The Case for Derivatives

My recent post, in which I shared my experiences as a derivatives salesman, elicited very strong reactions both on my blog and on Seeking Alpha. Many of the comments equate derivatives with scandal, fraud and loss, which is an unfortunate by-product of their mis-application, lack of transparency and disclosure.

The fact is, derivatives are powerful and valuable tools that, when used properly, can expand the value for all parties involved: the hedger, the speculator and the investor. And with standardized hedging instruments, a centralized clearinghouse for managing counterparty risk, accounting rules that support detailed disclosures and transparency and Boards of Directors that monitor their prudent use, derivatives will regain their rightful place in the capital markets - as a powerful tool for good.

Consider the hedger. It might be a corporation that has very cyclical cash flows, like a manufacturer of construction equipment. The manufacturer's cash flows will often rise and fall with GDP, giving it an asset duration that is short. As a result, the company would want a liability duration that is also short. But these companies often want long-term liquidity for investing in new plants, re-tooling of product lines and other capital-intensive activities, indicating that they'd want to issue long-term debt. But most companies that issue long-term debt can only do so by paying fixed rates, resulting in a liability duration that is long, much longer than its asset duration. The company, in this case, can secure long-term liquidity by issuing the long-term fixed rate bond, but can match liability duration with asset duration by swapping this bond back to floating. Assets and liabilities are matched, yet the manufacturer's long-term capital plans are secure. The fixed-to-floating swap is a key piece of the puzzle. This is a prudent hedger in action.

Consider the speculator. It could be a derivatives trading desk on Wall Street. It could be a hedge fund. They take the other side of the hedger's transaction, where they will receive fixed and pay floating, taking on a long duration exposure. They might do this because of a view on swap spreads, Fed policy, yield curve shape or any number of other variables. They could even hedge out part of the exposure and leave the rest open to express a view. Regardless, they provide liquidity to the hedger and make it possible for the manufacturer to see their total utility increase. To the hedger it no longer matters whether rates go up or down, because their asset and liability cash flows are highly correlated and, therefore, hedged. The speculator, meanwhile, sees their total utility increase as they are able to express a view using derivatives that they couldn't otherwise establish in the cash markets. Speculators, like short sellers, play a necessary role in the capital formation and allocation process.

Finally, consider the investor. They can sometimes use derivatives to establish positions in stocks more efficiently than they could in the cash markets, e.g., buying deep in-the-money calls instead of the the stock outright to secure upside participation with less cash required. They can also use derivatives to trade around positions and increase return while preserving the original investment thesis, e.g., selling out-of-the-money calls to collect income in flattish environments, or out-of-the-money puts to establish long positions at depressed price levels. Derivatives can also be used to generate cash against a long-term position, such as what Warren Buffett did by selling extremely long-dated put options against his cash portfolio.

And let me add a few words about credit derivatives. They are valuable tools for both managing risk and speculating on credits. Consider the bank, the hedger, that underwrites a loan to a corporation, and even after syndication still has a significant hold position in the credit. It may want to offload most if not all of this residual risk, and the most efficient way for doing so is often the credit derivatives market. By purchasing default protection on the name, it can effectively immunize the exposure posed by the cash loan. Conversely, the speculator can express a view on credit spreads and default probabilities by taking the other side of this trade, again providing liquidity to the hedger where no cash market alternative exists. The investor can use credit derivatives to hedge both its debt and equity exposures, buying downside protection that often costs far less than equity options (while bearing a measure of correlation risk). The lion's share of the problems we've seen in the credit derivatives arena are due to inappropriate mortgage-related transactions: an indictment of the entire industry is illogical, unfair and inconsistent with prudent use of the tools.

The point I made earlier still holds: pushing most of the OTC derivatives market to a central clearinghouse, together with common sense accounting rules and appropriate corporate governance will facilitate the safe and prudent use of derivatives. When used and monitored properly derivatives are financial assets, just like any other. Being scared and adopting a reactionary stance towards their use will only hurt the liquidity, efficiency and safety of the financial markets. It is so easy in times of crisis to throw the baby out with the bath water: this is one baby you want to be sure to wrap in a towel and keep safe.

