Derivatives: Facts and Fallacies
by Michael S. Rozeff
by Michael S. Rozeff
To worry or not to worry
Derivatives scare many people. They don't know what they are, or they may be quite unfamiliar with them. They don't know how they work, and it's not easy to learn. The amounts tossed around are fantastically huge. Most are traded behind the scenes. They are purchased in margin accounts, and this worries the untutored. Mysterious bankers, corporations, and dealers handle them mostly. Then there are the unnamed speculators and hedge funds. People worry about the financial system melting down. They worry about chains of bankruptcies. Sometimes there are big failures like Enron or Barings Bank or Orange County. People get scared. Regulation seems lax. Accounting for derivatives is tough and highly technical. Deciphering derivatives in footnotes of annual reports is unpleasant. People worry and worry, and there seem to be many reasons to worry. When they're not worrying, they're predicting disaster.
The worry is greatly overdone. Derivatives are worth some thought for investors, but they're a side show. They're the tail, not the dog. The tail won't wag the dog. They're worth some concern, but not too much. There are more important issues to worry about. (See Callahan and Kaza for another readable and useful introduction and defense of derivatives.) The degradation of responsible accounting because of government interference is a bigger concern. The Fed's too big to fail policy is a bigger concern. The root causes of bear markets are a bigger concern.
Monetary causes of bear markets
Stocks and bonds will again have their bear markets. Economies will recess and even depress. Trade cycles will cycle. Debts will deflate. Bankruptcies will rise. So will unemployment. Teeth will be gnashed. Hardship will spread. Times will be hard. Rhetoric and the blame game will boom. Austrians will be cleared of all charges of being bears. The depression may even merit the words Great II. Who knows when? Whenever this happens or some facsimile thereof, fingers will point at derivatives. They shouldn't. They should point elsewhere at basic causes such as the banking system, currency disruptions, wars, and benighted government policies that produce large economic dislocation. The big bear markets of the past nearly always have been associated with these sorts of causes. The press won't blame government policies as it should, or the Federal Reserve, or the perils of fractional reserve banking. It will blame the tail, not the dog.
It's happened before. The Congressional Pecora hearings in 1932 sought blame for the Wall Street crash and the Great Depression in Wall Street practices. They focused the spotlight on various Wall Street figures. Did these practices and people, shady or innocent, cause what happened to the economy? This defied fact and reason, but it satisfied the political lust for convenient scapegoats in reflection of voter anger. It led to new government regulations and agencies such as the SEC. The stock market crash on October 19, 1987 produced a similar result. The blame was shifted to program trading, to portfolio insurance, and to arbitrage. However, the crash began in Hong Kong which had none of these mechanisms at work. Crashes and price movements in general are notoriously hard to explain, but in this case the evidence points clearly to concerns about the international currency system. The latter was one of the basic causes at work in 1929 and again in 1972—74. After several such experiences and others in the nineteenth century, we have every reason to believe that monetary concerns are often central to bear markets. This important fact is not as widely known or appreciated as it should be.
Derivatives are like the cans of tomato soup moving along a conveyor belt in a factory, or so we can imagine. The cans move from one place to another on a conveyor belt. The farmer's tomatoes at the beginning end up inside cans being shifted to consumers at the other end. In our system, derivatives move risk and return from one person to another. This is done smoothly along a financial conveyor belt consisting of financial markets. It all works very smoothly. If the tomatoes go sour, don't blame the cans or the conveyor belt. If the boss turns off the electricity or the machine breaks down, don't blame the cans or the conveyor belt. When the government throws sand into the economic machinery or revs it up too fast, don't blame derivatives for currency and banking problems.
When financial markets again run into widespread and severe trouble, the root causes won't include derivatives although they may be blamed. Derivatives are a highly successful free market invention. They provide a model for how free markets can govern themselves and how they can quickly correct the errors that are bound to occur. And there have been some notable errors and failures, which, however, were absorbed and didn't unhinge the economy. No, look instead to government policies, politics, catastrophes, and/or major economic causes, especially emanating from the monetary system, that trigger major losses in market values. If derivatives play a role in these declines, they will reflect other more fundamental causes.
