It's derivatives at 20 paces

The WSJ online is having an open house and I caught a glimpse of one of its (apparently) regular columns, "Trading shots". This one (Friday, May 5, 2006) asked the question, "Are Derivatives Weapons Of Mass Financial Destruction?" and offered a debate by a couple of pundits, author Michael Panzner and money manager/blogger Roger Nusbaum.

Panzner starts the debate with a question:

What do David Li and Nicole El Karoui -- both of whom have been profiled in the Wall Street Journal -- have in common?

Hint: Mr. Li is a Stanford professor widely credited with developing a computerized model that helped turn credit derivatives into the fastest-growing segment of a $270 trillion global market. (See Mr. Li's profile.) Ms. El Karoui is a French mathematics professor whose courses have become, as the Journal noted, "an incubator for experts in the field." (See Ms. El Karoui's profile.)

Answer: Both have warned that some of those who buy and sell these complex instruments don't fully understand the risks involved. Instead of reducing their exposure to unwanted perils, they may well be adding to it.

Unfortunately, the very nature of these synthetically created securities makes it difficult for those outside Wall Street to debate their merits. For some, the definition alone is enough to cause eyes to glaze over. Essentially, derivatives are risk-shifting agreements whose value depends on -- is "derived" from -- an underlying asset, financial instrument, or event.

Making matters more difficult, however, is the fact that the value of certain complex varieties, such as options, asset-backed securities, and credit-default swaps, depends on many inputs. That often necessitates the use of complicated formulas and high-powered computers, especially when portfolios of derivatives are involved.

Yet the mathematical certitude this conveys is misplaced. In truth, pricing often depends on fickle or otherwise fast-changing financial relationships, less-than-adequate histories of how certain markets will perform under a wide range of scenarios and guesstimates about how volatile conditions will be in future.

That means a major financial institution with significant derivative exposure could easily find itself hit with a very expensive and potentially destabilizing loss if even one of its assumptions is wrong -- as, for example, a large hedge fund [GLG Partners' GLG Credit Fund] did when a multi-billion dollar portfolio shed 14.5% in May 2005, reportedly because of a "flawed model."

A lack of transparency and inadequate regulation, particularly where OTC derivatives are concerned, make it difficult to identify where the dangers lie. Historically, banks, Wall Street firms and hedge funds have been left to their own devices, on the assumption they were sophisticated operators who would act appropriately.

Unfortunately, as the classic example of the "tragedy of the commons" suggests, one firm's self-interested behavior, especially when large amounts of money are involved, is not necessarily in everyone else's interest.

When you add it all together -- the complexity, the opacity, the warnings, and the miscalculations -- it paints a rather unsettling picture.

Nusbaum narrows the issue:

The issue is not whether they could cause a market correction, is not whether some institutions are knowingly taking risks that they should not, is not whether there is another Robert Citron buying product he may not fully understand.

In the next few years we could see another Procter & Gamble or Gibson Greetings arise, where a company claims they did not know what they were buying and then seeks restitution from their counter-party. [editor's note: P&G and Gibson Greetings, along with Federal Paper Board Company and Air Products and Chemicals, lost hundreds of millions of dollars in bad derivatives bets in the mid-1990s. The four companies sued their shared investment bank, Bankers Trust, now part of Deutsche Bank, accusing it of not disclosing the risks associated with derivatives.] None of those episodes resulted in a deathblow.

The fear is not derivatives, but the misuse of derivatives via too much leverage.

The take-away here, from my point of view, is that someone's misuse of the product, which is likely to happen, has a very low probability of triggering a widespread meltdown.

Panzner tries to add context:

Total U.S. debt, for example, is more than three times output, the U.S. current account deficit is 7% of gross domestic product, unfunded U.S. retirement-related obligations add up to more than $50 trillion, and the notional value of derivatives outstanding is approaching the $300 trillion mark.

At the same time, risk has become more concentrated with respect to firms, markets and "events." In 1997, for example, the 10 largest banks controlled less than 34% of industry assets; by 2005, it was 44%. At the end of last year, the top five banks accounted for more than 96% of outstanding derivatives contracts versus 83% in 1998. And reportedly, there are more than $200 billion of credit default swaps riding on the financial health of General Motors alone.

Moreover, increasing sophistication and an aggressive hunt for higher returns have spurred hedge funds and proprietary trading desks to exploit a growing array of intermarket arbitrage opportunities, which frequently depend on derivatives to circumvent structural and operational hurdles.

More important, perhaps, is the fact that despite their differences, the one thing many synthetic securities have in common, as Roger seems to have alluded to earlier, is an inherent leverage component. In that respect, he may have made a more salient point. Maybe derivatives won't be the trigger for financial disaster. Maybe they represent just one small part of a far greater threat: too much debt.

Now that is a problem that has led to financial Armageddon--again and again throughout history.

Nusbaum responded that there are just too many participants in the derivatives trade for it to matter too much or too long is one of them tanks.

And in the same vein but more closely focused on Guambat's obsession with the dot-commodity boom, Stephen Wyatt in the AFR today (you need a ticket to read) notes:

Alan Heap, commodity analyst with Citigroup, noted recently that the monthly average value of speculative positions, both long and short, held in US commodity markets recovered sharply in April to more than $US120billion, the highest level since the all-time nominal record of $US128billion last October. "We believe the hike in speculative positions has been a key driver for the latest surge in commodity prices," he said.

Guambat's views on the subject:
Risque business
Guambat vindicated