Over this winter break, I spent a good deal of time reading finance-related books that were written prior to the current crisis. Although many people that bear responsibility for the crisis have attempted to exonerate themselves with the argument that “No one saw it coming,” it appears to me that many people warned about the dangers of derivatives well in advance. As many of you know, I’m not exactly enamored with the practices on Wall Street. So it came as even a surprise to me that I’d finish reading these books even more outraged.
I have always been somewhat skeptical about the value of derivatives. Looking at credit-default swaps*, for example, it’s quite easy to see how they can have many negative side effects. Many people look to the CDS markets as a sign of a company’s health; a less scrupulous trader might realize this gives them an opportunity sell a stock short and then manipulate the more thinly-traded CDS market to stoke unfounded fears about a company. CDS contracts also pay 100 cents on the dollar; this gives a CDS-buying creditor holding bonds nearing default an incentive to push a company into bankruptcy to recover its full investment, rather than working out a restructuring agreement with the company and other creditors that would benefit them all. Finally, CDS allow traders to wildly speculate on a market in dollar quantities many multiples of the available underlying assets; we all saw how that whole insuring CDO thing worked out for AIG.
* CDS essentially allow a trader to buy an insurance policy that will pay in the event another company defaults. However, unlike a home or car insurance policy, you don’t need to own the underlying asset (in this case a bond) in order to purchase the insurance.
After reading these books, I came away troubled not just because of the potentially nefarious uses of structured finance products, but because we've known about these issues for many years. As the quote in the headline of this blog post indicates (from Frank Portnoy’s FIASCO), investment banks can use the complex nature of these instruments to deceive naïve investors (see Orange County's bankruptcy and Proctor & Gamble's $100 million+ derivatives loss) and run-up their own profits. Or they can collude with fund managers to trick government regulators and investors about the true nature of their strategies — many derivative securities are created to allow fund managers to sidestep regulations that ban them from trading foreign currencies or making leveraged bets. And in one of the more egregious abuses of derivatives, investment banks have also used these products to help companies cover-up hundreds of millions of dollars of losses, turning bad investments into something that looked like a big gain for current management, but that would surprise shareholders with enormous losses later.
I really don’t understand why we allow so many things like this to go on in the financial sector without much questioning. There are certainly benefits we enjoy from the use of derivatives (especially the simple futures and forwards that allow for hedging) — but shouldn’t we also consider their costs? Again, I turn to the toaster analogy. If 86% of a certain type of toaster blew up, there’d certainly be some push for further regulation. But 86% of CDOs backed by mortgages (originated in 2007) have defaulted, and we’re still waiting for something to be done.