Comments

[smash:]

You have done a fine job of explaining the uses of derivatives, but not so fine a job of explaining their value to the economic marketplace. You talk about banks and corporations wanting to offload risk. That is exactly the problem with derivatives is they allow that process to happen, but it is only happening as a mirage. If I buy up all your risk and take it onto myself then all we have done is transfer the promise to pay another party. My actual ability to pay may be a whole different issue. As the party offloading risk, your only concern is getting the risk off your books, onto mine, so you can continue leveraging up your asset portfolio. This ignores the problem that you are still the primary party on the risk as the original contracting party. If it turns out I can't pay, then you are still on the hook for the losses. At least it seems that is how things have turned out with the current crop of structured investment and false transfer of risk. On top of this, transferring risk away from the party that originated the risk invites lax lending standards. Obviously, if I don't think I will be on the hook for losses then I am not so concerned long term if the debtor can pay - as long as they can pay until I move the loan off my books. You did mention in all your examples a certain party that ought not be involved in transactions which underly the foundation of finance system - the Speculator. Currently there are speculative derivative transactions in force equal to ten times World GDP. Clearly, in a major world-wide economic dislocation, such as we are now experiencing, if even a small fraction of the contracts start going sour, then it bankrupts the entire planet since it is numerically impossible that a relative few speculators (such as AIG) have the financial means to cover bad bets a few hundred trillion dollars in excess of their aggregate capital base. The reckless buffoons who accumulated this nightmare did so in full possession of the knowledge of what could happen if things went south and knowing they could not cover their promises. They acted in the same manner as a consumer who runs up $100,000 credit card debt and puts it all in the equity market, knowing that if they don't get a quick payout they will be forced to declare bankruptcy, but also knowing that that if nothing goes wrong they will make sooo much money. They only do this transaction because they know that in doing so they are actually engaging in a derivatives transaction of sorts, where they incur the obligation and the benefit of a payoff, but since it is unsecured debt, the ultimate risk of the transaction is actually born by the card issuer. The card issuer, however, is not a victim in this scheme because they were aware of this potential risk but took it knowing they could transfer the risk by selling off the credit receivables through a derivatives transaction. So it just turns into a merry-go-round game of hot potato, but with nobody accepting ultimate responsibility for the debt until the final speculator - who is either a shark with no intent to make good if things move against him, or is a ninny that did not fully understand the risk he was engaging but just succumbed to some bully sales pitch. The economy is better served if risk taking parties are required to backstop the risk the introduce into the marketplace with their own skins - at least to the level of their commercial interest.

2008 Nov 11 05:18 AM

[Mastery:]

Smash seems to miss the point. The entire stock market, futures markets and debt or bond markets are built on risk/reward ratios: from credit card lending at 24% return to cushion against high default levels to the US Treasury borrowing at less than 1% because it is considered risk free. The market is and always has been Caveat Emptor.
Buying shares is the same as selling put options and buying call options. Buying bonds the same as selling credit default insurance. HOWEVER the real risk issue here - purchasing a house and a pension fund are likely the most risky investment most individuals will make in their lifetime. Indeed so important does the government consider these activities are to the economy that they provide very substantial tax breaks for both. However both involve very risky investments in leveraged real estate as well as stock markets which as 100 years of experience has told us are volatile creatures. In 2007/2008 we saw house values dropping 25% (up to 50% in some areas), stock markets dropping 60% AND energy prices (oil) rising year on year by over 75%. These were the real culprits of the market collapse. What caused these three was only partially a subprime and derivative problem: it was basically almost entirely the Federal Government (a) pumping unnecessary liquidity into the market at the time of the dot com crash and therefore sustaining an already overheated stock market which by 2007 because of pension and blind index fund and hedge fund investment had reached absurd valuations (b) the collapse of the dollar and simultaneous rise in oil prices because of Bush's mid east wars threats to Iran, Syria and in Lebanon and as a result of the collapse of the dollar and high oil, the consequent massive trade deficit causing sovereign disinvestment (c) Federal Reserve lying about inflation which as any moron can tell has been running at almost 5% for some 20 years.(the same as the average rise in Fed Spending per capita, the average rise in the price of oil over the past 20 years, the average rate of inflation in England over the past 20 years AND the average rise in house prices as described by OFHEO AND with asset price inflation as measured by the stock market running at double this against anemic real growth (that is growth adjusted for that inflation number.)
It was the pressures of the above that resulted in massive deleverage and disinvestment as well as a collapse of the stock market to correct levels AND in turn which caused mass bankruptcy on Wall Street under simultaneous pressure from hedge fund fraud, auction rate preferred fraud, subprime fraud and derivative fraud AND the whole mess made worse by massive market manipulation in fast becoming illiquid markets by high frequency trading hedge funds and major investment bank proprietary trading desks causing obscene volatility and forcing further liquidation.
As if this were not enough Basle II in 2008 required banks to remove corporate and personal loan risk from their balance sheets and instead take mortgage and derivative (ie off balance sheet) risk thus paradoxically effectively removing massive capital from the system at the time it needed it most.

