The following is an excellent excerpt from the book “THE BANKERS’ NEW CLOTHES : What’s Wrong with Banking and What to Do About It” by Anat Admati and Martin Hellwig from Chapter Five titled “Banking Dominos” on page 69 and I quote: “Derivatives CDSs are an example of contracts known as derivatives. Derivatives allow the trading and rearranging of risks among different people. The word derivative indicates that the participants’ payment under the contract depend on, or are “derived” from, something else, such as whether a borrower defaults or the price of some asset that is uncertain at the time that the contract is written.
Derivatives allow nonfinancial and financial companies to manage their risks better. For example, a bank might enter a so-called forward contract with a U.S. manufacturer to exchange dollars for euros at a pre-set rate on a future date when the manufacturer expects to receive a payment in euros from a European customer. For the manufacturer, this contract eliminates the risk that, by the time it receives payment, the euro might be worth much less relative to the dollar.
This contract makes sense if the bank cares less about the exchange rate risk than does the manufacturer. If the manufacturer’s costs are paid in dollars, it may not even cover its costs if the euro loses a lot of value (relative to the dollar) by the time the manufacturer receives its payments in euros. The solvency of the firm might then be threatened. It might therefore be important for the manufacturer to transfer the risk to someone else so it is not exposed to this risk. By contrast, the bank might not be much concerned about the risk. Constantly active in currency exchanges, the bank might expect to match the forward purchase of euros from the U.S. manufacturer with a forward sale of euros to a European manufacturer that expects payment in dollars. Even if the bank cannot fully match the contract, it might consider the risk insignificant relative to its total investments. If the bank is a large corporation with many shareholders, the risk to any one shareholder is very small.
Forward contracts have been around for a long time, not only for currencies but also for metals, potatoes, pork bellies, and other commodities. Other derivatives have been traded in exchanges since the early 1970s. Starting in the 1980s, and especially in the 1990s, derivatives have expanded dramatically and have come to play a major role in the financial system. New techniques have been developed that allow banks to manage the risks on these techniques have been useful because, as mentioned earlier, risks from exchange rate and interest rate movements became much larger in the 1970s and 1980s than they had been earlier.
Have New Risk Management Techniques Made the System Safer? – Derivatives and new techniques for risk management have benefited society by providing better means of sharing risks. Better risk sharing can reduce dangerous exposures to risks and can transfer risks to those who are best able to bear them. This effect can make individual defaults and bankruptcies less likely and improve financial and economic stability.
However, the new markets and new techniques have also expanded the scope for gambling, and they can be used in ways that increase rather than reduce risks in the system. Over the past twenty or thirty years, many scandals in which banks and their clients lost enormous amounts of money have involved derivatives. In Chapter 4 we mentioned the case of Singapore banker Nick Leeson, who brought down the United Kingdom’s Barings Bank in 1995 when he bet that Japanese stock prices would go up and instead they went down.
By using derivatives rather than buying stocks, Mr. Leeson was able to build up extremely large positions in a very short time, with little control from the bank’s senior management. Since then, at least twenty incidents involving losses of more than $1 billion each have arisen from the speculations of individual traders, carried out using derivatives. In the case of Orange County, California, in 1994, this involved a significant loss of public money.
Speculation and gambling have always played a role in financial markets. In the case of derivatives, however, the gambles that individual traders take have become much larger and much more difficult to control. Moreover, the domino effects of even small institutions’ failing can be disastrous. Warren Buffett was right when he referred to derivatives as “weapons of mass destruction.”
Derivatives allow the magnification of risks in ways quite similar to the effects of leverage discussed in Chapter 3. However, the risks cannot be seen by looking at a bank’s balance sheet. If a bank concludes a forward contract for an exchange of currencies, the initial balance sheet entry is zero. Yet if the contract is for 1 billion euros, a 10 percent drop in the value of the euro implies a loss of 100 million euros.
Risks from derivatives are even larger if payments change more than proportionately with changes in the underlying variables on which the contract depends. Such bets involve complicated formulas that can be used to make large gambles and to hide them from others. Techniques for reducing risks from derivatives often involve complex trading strategies. Traders like to keep these strategies secret because they do not want others to imitate them. Often they go out of their way to obscure what they doing. This secrecy protects them not only from imitation by others but also from control by senior management. If senior management itself is involved in the gambling, the secrecy hides the risks from supervisors, customers, and investors.
The secrecy and the complexity of the contracts and strategies used in derivatives trading allow individual traders and individual banks to build up very large risks, sometimes very quickly, without any effective oversight or control. Because derivatives can magnify risks, extensive derivatives trading can threaten not just an individual institution but, through contagion, the entire financial system.. For example, large gambles involving complicated formulas and trading strategies were one reason that a small change in interest rates set by the Federal Reserve gave a large shock to the financial system in 1994; the size of the shock came as a surprise because most people were unaware how sensitive the positions of many derivatives investors were to the Federal Reserve’s policy.
Another early example of this risk magnification was seen in the so-called LTCM crisis of 1998, named after the hedge fund Long Term Capital Management (LTCM). With $4.7 billion in equity and $125 billion in debt at the end of 1997, LTCM was a relatively small institution. However, when LTCM incurred large losses in 1998, the Federal Reserve was afraid that an LTCM bankruptcy might trigger a chain reaction, pushing other institutions into insolvency as well.
