Derivatives: Eisinger Responds

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”

or “protection.”

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?

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