Monday, October 20, 2008

Derivative Thinking

(FT Alphaville) This (HT Footnoted) at first, looks faintly ridiculous:

WASHINGTON - Today, the House Agriculture Committee held a hearing to review the role of credit derivatives in the U.S. economy, and the role they may have played in the recent credit and financial crisis affecting markets around the world.

“We need to get a handle on these credit default swaps and determine the regulatory modifications that are needed to minimize the systemic risk to the economy that I am concerned they pose right now,” said House Agriculture Committee Chairman Collin C. Peterson of Minnesota.

Fresh from hearings on the Virginia Ridge and Valley Act, the House AgCom is moving in to credit derivatives. Every US lawmaker, it seems, wants a piece of the crisis pie.

And as the Capitol Hill theatre moves towards the big scene change, it’s exeunt subprime, enter derivatives.

Perfect villains really, these. Warren Buffet, the world’s savviest investor, famously labelled them financial WMDs. Quoted in notional terms, they’re pretty unbeatable in the number porn stakes: $58 trillion/1 quadrillion/pick a number, add some zeroes.

These are of course, hackneyed factoids. Yet still they’re given play, and not just by the house agriculture committee either. Last week in became fairly clear that tight regulation of “derivatives” was very much on the agenda. The punditry was up in arms about a “hard to understand” super-market that lurked sinisterly out of gaze.

Jesse Eisinger at Portfolio magazine writes:

Long celebrated as a way for banks to diffuse their risks, the credit derivatives invented by Demchak’s team have instead multiplied them. The new credit vehicles encouraged banks and other financial firms to take on riskier loans than they should have; helped increase leverage in the global financial system; and exposed a much wider array of financial firms to the risk of default.

Credit derivatives aren’t, of course, solely to blame for the pandemic that has helped bring down Wall Street. They didn’t single-handedly force Bear Stearns and Lehman Brothers to bulk up on toxic debt, dooming them to collapse. But they made the financial world more complex and more opaque.

This whole derivative debate needs paring back. There’s far too much derivative scare mongering going on.

A derivative is, after all, just a contract between two consenting adults. A contract linked to - derived from - characteristics of some underlying asset. Speaking generically, a derivative is really an easier abstract concept to come to terms with than a bond.

Alas much of the current brouhaha is only about one particular scion of the derivative family: the credit default swap. Derivatives which offer “insurance” against a company or a bond defaulting.

Corporate bankruptcies are certainly going to roil CDS participants. Whether the settlement of the Lehman CDS auction tomorrow runs smoothly or not, there will be plenty of other credit events in the next year to test the mettle of the market.

But trouble with CDS does not necessarily a derivative armageddon make. And there’s a whole ecology of derivatives out there which are being tarred with the CDS brush.

Derivatives on the price of oil, for example, to help airlines keep costs steady. Derivatives on currencies (by far the largest species) to enable the world’s companies to operate across different economies. Derivatives on weather to enable insurance companies - and others - to hedge risk against events like hurricane Gustav.

In terms of culpability for the current crisis, you might as well blame bonds: a huge, illiquid, unregulated and opaque world built around the trading of risk…

One more thing you might use a derivative for: efficient farming.

Derivatives are invaluable in mitigating the huge unpredictables farmers face: weather, crop failure, price volatility. As CFTC commissioner Joseph Dial said in 1997, derivatives offered a “new era for agriculture”:

I am convinced that in order for producers, processors, merchandisers and exporters to be profitable in this new era for agriculture, they must have the freedom to develop innovative ways to use both exchange-traded and over-the-counter derivatives to manage their business risks.

Turns out the House Agriculture Committee does have as much right to question the SEC on derivatives as the House Banking Committee.

[And here's some more misinformation from an otherwise spot on editorial in today's Washington Post ("Is Capitalism Dead?"):

Unregulated derivatives known as credit-default swaps did accentuate the boom in mortgage-based investments, by allowing investors to transfer risk rather than setting aside cash reserves.]

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