2008 Nov 11 05:57 AM

[athena:]

We have a functioning, regulated derivatives market called OPTIONS.
There are limits on number of contracts, forced transparency and limits on leverage. These other contracts, based on models, collateralized by a promise, unregulated, opaque, vehicles for commissions, and leveraged to the sky have destroyed this economy.
Dont you all look like math geniuses now- math models for derivatives are an oxymoron- the point of the markets is that you cannot fashion one.

2008 Nov 11 08:32 AM

[morph366:]

It is becoming increasingly apparent from the scale of the revised AIG rescue plan announced yesterday, and the fact that there has still been no real “pricing” of the really toxic stuff by the TARP, that the financial engineers that created this monumental disaster were either unintentionally reckless beyond belief or, if the obfuscation was intentional, this must surely be counted as the largest theft ever perpetrated and taxpayers should be demanding ongoing investigations leading to criminal prosecutions.

If we just focus on the more benign interpretation (i.e. that it was not malicious intention) one is forced to the conclusion that the mathematics that underlies all of the risk modeling that went into these structured products is absolutely flawed. Not just slightly wrong but fundamentally mis-conceived.

The saddest part of the whole mess is the hubris and arrogance of the people that signed off on the assessments made by the “quants” of the likelihood of defaults and the probability distributions of financial accidents. Extreme events in time series data are of a completely different complexion to the tails of a normal distribution.

If risk managers really insist on finding a bit of maths that can account for the likelihood of critical events taking place – such as collapses in real estate prices and implosions of liquidity – a better place to look would be the predator-prey modeling which has been conducted mainly in relation to bio and eco-systems.

Predators eventually run out of sufficient prey and their populations decline substantially until there is a chance for the supply of prey to be replenished. At such time the predators can get back to business. This modeling gives rise to oscillations in the ratio of predators to prey and right now we are in a bear phase for the predators. One slight modification to the model needs to be made for the government rescue plans etc which will perhaps keep those marginal survivors from the last predation on a life support system long enough so that they can limp off and become ensnared in some new financially engineered scam.

2008 Nov 11 08:57 AM

[Roger Ehren...:]

Please come over the blog directly to comment. Given the lack of Disqus functionality I can't directly respond. This is a lousy format with which to have a dialogue.

2008 Nov 11 10:05 AM

[Otho Thotho:]

