The Dangers of Derivatives

Custom-tailored financial derivatives are a neat example of how invention becomes the mother of necessity. Since the financial engineers began tinkering with the machinery of money flows in the late 1980s, banks and other intermediaries have backed up behind these ingenious dams an estimated $70 trillion of derivatives (financial instruments valued according to the changes in price of other financial instruments). They have done so because derivatives create a felt need for their own employment.

Derivatives make it possible for businesses from construction to food processing to energy to shipping to make plans with greater certainty about their financing costs than they ever could before. The creation and trading of derivatives earns something like a third of the profits of the big banks—and perhaps more, because many of the deals they make are done only for the derivatives activity they will stimulate.
Derivatives provide a plausible rationale for financial-industry mergers that otherwise would not make sense.

Unlimited Leverage

Unfortunately, these “over the counter” derivatives—created, sold and serviced behind closed doors by consenting adults who don’t tell anybody what they’re doing—are also a major source of the almost unlimited leverage that brought the world financial system to the brink of disaster last fall. These instruments are creations of mathematics, and within its premises mathematics yields certainty. But in real
life, as Justice Oliver Wendell Holmes wrote, “certainty generally is an illusion.” The derivatives dealers’ demands for liquidity far exceed what the markets can provide on difficult days, and may exceed the abilities of the central banks to maintain orderly conditions. The more certain you are, the more risks you ignore; the bigger you are, the harder you will fall.

Meanwhile the rules of this game—adopted and enforced by the world’s banking supervisors—further shrink what are already low time horizons in the financial markets. Measuring their positions every day through the algorithms of “value at risk” analysis, players must make constant adjustments of hedges and options to control the losses they may suffer from unanticipated volatility of market prices. In real markets,
often enough, you can’t do that. As Eugene Rotberg, former treasurer of the World Bank, says, “The only perfect hedge is in a Japanese garden.”

The current [plat du jour]—the “credit derivative”—is the most dangerous instrument yet, and neither the risk controllers at the big banks nor the bank examiners seem to have any good ideas about how to handle it. A vehicle by which banks can swap loans with each other apparently gives everybody a win—banks can diversify their portfolios geographically and by category with the click of a mouse.

But the system is easily gamed, and it sacrifices the great strength of banks as financial intermediaries—their knowledge of their borrowers, and their incentive to police the status of the loan. After the disturbances of last autumn, a senior executive of a large Wall Street house wrote a series of rules for its executive committee to keep in mind. Among them: “When a loan is securitized, nobody has the credit watch.” Researchers at the Federal Reserve Bank of New York concluded that in the presence of moral hazard—the likelihood that sloughing the bad loans into a swap will be profitable—the growth of a market for default risks could lead to bank insolvencies.

Worse yet: As this business has grown, it has moved far from its early days as a way to swap risks. Most “credit derivatives” now are simply a way for a market participant—a bank or a hedge fund—to acquire a portfolio of loans or securities with no up-front cost and very low interest charges.

The instrument is called a Total Rate of Return Swap. One side of the swap promises to pay the interest that would be earned in the London interbank market on the value of the securities in the package, plus, say, a premium of 100 basis points (one percentage point). The other side promises to pay the yield on the securities. The receiver of the payments on the securities usually puts up some form of collateral, which may be as little as 5% of the value of the package, to assure the payer that he will get his interest and premium. In effect, the receiver of the payments on these loans or securities has bought the securities for the duration of the swap on 95% margin, even though the law says nobody can buy securities without putting up half the price.

Banks and supervisors have a lot of trouble accounting for these instruments. If the bank owns the loans and securities it is swapping, it will own them again when the swap expires, which argues that capital should continue to be allocated against the principal. If it doesn’t own them, then the transaction is simply a bet on price movements that does not acquire or dispose of an asset, and can be carried off the balance sheet at a much lower capital charge. In June 1997, the Fed ruled that banks could take all such transactions off the balance sheet, making them virtually cost-free to banks—especially if the swap partner is another bank and qualifies for the 80% reduction in capital requirements given to interbank loans by the rules of the Bank for International Settlements.

Why are such derivatives dangerous? The one lesson history teaches in the financial markets is that there will come a day unlike any other day. At this point the participants would like to say all bets are off, but in fact the bets have been placed and cannot be changed. The leverage that once multiplied income will now devastate principal.

The banking supervisors have not begun to control the buildup of leverage on the derivatives chassis. Indeed, Federal Reserve Chairman Alan Greenspan has argued that the mathematicians are improving their formulas to make the business less risky. But the more security the math seems to give, the greater the risk on the day the highly improbable happens. Eighty years ago Frank Knight, arguably the greatest American economist ever, wrote that economists did not always make clear “the approximate character of their conclusions, as descriptions of tendency only.” In theoretical mechanics, perpetual motion was possible; in real life it was not. “Policies must fail, and fail disastrously, which are based on perpetual motion reasoning without the recognition that it is such,” Knight wrote.

Questions for Congress

The House Banking Committee holds hearings today on the lessons of last year’s financial crisis. Congressmen should inquire about the extent to which both practitioners and supervisors are using what Knight called “perpetual motion reasoning” in dealing with derivatives.