In Defense of Derivatives: Between Enron, WorldCom, and Global Crossing, the Controversial Financial Instruments Have Gotten a Bad Rap. Here's the Truth
Callahan, Gene, Kaza, Greg, Reason
THREE OF THE six largest bankruptcies in American history--WorldCom, Enron, and Global Crossing--occurred between December 2001 and July 2002, shattering investor confidence and helping to knock 22 percent off the Dow Jones Industrial Average. The failures had more in common than just timing and size: All to varying extents involved the use of the controversial and poorly understood financial instruments known as derivatives.
In the season of finger pointing that followed, derivatives trading was singled out for abuse. "If you deep enough into any financial scandal," BBC business reporter Emma Clark claimed in February 2002, "you can usually find a derivative or two to take the blame." Howard Davies, chairman of the U.K. Financial Services Authority, told a conference the month before that an investment banker described to him one popular type of derivative (collateralized debt obligations) as "the most toxic element of the financial markets today." Even famed investor Warren Buffett warned that derivatives posed a grave threat to the global financial system. "We view them as time bombs, both for the parties that deal in them and the economic system," Buffett wrote in his 2002 annual report for Berkshire Hathaway. "Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
What are these Wall Street WMDs, and what should be done about them? Technically, derivatives are financial products whose value is "derived" from that of an "underlying" asset. For example, stock options, perhaps the best-known derivatives, are based on the underlying value of the stock that the option enables the purchaser to buy at a later date. Futures contracts--used extensively by farmers to protect themselves from poor crop yields and fluctuating prices--are derived from the root value of the good to be bought or sold in the future.
Derivative products are not just a sophisticated way for investors to gamble. They also give producers a crucial tool for hedging against risk and uncertainty. And they have played a central role in the flowering of innovation that the financial markets have enjoyed during the last two decades. There are derivatives betting on the likelihood of a natural catastrophe; consumer credit card debt has been converted into bonds; futures markets have been established for such things as barge rates; and options allow investors to speculate on the temperature, wind chill, and amount of rainfall in many cities.
The common denominator in all these products is that they allow companies and private investors to trade away risk with which they are ill equipped to deal and focus instead on taking risks in areas in which they specialize. Many international corporations, for example, use currency derivatives to swap out their exposure to exchange rate fluctuations. This allows them to focus on their core business while allowing professional currency traders to worry about international valuations.
This wave of financial innovation has washed into unlikely places. Glam rock pioneer David Bowie, long famous for his innovative music and embrace of the new, became the first songwriter in history to use derivatives to securitize future royalties from his own song catalog when he created "Bowie Bonds" in 1997. Bowie and his business manager, the Rascoff/Zysblat Organization, sold the royalty rights to his 25 pre-1990 albums to the Prudential Insurance Company. The singer/songwriter was able to pocket $55 million immediately, while Prudential received a 7.9 percent return on bonds that were backed by Bowie's future royalty payments. Bowie's groundbreaking move was quickly emulated by James Brown, the Isley Brothers, Ashford and Simpson, Joan Jett, and other artists, as well as the estate of Marvin Gaye. Bowie Bonds even inspired a thriller novel, Something Wild (2002), by Linda Davies.
But all has not been hunky dory for derivatives. …