The Great Derivative Hysteria

Recently, I've been hearing a lot of nonsense in the media regarding the role derivatives played in the current crisis. For instance, in a truly ridiculous piece, Katerina Vanden Heuvel of The Nation suggests that there was some woman working under Greenspan, warning about the dangers of derivatives who was silenced, and her voice could have saved us from the current mess we find ourselves in. In another piece, Bernie Sanders, the socialist senator from Vermont, also seems to suggest derivatives are somehow responsible. The highlight of Sanders' piece is the following quote:

"This bill does not deal at all with how we got into this crisis in the first place and the need to undo the deregulatory fervor which created trillions of dollars in complicated and unregulated financial instruments such as credit default swaps and hedge funds."

Both Sanders and Vanden Heuvel are clearly very bright people, but their ignorant pontificating about finance merely serves to obfuscate the reader as to true nature of the crisis and realistic solutions to it. In reality, derivatives have only played a small role in the crisis to date. AIG is the only company that has gotten into trouble with them, and at that their inability to raise money in the capital markets to pay off claims on their derivatives was what did them in, not the actual derivative contracts themselves. As I have stated countless times over, this crisis was the result of 20 years of reckless monetary policy. Investment banks are over-leveraged. The American consumer is over-leveraged. One sixth of American home owners have negative equity in their homes. Are you trying to tell me that derivatives are responsible for this, or was this just the bursting of an asset bubble? While this is not to say that derivatives should not be subject to greater regulation, the fact of the matter is there are many more important and pressing matters right now than the regulation of derivatives. Focussing so much on derivatives merely draws attention away from more pressing matters.

A lot of people are confused about what derivatives actually are. Collateralized debt obligations (CDOs), while complicated, hard to value structured products, and mortgage backed securities (MBS), while difficult to value, due to the inability to predict the future, are not derivatives. In both cases, you actually own a piece of the underlying mortgage. CDOs are essentially pieces of many different securities, mortgages and other forms of debt, which are chopped up and reassembled in the form of a tradeable security. While extremely complex, due to the amount of structuring, a CDO holder still ultimately owns a portion of the debt. Mortgage backed securities are simply mortgages have been transformed into bonds and are freely traded. Banks and investors are having trouble valuing them, because nobody can accurately predict how much further house prices are going to drop and how this will affect default rates amongst homeowners. In effect, CDOs and MBS are just iterations of traditional publicly traded debt securities, like corporate bond and government bonds. While a lot of companies that have gotten into trouble with CDOs, both Lehman Brothers and Bear Stearns, the two banks that really failed, had almost none on their books.


Derivatives are something different and generally fall into three categories: options, futures and swaps. Options are just an option to buy or sell a security at a certain time. The option is just that, as in you don't have to actually exercise it. They are generally very useful for hedging trades, as if a security drops significantly, an investor holding a put option, an option to sell at a certain price, can sell off the security at above market rates, thus cutting his losses. Futures are simply contracts to buy or sell a certain asset at a certain time in the future. Finally, swaps are the most complicated one, but for the sake of brevity, let's just say they are a string of futures tied together, which can last up to several years in the future. From a lot of what I have been reading, it seems like a lot of authors are referring to credit default swaps (CDS). Credit default swaps are essentially insurance contracts for bonds. An investor agrees to pay a counterparty a certain amount of money over a certain amount of time to insure bonds that they are holding. There are currently about $58 Trillion of credit default swaps outstanding. Credit default swaps are long term contracts between two counterparties, lasting up to several years, however traders rarely hold positions for more than a few months. When a trader wants to exit a CDS position, the trader cannot simply sell the CDS off as they would a stock, bond, option or future. They are on the hook for the whole length of a contract. Therefore, in order to exit a position, a trader generally buys or sells a credit default swap of a corresponding term to net out the trade. As a result, the true net exposure to credit default swaps is only a fraction of that $58 Billion.

Nevertheless, the main concern with CDS right now is that the market is completely unregulated. Anyone can sell credit default swaps, regardless of whether or not they have the financial strength to pay off the contract in the event of a default, thus setting off a domino effect of defaults amongst counterparties. While this is a legitimate fear, I think to some extent it's a bit overstated. For one thing, no investment bank or broker worth their salt would allow significant exposure to some rinky-dink hedge fund, known for making wild bets and lacking the capital base to cover them. Secondly, while a counterparty default would result in losses for the fund or bank that traded with them, I doubt that these losses would be catastrophic in most cases, as hedge funds tend to try and be pretty diversified to avoid such an event wiping them out. We have also already gotten through $400 Billion of Lehman Brothers debt defaulting and several billion dollars of CDOs and MBS defaulting without too huge problems, outside of the monoline insurers and AIG. While there will probably be more losses tied to CDS in the future, I doubt it will result in the financial apocalypse some in the media are making it out to be.

Derivatives seem like an easy target for critics, due to the size of the market and the fact that they are so esoteric. Nevertheless, derivatives did not cause the current mess that we are in. While there is definitely a need for greater regulation in the CDS and other derivative markets, there are more pressing concerns right now, like ensuring the entire global banking system does not become insolvent in the next six months. Making misinformed attacks against the derivatives market is completely counterproductive, as it merely distracts from the true problems at hand. Finally, despite the fact that I am extremely opinionated and quite vocal about my opinions, I have generally found it best to keep my mouth closed when I don't know what I am talking about. I would recommend many of these editorialists do the same.