I think that what SMASH was pointing to, given that the stock market is built on risk/reward ratios, is that if speculative traders, hedgers, or whoever, want to place side bets -- because I've heard "derivatives" described as this by more than just a few money men -- then they can do it on their own dime -- not the tax payer's.
Let's say Mom's only income is monthly social security. Let's say she's not happy sitting there in her warm home watching TV, baking up a storm, and tending to the flowers in her garden. Let's say she needs a lift from the hum-drum. What's this? A casino? Ah, the lift she was looking for.... Well, what happens if she tosses it all in; it all goes to the house. What now? She's coming to you. At first you give her a bit. Then you wonder why she needs more. And more. And still more. Then one day you follow her to the casino. And let's say you can make the distinction between the casino and the stock market and you know your limits (the distinction is a little blurry right now, but let's just say...).
Short of cuffing her to a pipe in her home, how does she not become your problem?
These financial titans that have tumbled were ill-supported by their side-betting strategies. In the future, because of a few malignant ones, they will all be cuffed to the pipe. The sad thing is that the individual recklessness and/or fiduciary malfeasance of all the star players, whether business leaders or political leaders, will go unpunished where it really counts. Money is king. The likelihood that those involved in the destruction of the system have planned accordingly is pretty good. It's the vision thing. They have already piled their fortunes in off-shore accounts and they will return to divvy up the spoils when the coast is clear. They just have to be patient and not show their hand until all the chips are in. To hold up until then takes the spine of Godzilla. What's a better face for a monster?

2008 Nov 11 11:29 AM

[BerkeleyBob:]

To say that hedging, options transactions, credit swaps and short sellers/hedge funds have a place and serve a useful function, as does Mr. Ehrenberg, does not fully state the problem. Although many factors, including disastrous policy and political decisions by this administration in particular, are a factor in what is shaping up to be a global fiscal collapse, the activities of AIG aided and abetted by the likes of Lehman and the ratification by Standard & Poore, Moody's, etc were the primary causes. There is a lot of justified anger and resentment out there from those who have experienced the unfamiliar pain of value destruction on an unprecedented scale. God help us all.

2008 Nov 11 12:34 PM

[jdl51:]

What seems to have happened in the CDS markets is that they were deliberately structured to avoid regulation. They made investment banks tons of money when the underlying securities behaved themselves but increased risk exponentially when they didn't. From what I understand, they are like insurance policies, yet anyone can participate in them. So if I have a life insurance policy on my wife, and my whole neighborhood does too, then when she dies the whole neighborhood has to get paid off. And to top it all off, this huge liability was not on the books of the issuers which would have prevented them from exposing themselves in the first place. This is what happens when you have deregulators in charge. They looked the other way when all this was going on and now the chickens have come home to roost.

2008 Nov 11 01:32 PM

[junkbmw:]

