Derivatives: What, How, Why
05-07-2009, 12:01 PM
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Derivatives: What, How, Why
An interesting article on the history of derivatives and the what, why and how. Written prior to the latest crash, but quite predictive in it's content.
In Defense of Derivatives: Between Enron, WorldCom, and Global Crossing, the controversial financial instruments have gotten a bad rap. Here's the truth. - Reason Magazine
Excerpt:
"Take Enron. Derivatives did play a role in what was the second-largest bankruptcy in U.S. history (behind only WorldCom), but not in the way most people think. The Houston energy company did not go bankrupt because it lost money in derivatives trading. In fact, Enron was tremendously successful in its trading operations, racking up billions of dollars in profits. As documented by economic historian Frank Partnoy, the company went under not because it was losing money but because it tried to use these profits to disguise heavy losses in its consulting and technology businesses. When the accounting shenanigans were exposed, the company's credibility evaporated, as did its sources of credit and cash. The company was killed by a lack of cash flow, not a lack of profits.
But there are other troubling aspects of derivatives. For one thing, they may be used in what is called "regulatory arbitrage." Partnoy notes, in his financial history Infectious Greed (2003), that "bank regulators, by tightening their focus on banks to reduce their risks and prevent a banking crisis...pushed credit risks onto other, less regulated institutions." In other words, while it may have made sense in other ways for banks to retain more of their own credit risks, the regulatory environment prompted them to trade that risk away. Similar types of regulatory arbitrage have motivated other economic actors, such as insurance companies, to enter into derivative contracts that otherwise would have been unattractive to them.
It's clear that the legal system has a role to play in preventing financial scams. It is also clear that if a particular regulation is desirable, the use of derivatives to dodge it is not. If the regulation is not desirable, it is simply generating transactions that serve no purpose other than evasion, thus creating superfluous costs and transferring risk from specialists (such as banks and insurance companies) to the less experienced.
Another problematic aspect of derivatives is their often unmonitored use by government agencies. While there has been increased legal and social pressure on private corporations to be transparent in their use of derivatives, politicians have shown little interest in similar standards for government derivatives trading."
In Defense of Derivatives: Between Enron, WorldCom, and Global Crossing, the controversial financial instruments have gotten a bad rap. Here's the truth. - Reason Magazine
Excerpt:
"Take Enron. Derivatives did play a role in what was the second-largest bankruptcy in U.S. history (behind only WorldCom), but not in the way most people think. The Houston energy company did not go bankrupt because it lost money in derivatives trading. In fact, Enron was tremendously successful in its trading operations, racking up billions of dollars in profits. As documented by economic historian Frank Partnoy, the company went under not because it was losing money but because it tried to use these profits to disguise heavy losses in its consulting and technology businesses. When the accounting shenanigans were exposed, the company's credibility evaporated, as did its sources of credit and cash. The company was killed by a lack of cash flow, not a lack of profits.
But there are other troubling aspects of derivatives. For one thing, they may be used in what is called "regulatory arbitrage." Partnoy notes, in his financial history Infectious Greed (2003), that "bank regulators, by tightening their focus on banks to reduce their risks and prevent a banking crisis...pushed credit risks onto other, less regulated institutions." In other words, while it may have made sense in other ways for banks to retain more of their own credit risks, the regulatory environment prompted them to trade that risk away. Similar types of regulatory arbitrage have motivated other economic actors, such as insurance companies, to enter into derivative contracts that otherwise would have been unattractive to them.
It's clear that the legal system has a role to play in preventing financial scams. It is also clear that if a particular regulation is desirable, the use of derivatives to dodge it is not. If the regulation is not desirable, it is simply generating transactions that serve no purpose other than evasion, thus creating superfluous costs and transferring risk from specialists (such as banks and insurance companies) to the less experienced.
Another problematic aspect of derivatives is their often unmonitored use by government agencies. While there has been increased legal and social pressure on private corporations to be transparent in their use of derivatives, politicians have shown little interest in similar standards for government derivatives trading."
05-11-2009, 12:09 PM
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Joined APC: Jan 2006
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Just a little update. Buffett is quoted in the story by noting derivatives are economic weapons of mass destruction. Isn't it curious that he would employ them on a grand scale?
"Buffett had already acknowledged a mistake a huge mistake in ConocoPhillips, and his derivative losses are still criticized even if they may all work in his favor through time. Those derivative losses are easy to criticize when the markets are in free fall and there is noway to issue a real stated value on them, but he is opportunistic there even if he paid out close to $675 million on credit risk derivatives in the quarter. Berkshire has also paid out another $450 million on credit default derivatives since the end of the quarter, and has roughly $3.3 billion set aside in reserves for future derivative losses tied to the same."
"Buffett had already acknowledged a mistake a huge mistake in ConocoPhillips, and his derivative losses are still criticized even if they may all work in his favor through time. Those derivative losses are easy to criticize when the markets are in free fall and there is noway to issue a real stated value on them, but he is opportunistic there even if he paid out close to $675 million on credit risk derivatives in the quarter. Berkshire has also paid out another $450 million on credit default derivatives since the end of the quarter, and has roughly $3.3 billion set aside in reserves for future derivative losses tied to the same."
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