As promised, here’s Jesse Eisinger’s response to my earlier blog
entry on derivatives. It’s a good one, too, so I’ll let him have the last
My first blog entry on Portfolio! So exciting.
First of all, I think we agree on much here. Derivatives are mostly used as
a form of insurance. (As an aside, the derivatives industry doesn’t like
the comparison to insurance, because insurers typically are heavily regulated
and required to hold minimum amounts of capital against their policies. Derivatives
traders are not. Hmm.) The industry types prefer the words “hedging”
These instruments are, I agree, used mainly to smooth cash flows, make markets
more predictable and spread risk from those who are vulnerable (say, farmers)
to those who want it or can handle it better (commodity speculators).
And I will concede a bit of First-Issue-of-Big-Glossy-Magazine fear-mongering
in referring to nominal figures when talking about the size of the markets.
The headline of my column uses the $300 trillion amount for the whole derivatives
market. In the column, I refer to the $26 trillion amount for the notional amount
outstanding in the credit default swaps market. They are the real nominal figures
but they are a bit hyperbolic. I disagree they are meaningless. They show how
much the derivatives markets have grown, for one. Answer: a lot. These are the
fastest growing markets in the world.
But there are some inherent concerns about derivatives. One is that they are
a form of leverage. Anyone can write a credit default swap on Felix Salmon Fisheries
Corp., take a fee, and be on the hook for some big sum in the event that Felix
goes belly up. (Groan.)
Maybe the writer can handle the risk and maybe not. You think that “most
derivatives” are not “speculative” investments. Oh really?
How do you know? What’s the breakdown of prudent hedging compared with
speculative? You don’t know. I don’t. No one knows how much leverage
there is and how much speculation there is.
What we do know is that the derivatives markets are large, liquid, for sophisticated
investors, and are largely off the radar screen. That is pretty much the platonic
ideal of a natural environment for speculation. Now speculation has a bad connotation,
but it’s not inherently bad. Some of the speculation transfers risk properly.
If the speculators are taking risks that they can handle, that is. Amaranth
couldn’t handle the risks, but the fallout was minimal. Long-Term Capital
Management couldn’t either – but the
fallout was hardly minimal and the fund needed a massive bailout.
The question becomes whether the users are accounting properly for how much
exposure they have and whether they are doing proper due diligence on their
counterparties. Warren Buffett writes that the accounting can be screwy and
that both sides of derivatives trades can immediately book paper profits.
I’ll trust him on that.
Are derivatives being valued properly? Gen Re wasn’t the most cutting
edge derivatives player but they were a financially savvy group of guys. They
didn’t value some of their instruments correctly. Maybe they are the exception,
but I doubt it.
The sophisticated institutions supposedly have good risk controls that should
prevent similar problems, but do they? Amaranth and LTCM were widely viewed
as having top-class risk controls. That doesn’t give me much faith in
risk controls, especially in a crisis.
Does that mean we are going to have a crash? I don’t know. I agree that
it’s a zero sum game in theory and that they cannot wipe out wealth of
non-participants per se. But their prices are derived from securities. If the
securities markets sneeze, you say the derivatives markets are the tissues;
I say they might be the virus. That’s where the worry about systemic risk comes
in; if the gains are concentrated in a very small number of players but the
losses hit a big bank, look out.
And the concept of a crash doesn’t simply mean wealth-destruction. These
markets can crash in a very real way: They can go away. There are relatively
few major derivatives dealers; in a panic, they won’t pick up their phones.
It’s conceivable that one day investors will wake up and the CDS market
or some part of the collateralized debt obligation market or something else
won’t be open for business – as the subprime mortgage originators
essentially found a few weeks ago. (Obviously, this is a matter of price. Things
settled down in subprime and now the subprime window is open. But mortgages
are being packaged and sold at a discount, rather than a premium.)
So what do we have? We have relatively new markets that are wildly popular
with risk-hungry investors, growing like weeds, haven’t been tested in
a crisis, and have the potential to increase leverage dramatically. Furthermore,
mostly derivative transactions aren’t transparent to other market participants
or the regulators.
And Felix says, What, Me Worry?