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What are Derivatives and Why We Should Care?

PBS’ FRONTLINE last week did a very insightful report on the derivatives “Over the Counter” (OTC) market and how one person, Brooksley Born, was warning the Treasury Department and the Federal Reserve about the risks and dangerous of derivatives in the OTC market.  Obviously, her warnings were ignored because things were going so well in this market and financial conglomerates were making a ton of money in it.  But, shortly after her warning there was a potentially devastating financial crisis that didn’t get much attention caused by one hedge fund: Long Term Capital Management.  Jump ahead to our current crisis we have the OTC market and derivatives again having a role in a financial crisis, but this time the impact was far greater.

What are Derivatives and Over the Counter Market?

Derivatives are financial instruments in the form of contracts between two parties.  These derivative contracts can be created on and traded in an derivatives trading facility, such as the Chicago Board of Trade, or “over the counter” - OTC (more on this later).  The derivative contracts can be standardized or they can be customized to fit a given situation.  The standardized versions are typically traded on an derivatives trading facility as known as an exchange (Chicago Board of Trade).  Derivative contracts can be for “forward commitment” or “contingent claims”. 

“Forward Commitments” are agreements between two parties where one party, the buyer, agrees to buy from the other party, the seller, an underlying asset at some future date at a price established at the start of the contract.  A standardized version of a “Forward Commitment” is a futures contract such as pork belly futures, interest rate futures or corn futures.  “Forward Contracts” can be very useful for companies, such as food producers or airlines, who want to protect against changes in the price of an important input such as corn or airplane fuel.  Interest swaps are another example of “Forward Contract”.  “Forward Contracts” are not standardized.

“Contingent Claims” are derivatives in which a payoff occurs if a specific event happens such as the price of an underlying asset goes down or up, or a company defaults on a debt obligation.  Generally speaking these types of derivatives are options.  These type of derivatives give one party the right, not the obligation, to buy or sell an underlying asset from or to another party at a fixed price over a specific period of time.  In many respects “contingent claims” take the form of insurance against a particularly event.  Options traded on an option exchange are standardized versions of a “Contingent Claims.  Credit Default Swaps (CDS) are examples of non-standardized “Contingent Claims”.

Derivatives can be very complex and complicated, particularly non-standardized contracts.  They can be extremely risky investments.  And they can be traded not to hedge against certain risks (which is good) but they also can be traded for speculative gain.  In the hands of people who don’t understand them, or are over confident in computer models or just plan greedy and reckless they can be incredibly dangerous.

“Over the Counter” Market (OTC) is like a “black market” of derivatives trading.  A “black market” not because of the legal/illegal nature of derivatives but because the OTC market happens very much behind closed doors or underground.  There is very little transparency in this market.  It is unregulated.  Non-standard derivatives trade on OTC.  Needless to say because of this lack of transparency it is hard to measure the size of this market.  Most estimates indicate the size is about HUNDREDS OF TRILLIONS of dollars (that is TRILLIONS with a ‘T’).  The size of this market makes our economy look like peanuts.

History

Frontline’s report “the warning” provided incredible insight into the lead up to our current economic crisis.  It started with ‘the warning’ from Brooksley Born, who in 1990’s was the chairwoman of the Commodities Futures Trading Commission (CFTC).  The CFTC is responsible for regulating the futures and options exchanges.  Ms. Born and her staff were researching OTC after Proctor & Gamble sued Bankers’ Trust for millions of dollars in losses it said it incurred because of OTC derivatives it bought from Bankers’ Trust.  Proctor & Gamble claimed it was misled in the sale of the derivatives by Bankers’ Trust. 

The CFTC started investigating and researching OTC market and Ms. Born and her staff came to the conclusion that OTC market, left unregulated, posed a grave threat to entire financial system.  The problem was that very little was known about OTC market because of the lack of transparency.  But in the late 1990s, when she issued the warning, the economy was doing well and the stock market was reaching new highs almost every month.  Obviously, the Clinton Administration and the Fed Chairman Alan Greenspan dismissed Ms. Born’s warning. 

Then something happened in the dark of the night in September 1998.  A hedge fund, not known to the public, called Long Term Capital Management (LTCM) rocked the financial world.  LTCM was well known in the financial world. It was founded by John Meriweather, a former vice-chairman for Solomon Brothers (who BTW had to resign from that position because questionable and illegal practices of an underlying), and it had two Nobel Prize winning economists (Myron Scholes and Robert Merton) serving on its board of directors. 

LTCM used complex and proprietary computer trading models to take advantage price differences in investment securities around the world.  It was very successful at first.  LTCM’s trading scheme relied heavily on leverage (ie. debt).  It dealt heavily in interest rate swaps which are OTC derivatives.  Some reports say its derivative investments had a value of $1.25 trillion.  Clearly, these were bets that they could not cash.

When the markets, particularly in Russia, started to move against LTCM, the House of Cards began to collapse.  The Federal Reserve Bank of New York organized a buy out by a few of LTCM’s creditors in the amount of $3.625 billion.  The fear was that if LTCM collapsed it would bring down the entire financial system.  This all happened with very little public attention.

After LTCM, one would think that rational people would say maybe we should investigate this OTC market further.  Nay.  In fact, the Clinton Administration and Senator Phil Gramm go a step further and include a provision in the Commodities Financial Modernization Act of 2000 to make clear that OTC derivatives market were NOT to be regulated.

Jump to 2008, American International Group (AIG), the world’s largest insurance company, is about to collapse and the fear is that they will bring down the financial system.  Like a broken record.  AIG was gambling in the OTC derivatives market.  Some reports say they sold credit default swaps (CDS) in the amount of $400 billion.  Again, bets their ass could not cash.  But because of the lack of transparency in this “black market” regulators didn’t know the magnitude of the problem. 

This time the taxpayers did the bailout.  Treasury lent AIG $85 billion at first and then a few more loans for good measure which eventually totalled $173 billion.  Much of this bailout money may have gone directly to counterparties (buyers of CDSs) on the CDS derivatives such as Goldman Sachs and Germany’s Deutsche Bank.

So, there you have it - OTC derivatives market - 2 greedy and reckless companies and 2 bail outs and one financial crisis that leads to an economic meltdown.  Again, rational people would look at this and say wow, maybe we need to do something.  Think again.

Derivative Regulations

The Obama Administration proposed regulations of the OTC derivatives market that required a little more transparency and more margin requirements.  But it still was hands-off the non-standardized derivatives contracts.  Then two congressional committees got a hold of the proposal: House Financial Services Committee and House Agricultural Committee.  This past week both committees passed OTC derivatives regulation that had so many exemptions from the rules that they render the entire piece of legislation meaningless.

So why should we care?  Nothing changes with OTC derivatives and if history repeats itself, we will be back again dealing with another financial and economic crisis but this time it may be worse.  The problem is that we bear the brunt of these financial crises not the financial conglomerates or financial oligarchy.

Good luck.