This past week witnessed almost a complete meltdown of the global financial system after derivatives knocked down Lehman Brothers and AIG.
Worldwide losses from speculative excesses could exceed $1 trillion, and the word “derivative” has become a dirty word.
It is difficult to overstate the significance of derivative investments. In fact, the comments in 1999 by then-Federal Reserve Board Chairman Alan Greenspan should be noted: “By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives.”
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. In recent years, almost anything can be used as an underlying asset, from bets on the weather to housing prices in Atlanta.
The size of the derivative market, which is primarily unregulated, baffles the imagination. According to the Web site www.EconomyWatch.com, the notional value of derivatives surpassed $370 trillion as of June 30, 2007. Indeed, the tail is longer than the proverbial dog; that is, the world’s gross national product of some $56 trillion is less than 20 percent of the derivative market.
Even the financial catastrophe of the past year will not eliminate the use of all derivatives. Their wide spread usage reflected in large part legitimate as well as speculative financial goals-hedging, dealing, and speculating. Global financial institutions’ survival depends upon understanding, measuring, and managing financial risks effectively so they can perform their functional responsibilities of serving international commerce. Given the increased complexity of the globalized world economy, there has been a corresponding growth of financially engineered products in order to keep the engines of commerce humming.
We need to become familiar with some of the business applications of derivatives:
* Reduce risk for one party while offering the potential for a high return (at increased risk) to another.
* Meet their risk-management objectives so that funds are available for making worthwhile investments.
* Make it possible to initiate productive activities that might not otherwise be pursued such as operating globally without exposure to foreign currency fluctuations.
Richard Bookstaber, a former colleague of mine at Morgan Stanley, has written an excellent book, “A Demon of Our Own Design,” that highlights the perils in the financial world and the market place of derivatives.
Bookstaber said, “You do not deliberately obliterate hundreds of billions of dollars of investor money. The financial markets that we have constructed are now so complex, and the speed of transactions so fast, that apparently isolated actions and even minor events can have catastrophic consequences.”
Greenspan expressed concerns about the leverage of financial institutions and whether regulatory capital requirements were appropriate. In essence, Greenspan worried whether the regulators could measure all the complex variables that accentuate price movements and thus losses. Today’s dismal financial problems have been accentuated by an absence of enough financial bottom-fishers to provide liquidity for distressed sellers. Thus, the world’s central banks, rather than the private sector, have needed to provide liquidity to financially leveraged institutions that cannot unwind their derivative contracts or obtain funding in the marketplace.
Certainly, the deflation in housing prices both in parts of Europe and in the U.S. has so threatened the world financial system that central bankers have taken unprecedented actions to stop systemic risks. The seizure of Fannie Mae and Freddie Mac who collectively had more than $5 trillion of obligations, including massive derivative holdings, reflected concerns that their failure could precipitate a global financial crisis.
In conclusion, interested parties around the globe will need to ask a few basic questions. First, which risks should be hedged and which should remain unhedged? Secondly, what kinds of derivative instruments and trading strategies are most appropriate? Thirdly, do these parties have the risk management tools to assess their loss exposure? Fourthly, do they have sufficient equity capital to absorb unforeseen losses?
In essence, we should remember the warnings of Warren Buffet. “Risk is a part of God’s game, alike for men and nations.”
Originally published in the Sarasota Herald-Tribune