You all are missing the point about the cause of the falling markets although some points about derivative are good. What has happened shows how intertwined the capital markets are. Here is my take and I do blame structured investments created out of primarily subprime mortgages as the catalyst to everything that has occurred since mid 2007.
When subprime mtg defaults climbed faster than anticipated in Spring, 2007 the following occurred:
Owners of CDO's - specifically AAA rated saw prices fall much more than ever expected, i.e. in dollars vs normally in bps
Owners of CDO's then began selling CLO's (leveraged bank loans - the funding for all those LBO's, etc.) because mkt liquidity for structured investments was decreasing thanks to the sudden volatility in CDO pricing, not what AAA buyers are use to.
Banks couldn't sell their unsyndicated bank loans
Money mkt funds started puking out their structured investments
It was revealed that asset backed com'l paper was invested in CDO's, etc. and some of these vehicles were levered causing rapid pain.
Money mkt funds started selling AB-CP
Other AB-CP issuers such as auto captive finance co's couldn't get financing
Money mkt funds got more risk adverse and stopped buying credit card asset back securities.
Meanwhile the subprime mkt was being driven by the underlying ABX derivatives index. As it continued to slide fr what were presumably cheap AAA, AA, A, BBB levels to prices reflecting distressed assets it forced everyone holding CDO's to reprice accordingly.
The bond insurers who normally insure default of mostly municipal bonds but also asset backs, and some corporates, entered the subprime CDO market over the past 5 yrs, leading to them hitting the wall when CDO prices fell.
This led to significant problems with many municipal bonds including the student loan market. Now everyone who thought they were invested in AAA-AA muni's because of the insurance were no longer. Their risk appetite went away as their portfolios' credit quality went south.
Meanwhile buyers strike continued for CDO's and CLO's and we haven't even gotten to 2008.
Banks started feeling the pain of charge-offs associated with structured investments that had fallen in price or no longer had valid bond insurance. Furthermore, banks couldn't get rid of upwards to $200 bil in unsyndicated bank loans still hanging from bridge loans/promises made to all the LBO shops. Anyone who knows anything about bank accounting will quickly realize that charge-offs erode capital that must be replaced if these companies are to remain sound and viable.
Now we are going into Dec, 2007 and one very large insurer announces to the world that they also have made some very big subprime CDO bets via selling insurance (CDS) on many of these subprime CDO's that are now headed south in price. However, this large insurer, AIG, also had been selling insurance on bank loan portfolios worldwide to the tune of half a trillion dollars. Thus what should have remained a subprime problem was growing much larger.
One other market was also beginning to fall apart beginning in the 4Q.07 which was the commercial mtg mkt. It turns out that many com'l mtgs are underwritten and then sold into structured investments just like residential mtgs, i.e. CMBS. So if you figure the typical buyer of all the structured investments rated AAA were money mkt funds and other conservative investors they were not going to stay invested in AAA rated CMBS's either leading to lack of liquidity in this market. So now another large part of the economy is losing steam because the capital markets are increasingly not there.
Hedge funds - they are mostly based on leverage (sound familiar) and thus their returns became very exagerated, both up & down. As banks continually shrank their balance sheets it consequently led to lack of access to borrowing for hedge funds. This in turn led to rapid unwinds of hedge fund portfolios (think $2.5 tril in hedge fund money levered by 2-3x). And what normally gets sold out of portfolios first are the best and most liquid assets and then the unwind story continues leading to the rapid decline in commodities exacerbated by the fear of a global economy slowing.
The rest of the story is pretty simple: the key capital markets continue to decline, stock investors begin to catch up with the bond markets, more people get nervous, and then things just start to unravel faster and faster until we get to this fall. As banks and brokers continue to see their capital erode sources of new capital are no where to be found. Now AIG which is continuing to see a rapid erosion in its subprime portfolio is downgraded by the rating agencies leading to more collateral required to back up all those insurance policies, specifically the $500 bil in bank loan CDS spread across banks globally. Do you save it or potentially watch a global catastrophe result.

So really if the subprime mtg debacle never occurred there is some likelihood that we wouldn't be here today. For some perspective:
Residential mtg backed securities mkt has functioned fine since the early 1980's just not in the form of CDO's
Asset backed mkts for autos, credit cards, equipment has functioned for over 20 yrs
Derivatives mkt in most forms has functioned well for 20 yrs
Bond insurers have been around for many yrs

However, the CDS mkt has been around for less than 10 yrs and was probably going to create some problems given the slow pace of regulation of this mkt and the lack of a central clearing house for trading. The Fed was on to this a few yrs ago but the players were not acting quickly enough.

In the meanwhile everyone wanted to own AAA paper that paid a yield higher than AAA, the 'free lunch' which there is none in this world. So subprime mtgs met the needs of the 'free lunch' and the rating agencies, investment bankers, and investors all helped it succeed.
Unfortunately, now that all hell is breaking out it is easy to blame everyone and everything which when the dust settles is probably going to leave some ugly regulation.

2008 Nov 11 03:56 PM

[Henry Buttal:]

Great comment, junkbmw. I think that compliments Roger's post exceptionally well. The current market pertubations may be caused by improper use of derivatives, but that doesn't mean you outlaw them (or their regulated equivalent, insurance). People drown all the time; but we still need water.

2008 Nov 11 06:59 PM

[bryanz:]

Derivatives have definitely gotten a bad rap lately. I agree that a centralized clearinghouse for certain derivatives makes sense, look at the futures market.

With the thinly traded securities it may present a challenge as the dramatic mark-to-market revaluations of certain "asset"-backed derivatives could really hurt the clearinghouses themselves if the counterparty fails though, right?

The whole derivative of derivative or derivative where firms couldn't even properly value their holdings seemed to cause a lot of problems as well. How do you value something based on something else that can't be valued?

2008 Nov 11 07:49 PM