Mad, Bad and Dangerous to Know. or Do Derivatives Just Need a Bit of Loving Care?

Article excerpt

Are we facing a financial crash, triggered by a crisis in the huge and mysterious over-the-counter derivatives market? Finance bloggers certainly think so, as do some of the world's most admired investors. Warren Buf-fett, known for the spectacular success of his old-fashioned stock picking - and regarded as a bit of an old buffer by the flaming Ferraris of the markets as a result - has described derivatives as "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal".

Popular misgivings about the crazy twilight world of derivatives - estimated to have had a notional value in mid-2005 of $270 trillion by the Bank for International Settlements (BIS), but incomprehensible even to many market professionals - have been ratcheting up. That's partly due to headlines about high-level meetings between regulators and the big players, partly to instinct.

After all, derivatives have been at the centre of some spectacular implosions - including that of Long-Term Capital Management (LTCM), which in 1998 had to be bailed out to the tune of $3.6bn (pounds 2bn) and whose failure, said the US Federal Reserve, had posed "unacceptable risks to the American economy". Barings was famously brought low by huge exposures to derivatives contracts that went south, while Enron, which had diversified into fairyland accounting and relied on derivatives trading to inflate its growth, also failed. And partly because of a bad derivatives exposure, Parmalat, the Italian food giant, went bankrupt too.

In 2005, Refco, the fourth-largest futures broker in the US, filed for bankruptcy. In February 2004, it was reported to have had $69bn in off-balance sheet derivative contracts' that figure had risen to $150bn by May 2005. In the same month, the exposure of former blue-chip companies GM and Ford was laid bare when ratings agency Standard & Poor's downgraded $453bn of outstanding debt. The announcement caused panic in both the markets for their bonds and their credit derivatives - instruments that allow a bank to unbundle the risks of a corporate exposure to investors, who then bet on corporate downgrades and bankruptcies. The BIS said that the system had come close to meltdown.

The spectacular numbers involved in derivatives trading are enough to make any observer queasy. In December 2004, the US Comptroller of the Currency reported, for instance, that JPMorgan Chase had $43 trillion of derivatives onitsbooks (some four times US GDP). Another example was provided by Deutsche Bank, which reported at its 2004 year-end that it held derivatives positions of a nominal volume of $21.5 trillion - some 10 times the annual turnover of the German economy.

But are we naive to be scared just because we don't understand these things or the sums of money involved? Are derivatives intrinsically dangerous, or are they instead a useful tool for spreading risk and an attractive investment opportunity for the brave? Have they been given a bum rap because of a few instances of industry mismanagement and individual venality or incompetence?

Derivatives aren't new - arguably they go back to biblical days. Genesis, chapter 29, tells the story of Jacob, who purchased an option costing him seven years of labour in return for the right to marry Laban's daughter, Rachel. …