Nobel Laureate Merton Says Buffett’s Financial WMDs Help Society

  • MIT professor says financial innovation brings great gains
  • Merton won Nobel in economics in 1997 for work on options

Robert Merton.

Photographer: Shigeki Nozawa/Bloomberg

When Paul Volcker said the last financial innovation that improved society was the automated teller machine, Robert C. Merton took offense.

Now the Nobel Prize-winning professor is hitting back, pointing to markets for options and interest-rate swaps that are humming along as fast as ever. He says Warren Buffett’s remark that derivatives are “financial weapons of mass destruction” was taken out of context by those who want to banish them, when a better solution is to make them safer without sacrificing their advantages.

For Merton, it’s personal. A year after he won the Nobel in 1997 for his work on pricing options, Long-Term Capital Management, a hedge fund where he was a director, had to be bailed out after leveraged bets on derivatives went sour. Then came the 2008 crisis, where collateralized debt obligations and credit-default swaps took some of the blame. Still, the 72-year-old says, that’s no reason to abandon the tools.

There are “enormous gains from financial innovation and finance science,” Merton, who teaches at Massachusetts Institute of Technology in Cambridge, Massachusetts, said in an interview during a visit to Kyoto, Japan. “We need to find a way to realize those gains.”

Eight years after the financial crisis, there’s little evidence of a fall-off in trader appetite for the instruments Merton pioneered. More than 3 billion equity options have changed hands on U.S. exchanges in 2016, and a record 4.5 billion sold in 2011. Total notional volume for interest-rate derivatives rose to $2.7 trillion per day from from $2.3 trillion in 2013, including swaps, forwards and options, the Bank for International Settlements said last month.

Options, Swaps

In the interview, Merton looked back on the 1970s, when the collapse of the Bretton Woods system of fixed currencies and oil shocks spurred market turbulence. He said the crises of that era led to inventions that still have benefits today.

He lists the creation of the options market for hedging investments as one example. Another was swaps, which he says eliminated interest-rate risk for lenders practically overnight, stopping many of them from going insolvent every time rates moved. Others included:

  • the national mortgage market in the U.S., which improved the availability of funding for housing
  • international diversification of investments, which is widely accepted today but was new at the time
  • index funds
  • employer-funded pension schemes

“Do you know when the ATM was invented? 1969,” he said. “So if that statement held, it means that everything that happened in the 1970s and beyond was not useful to society. I think my list kind of suggests that that’s not very accurate,” referring to comments by former Federal Reserve Chairman Volcker in 2009.

Financial Crisis

Useful or not, some instruments on Merton’s list had at least a passive role in speculation that nearly collapsed the world economy in 2008. Put options priced according to his formulas are the forefather of credit default swaps, a market that had swollen to $62 trillion at the end of 2007, according to the International Swaps & Derivatives Association.

“I hear about these wonderful innovations in the financial markets, and they sure as hell need a lot of innovation,” Volcker said at a Wall Street Journal event in 2009. “I can tell you of two -- credit-default swaps and collateralized debt obligations -- which took us right to the brink of disaster.”

Merton defended credit-default swaps, saying they’re even an important tool for big manufacturers who need to provide financing to risky companies to sell their products. The problem, he says, wasn’t with the contracts but with the providers, such as American International Group Inc., who took on too much risk in selling them.

After the failure of Lehman Brothers and the government rescue of AIG, policymakers pushed to reduce counterparty risk in the privately negotiated derivatives markets by requiring trades to be moved into central clearinghouses, which are collateralized by dealers. For trades not cleared, rules are also being created to require trading partners to exchange collateral that stands behind the trades.

Fools, Knaves

For Merton, financial institutions and regulators lost trust during the financial crisis, both by being incompetent and acting in bad faith. He says regulators have to be able to understand the complex markets they oversee, and they should be paid more if necessary to attract the best people. But while “fools and knaves” exist in all industries, he disagrees with the theory that most of Wall Street is motivated only by greed.

“Most of the people I know in the profession or in academia take their jobs seriously, are not interested in ripping off the public, are not crooks, are not unethical,” said Merton, who’s also resident scientist at Dimensional Holdings Inc. “That’s not the majority of people.”

In Berkshire Hathaway Inc.’s annual report for 2002, Buffett wrote that he saw derivatives as “financial weapons of mass destruction,” with the potential to have a domino effect on the economic system when one weak institution fails. Central banks have found no way to control or monitor the risks associated with them, he wrote.

Buffett Comments

“He uses derivatives all the time,” said Merton. “I don’t believe it’s because Warren Buffett’s a hypocrite. I believe they’ve conveniently misinterpreted his quote out of the context in which he made it. You can ask him. And it’s very interesting, nobody wants to ask him. It’s too good a thing to be able to keep coming back to.”

Buffett didn’t respond to a request for comment sent to an assistant. Berkshire Hathaway paid $195 million in July to wind down its last credit derivatives contract, according to a regulatory filing. Berkshire still has some derivatives tied to the performance of stock indexes.

Merton says MIT is seeking to train more people who can understand the complexities of derivatives today. He says he’s been working for much of the past 12 years on ways to help pension savers better fund their retirements, which is another important use of financial innovation, especially in the current low-rate environment. And while mistakes have been made, that’s no reason to go back to a world with just stock and bond markets.

“If there were no benefits, it’s easy, just don’t do it,” he said. But “there’s a huge amount of value to be created for society using these technologies.”

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