freddie Mac, is a publicly traded, government-sponsored enterprise (GSE). It was created in 1970 to expand the secondary market for mortgages in the US. Along with the Federal National Mortgage Association (Fannie Mae), Freddie Mac buys mortgages, pools them, and sells them as a mortgage-backed security (MBS) to private investors on the open market.
Q: What were the challenges in creating a financial future, e.g. with physical delivery? And what was the first contract that you created?
In the 1980s the idea of managing interest rate risk didn't exist: no single bank had a department that did that, for example, you borrowed short and you lent long. Jack sums it up as the 3-6-3 concept: you borrow at 3%, lend at 6% and you're at the golf course by 3 p.m.
In the 1970s there were only agricultural commodities as futures contracts, no energy, no interest rates, and no options mainly for two reasons:
Prices were quiescent and there wasn't a lot of volatility
The law was ambiguous, so no one had the technical ability to trade financial commodities.
The first thing to do was to find a financial commodity that people needed to hedge. Ginnie Mae loans were the first natural ones: they were originated by mortgage bankers, sold to Wall Street and then sold to investors. These characteristics made them look like wheat. With the Arab oil embargo, droughts in China and Russia, inflation, etc. at the beginning of the 1970s, interest rates became more volatile.
In 1973 the US decided to regulate the futures industry. Since Richard was working at the CBOT he convinced his president to lobby for changes to the definition of a commodity to “anything tangible or intangible” among other things. The bill passed and regulatory impediments were removed, and now there was demand because of volatile interest rates.
The first interest rate future was created in 1975. Around that time, the government started to issue long bonds: the first 30-year bond was issued in 1977 and called the “007” because it matured in 2007. The total outstanding debt was only about 18 billion USD, but Richard believed it would increase by a lot, so he wanted to create a futures contract for treasury bonds and later the 10-year future.
Jack shows a chart of interest rates during the 1970s and 1980s to highlight the volatility:
Q: Was demand for the long bond future very high because many people needed to hedge? And how do you get others to take the other side of that bet?
Richard responds that the argument that there's only one-sided demand came up on pretty much everything he worked on over the last 50 years and that it's usually a sign that he was on the right track. There are usually two or three arguments:
We don't need it.
There's no opposite side in the market.
But: you have natural hedgers on the long and the short side. The only thing you need to fill in is the delta between the long and the short hedgers. They educated potential participants and created special exchange memberships among other things to bring people into the market.
Richard remarks that it usually takes two crises to create a market: the first one alerts people to a problem, and the second one makes it clear that it's better to do something before competitors will. The first crisis in interest rate futures was inflation in 1973, and the second was the oil embargo in 1979.
Q: Tell us about the Eurodollar futures market, i.e. the future rate of 3-month LIBOR.
The most important thing is that it is dead because it was manipulated. It also wasn't based on real transactions but purely hypothetical.
It started out well but there were too few underlying transactions for a $200 trillion hedging market: Eurodollar futures are extremely liquid but there's no underlying viable cash market.
To Richard, it was obvious that there was a huge incentive for certain people to misbehave (he's referring to the LIBOR scandal). It also didn't make sense to him that US rates, e.g. a mortgage in Arkansas, were based on an interest rate set by about 30 banks in London.
There's no new debt issued with LIBOR as a benchmark, it only has a use as a legacy measure. By June 2023 even that will be migrated to a new benchmark.
Q: What are the new interest rates to replace LIBOR? Also, tell us about AMERIBOR.
AMERIBOR is the overnight rate among regional mid-sized community and depository institutions: everybody but systemically important financial institutions. That makes it a credit-sensitive interest rate set by real transactions. There are also 30-day and 90-day rates. It's critical to provide a choice of possible interest rate benchmarks, for some institutions SOFR might be more appropriate, for others Ameribor, for example.
Q: Ameribor is credit-sensitive, so what does it do when there's payment stress?
Years ago there was the TED-spread, and it reflected the fact that in a crisis credit-sensitive interest rates will go up more than risk-free rates. There are different buckets of credit sensitivity in rates from junk bonds to treasuries. A regional or a small bank will find it harder to borrow in tough times, and they will charge customers a higher rate because there's a higher probability of default.
Q: Jack mentions he just looked up Ameribor and it also collapsed during February/March of 2020 and asks why that was.
A lot of liquidity was added by the Fed so the difference between risk-free rates and credit-sensitive rates was still there but imperceptibly low on an absolute basis: if the risk-free rate is 10 bps and 12 bps for the credit-sensitive rate it's very small on absolute terms, but it's still 20% on relative terms. When you have zero interest rates and a belief that the Fed will bail out everything and everyone it's not a normal environment.
One notable quote:
In my career I have lived through everything that was a one in a hundred year event, except that it occurs every ten years or so.
He mentions Covid-19, the GFC, 9/11, the tech stock bubble of 2000, Volcker, the market crash of 1987 all as supposed 1-in-100-year events.
Q: The current Fed Funds Rate is at 225-250 bps, and AMERIBOR currently is at 245 bps and SOFR around 218 bps. How can you explain that differential?
SOFR is risk-free, so you would expect AMERIBOR to be higher, and it's behaving that way. Typically it trades in the top quartile or top 1% of the Fed Funds Rate.
Q: When did you get involved in carbon and climate futures?
Richard got into it in about 1990. He was approached by people in the lime industry when acid rain was a big problem, so they asked him if he could commoditize air. He worked on the development of the Clean Air Act in 1990, and the United Nations wanted to know if a carbon futures market would be viable. Similar to interest rate volatility in the 1970s, he expected carbon emissions to become an existential problem. He securitized the Costa Rican rainforest and got very active in funds and exchanges around climate and sustainability.
Q: The implementation of climate measures requires government participation, so are climate futures, greenhouse gas emission credits, etc. only as good as the governments that are implementing them?
Richard doesn't think so. The Chicago Climate Exchange got 108 companies on board completely voluntarily (Ford Motor Company, Intel, IBM and others). Single states and cities joined as well. He believes a voluntary approach can work, and that government backing doesn't necessarily mean the federal government. The open interest for environmental commodities is at least as big as the size of gold without the involvement of the federal government.