Derivatives’ Destructive Role

In my studies of the European conquest of Native Americans, I leaned how a relatively few invaders could subdue millions. Europeans possessed several formidable advantages, including rifles and cannon, horses and better protective apparel.

Their greatest advantage, however, was the Native Americans’ lack of resistance to illnesses that the Europeans introduced: measles, smallpox and influenza. The Native Americans of course didn’t understand the true nature of this invisible threat. They believed the white man possessed evil magic because the plagues started several weeks after the Europeans had deserted their villages.

In today’s world, the financial tool known as the derivative, improperly used, can be a modern plague.

In finance, a derivative is a security or contract whose value is derived from one or more underlying assets. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.

They are intoxicating and dangerous because they can cause significantly greater profit — or harm — than traditional securities; on a percentage basis, their movement dramatically exceeds the underlying assets. For example, an option to buy could double in value if the underlying stock goes up 10 percent. On the flipside, an option to buy a stock can become worthless if the value of the stock does not rise within the lifespan of the option.

They are also a huge issue. According to the Bank for International Settlements, the total value of over-the-counter derivatives slightly exceeded $25 trillion as of June 30, 2009.

Unfortunately, global leaders can neither agree on the most effective way to regulate over-the-counter derivatives nor restrain special interest groups who profit from these private transactions.

Derivatives’ toxic strength, plus massive borrowing, have damaged the global financial system on at least three occasions:

The collapse of the hedge fund Long-Term Capital Management in 1998. LTCM held about $1 trillion in assets, including many derivatives, on an equity base of only $5 billion.

The current real estate meltdown. The slicing and dicing of mortgages created a maze of opaque derivatives.

Economies across Europe used complex derivative transactions to hide the true size of their debts and deficits.

Greece is on life support after revealing a debt of $3.2 billion it had hidden in order to qualify for membership in the European Union. The revelation roiled world financial markets on fears that the country would default.

Reportedly, Greece and Goldman Sachs in 2001 engaged in a derivative transaction to convert billions of dollars in Greek government debt into euros. The transaction used “off market” exchange rates that did not accurately reflect the actual market value of the euro. This allowed Goldman Sachs to effectively loan Greece $3.2 billion, under the guise of a currency swap, without Greece having to disclose this debt. In 2008, the EU changed its rules to prohibit members from using these types of derivative transactions to hide debt.

This financial chicanery was revealed in 2009 when a newly elected Greek government admitted the $3.2 billion debt and acknowledged that the country’s fiscal deficit was a EU-prohibited 12.7 percent of GDP.

German Chancellor Angela Merkel said this month, “It’s a scandal if banks are found to have helped Greece conceal its budget deficit. The country falsified statistics for years.”

Goldman Sachs reportedly earned $300 million in fees for developing the contract. And Goldman apparently continued to hide the Greek derivative transaction. On Feb. 17, Bloomberg, a leading financial Web site, wrote that Goldman failed to mention the swap in six of 10 bond sales where they were the lead underwriter.

Unless we learn to control the use of derivatives, we will die like the Native Americans or end up living in a tepee.

The challenge for regulators and corporations is measuring, understanding and managing the financial risks of derivatives in order to reach legitimate financial and speculative goals.

The most recent crisis reminds us that the term caveat emptor preceded Columbus’ discovery of the New World.