LTCM had huge derivatives positions, and the fear that LTCM’s partners in these contracts might suffer greatly from an LTCM bankruptcy was exacerbated by significant legal uncertainty about the treatment of these contracts. Moreover, because investors were afraid of a major financial crisis, attempts to sell LTCM’s assets might have caused the prices of these assets to fall dramatically, with potentially disastrous effects on the many other institutions that had been following strategies similar to those of LTCM.
To forestall such contagion effects, the Federal Reserve Bank of New York pressured major banks, creditors of LTCM, into bailing out LTCM by putting in equity, which would enable a slow unwinding without a bankruptcy procedure. LTCM was treated as a systemically important financial institution even though before the crisis it had not looked like one.
In the spring of 2008, similar concerns made the Federal Reserve want to avoid a Bear Stearns bankruptcy, so it arranged the takeover of Bear Stearns by JPMorgan Chase instead. In the process, the Federal Reserve took over a portfolio of close to $30 billion of dubious assets with a $1 billion contribution from JPMorgan Chase and close to $29 billion of its own money. The Federal Reserve acted in this way because it feared that a Bear Stearns bankruptcy would impose great damage on the partners of Bear Stearns in derivatives contracts.
People in the financial industry often claim that they are experts at detecting and managing risks and therefore that their actual risks are much smaller than others might consider them, certainly much smaller than the risks of nonfinancial companies. Quantitative models and so-called stress tests are said to provide precise and reliable assessments of risks and a basis for reducing risks by sophisticated techniques using derivatives.
These claims should not be taken at face value. Although bankers might be experts at analyzing and managing risks, they often come across risks that they have not anticipated. As former U.S. Defense Secretary Donald Rumsfeld famously said: “There are known unknowns; that is to say there are things that we now know we don’t know. But there are also unknown unknowns; there are things we do not know we don’t know.”
For example, people at LTCM, some of the most sophisticated minds in finance, had carefully calculated the risks of different movements that various interest rates might take, but they had not thought of the possibility that market investors might become more apprehensive about risks altogether so that the value of all debt securities except for the safest U.S. government bonds would go down. Similarly, before August 2007 bankers who purchased U.S. mortgage-related securities had managed their risks of the assumption that these securities could always be traded in the market. In August 2007, however, the markets for these securities suddenly froze up.
The high quality of risk management itself can be a problem if people in the industry become excessively confident about their models and about their ability to manage risks. This is analogous to the observation that the sense of safety provided by seat belts seems to cause many people to drive less carefully. Similarly, the sense of control that is provided by the use of quantitative risk models and derivatives markets for risk management seems to make people less careful about limiting their exposures and vulnerabilities. This may explain why speculative gambles using derivatives have become so large and institutions that have been particularly highly regarded for the quality of their risk management.
The chosen risk management strategies themselves may also provide a false sense of security. Buying credit insurance from AIG, investors in mortgage-related securities felt that they were safe. They failed to see that, if those credit risks were realized, the contract with AIG itself might be problematic at the very time that it would be most needed. To fully understand the situation, these investors would have had to know the full extent of the contracts AIG had signed with others and the extent of its exposure.
Usually, however, investors do not know the positions of other market participants. As mentioned earlier, market participants often go out of their way to keep their positions and strategies secret. Because most trades are made over the counter, out of the sight of other market participants, it is all but impossible for anyone to have a precise picture of other participants’ overall exposures and default risks. In particular, it is all but impossible to know whether the transfer of risks that has been promised will actually work or whether and under what conditions the entity on the other side of the contract might default.”
(IN TALKING ABOUT DERIVATIVES, THE FOLLOWING FOOTNOTE NUMBER 37 , CONCERNING PAGE 69-70 WHICH IS FOUND ON PAGE 260, I QUOTE:
“37. “Among the most popular derivatives have been interest rate and currency swaps. For a description of derivatives trading and markets, see Partnoy (2009,2010), Hull (2007), Das (2010), and Dunbar (2011).
SINCE THE GROWTH OF THE UNREGULATED DERIVATIVE MARKET IS ASTRONOMICAL and NO AGENCY HAS REALLY DECIDED IF THEY HAVE ANY VALUE AT ALL, SUCH AS GOLD, SILVER, OIL OR LAND, WHICH ARE REAL ASSETS AND OTHERS, SUCH AS GRAINS, IT’S EVEN RIDICULOUS TO CONSIDER DERIVATIVES AS AN INVESTMENT, OTHER THAN GAMBLING AND BETTING ON SOMETHING IN THE FUTURE THAT HOPE WILL BE THERE AND PERHAPS LEAD TO, MAYBE WE CAN GET MORE MONEY OUT OF ROAD FUNDS, VETERAN’S BENEFITS, FOOD STAMPS TO PAY FOR THE CASINO-TYPE DERIVATIVES’ LOSSES THAT THE BIG INVESTMENT BANKS ARE INCURRING THROUGH THE USE OF DERIVATIVES AND NO REGULATION.
LaVern Isely, Overtaxed Independent Middle Class Taxpayer and Public Citizen and AARP Members