Derivatives: The Risk That Still Won’t Go Away
By Carol J. Loomis
Washington wants to step up regulation of these complex instruments, hut new rules may not be enough to tame them.
Inevitably the center of controversy is going to be the complex instruments called over-the-counter derivatives. These are contractual arrangements between two parties—at least one of which is likely to be a giant financial institution that transfer risk. They typically have notional values (par values, essentially) in the millions of dollars, are often long in duration, and go by such names as swaps, forwards, and options. And they are, not incidentally, a source of lush profits for banks.
Perhaps for that reason, it is the amazing contention of some in the financial world that derivatives sailed quite smoothly through the financial crisis. One banker said recently that the derivatives problem at AIG was mainly that management wasn’t paying attention.
This article will present a different view. We’ll start with reminders of how derivatives contributed to the collapse of Bear Stearns and AIG, in the process delivering a large, and detested, bill to the U.S. taxpayer. We’ll also go behind the scenes of the bankrupt Lehman Brothers, whose 900,000 derivatives contracts are proving once again that the sheer complexity of these instruments is itself an enormous problem. So is regulating them, which does not mean we shouldn’t be trying.
A basic reason for favoring regulation is that derivatives create a kind of mirage. They don’t extinguish risk, they simply transfer it to a different party—a counterparty, as the term goes. The ultimate outcome is millions of contracts and an endless, virtually unmapped, web of connections among financial institutions. That maze exists today, and so does the systemic threat it raises: that some major counterparty will go bust and drag down other institutions to which it is linked.
We came perilously close to such a chain reaction in the past 18 months, as both the economy and the financial system buckled in distress. Derivatives cannot be called the central villain in this drama. That dishonor belongs to some combination of bad management and a real estate world gone crazy. But derivatives elevated the stakes, as they seem constantly to do. Today, as the financial system goes about digging itself out of the muck of trouble, no one imagines that the risks of derivatives have diminished. That’s what the regulatory clamor is all about.
Not too long after that, Warren Buffett tagged derivatives with the name that follows them everywhere, “financial weapons of mass destruction.” But if this description was to enter the lexicon of finance, it was not to stop derivatives’ spread. Between 2000 and mid-2008 (the peak so far), the worldwide notional value of derivatives went from $95 trillion to $684 trillion, an annual growth rate of 30%. A new form of derivatives, credit default swaps, a sort of rich chocolate to the plain vanilla of interest-rate swaps, became the rage during this period. Initially these CDS allowed institutions to insure the creditworthiness of bonds they held, and next permitted speculators—controversially, to say the least—to pressure the prices of bonds and other fixed-income securities.
The CDS growth was marked by a back-office breakdown: Unsigned confirmations proliferated and general confusion reigned over who owed what or even how many CDS had been written. Timothy Geithner, then president of the New York Federal Reserve, and one of his predecessors, Gerald Corrigan, attacked this disorder in 2005, leading a drive that has greatly improved the infrastructure of CDS the plumbing, so to speak, that connects one derivatives party with another. Corrigan, a top Goldman Sachs executive since he left the Fed, is proud of the progress that, has been made, advances that have been compared by others to taming the Wild West. Without these process improvements, Corrigan recently told
That’s a head-snapper for sure, considering that despite this progress we suffered a disaster so cosmic that it crushed the economy and brought down an appalling collection of famed U.S. financial companies. Consider the main wreckage of 2008: Bear Stearns, bought by J.P. Morgan Chase; Fannie Mae and Freddie Mac, taken over by the U.S., the parent that didn’t want them; Merrill Lynch, bought by Bank of America; Lehman, gone bankrupt; AIG, rescued by the U.S.; Wachovia, bought by Wells Fargo.
Bankruptcy, of course, didn’t happen. On Sunday, March 16, 2008, J.P. Morgan agreed to buy Bear in a government-brokered deal to which the feds contributed guarantees of $30 billion (later reduced by $1 billion). And two weeks later Geithner appeared at a Senate hearing to explain this huge intervention (well, it seemed huge at the time). He didn’t talk about the overnight loan market. He stressed instead that bankruptcy for Bear could have led to the “sudden discovery” by its derivatives counterparties that hedges they had put in place to protect themselves were wiped out. The prospect, he said, would then be a “rush” by Bear’s counterparties to liquidate collateral and replicate their hedges in already fragile markets. Derivatives, in other words, had changed Bear from a broker-dealer that could have been simply the latest name on a Wall Street tombstone to an entity that the government needed to save because it was too interconnected to fail.
That dread epithet could be applied in spades to AIG. On Sept. 16, precisely six months after Bear’s rescue, AIG’s board called in lawyers and prepared to file for bankruptcy. But, as the whole world knows, the government stepped in to save the company, eventually committing $180 billion to keeping it solvent.
AIG’s particular burden was $80 billion of credit default swaps it had sold that exposed it to subprime mortgages (see “AIG: The Company That Came to Dinner” on fortune.com). When real estate caved, AIG’s financial products operation (FP) received calls for collateral from its CDS