Bank failures and derivatives
There is nothing that can or should be done by the state about derivatives that will stop or prevent a financial or economic meltdown from occurring. If it's going to happen, it will. The causes will be the usual ones. The banking system will be implicated, but the basic problems won't stem from their overuse of derivatives or heavy leverage resulting from outright speculation using derivatives. Banks are barred from such activities and ordinarily their uses of derivatives are managed well enough, even if they are on a learning curve. Even if one major bank has a rogue trader who secretly and fraudulently runs up huge losses, it won't bring the system down by itself if the system and the economic fundamentals are sound. Most banks do not have rogue traders, so the losses will be limited to the affected bank as in the case of Barings Bank.
The downfall of a major bank through a derivatives loss is possible. A big bank could also have its capital impaired and fail if it took too large a position in bonds or currency that ran into losses. These sorts of activities are also barred, but they could happen anyway. Or it might be that interest rates move in such a way that a bank or many banks become insolvent as was the case with the savings and loan industry in the 1970s. In all of these cases, including the derivatives case, a bank failure can cause a crash and lead into a depression. This is undeniable.
It can happen that a bank failure signals widespread problems throughout the industry or that it heralds an impending economic crisis. Problems at one or two major industrial companies could do the same thing. Events such as these not only can signal something fundamentally bad but they can lead to changes in expectations or confidence that then lead to further market and economic declines. If one bank has a larger than expected number of bad loans, it is natural to expect that bad loans may be higher than expected at other banks. These scenarios have happened before and will again. If one bank had large derivative losses, no doubt traders might expect higher such losses at other banks; but this would depend on many circumstances and particulars. But the reasons for large losses make a difference. Are they because of a rogue trader, or are they because a sharp interest rate movement went against a position? The point is that derivatives are not the cause of interest rate or currency movements. The latter cause gains and losses in derivative positions. Those gains and losses would exist even if there were no derivatives. The derivatives merely parcel them out to a variety of different parties. They spread risk and probably stabilize the system. Hence, even if we happen to see derivatives play a prominent role, they do not cause the unwinding of an unstable economic boom or an unstable banking system.
Swaps are not a big issue
The main case that people worry about is a large default because of derivatives that triggers a cascade of defaults. One reason for this fear is that the reported amounts of derivatives contracts are very, very large. But the reported numbers vastly overstate the true significance of derivative contracts. In particular, the latest report from the Bank for International Settlements (BIS) places the amount at $285 trillion dollars. The largest component of this is interest rate contracts at $215 trillion. These numbers should be compared with estimates of the total amount of bonds outstanding worldwide, namely, $45 trillion. How can derivatives eclipse the value of the assets that they are written on by such a large factor? Several simple technical factors explain what is going on. After we look at them, we'll know what to look at to get a far more accurate picture of the amount of derivatives outstanding.
Swap contracts are the main type of interest rate derivative. A swap is on a "notional" amount which is a bond's face value of $1,000. A corporation may have a loan outstanding that pays a floating rate of interest (like an adjustable rate mortgage). The company may wish to change this loan into a fixed rate loan, perhaps because it thinks interest rates will rise. It could renegotiate the loan with lenders, or it could retire the debt and reissue new fixed rate debt. These are both expensive maneuvers. It's cheaper to find a counterparty who will take over the floating rate payments. The corporation, in turn, will make fixed rate payments to the counterparty. The two swap. The company swaps floating for fixed, and the counterparty swaps fixed for floating. That's a swap contract. They do not swap the actual underlying bonds. They only agree to make each other's interest payments every 6 months when they come due. Now, here's the critical part. These contracts are for the life of the debts, which can run anywhere from 6 months on up to 10 years or more. They can't be cancelled unless both parties agree, and they can't be cancelled without high termination fees. Therefore, after time has passed, if a party wishes to get out of an obligation, the cheapest way to do it is to enter another swap with someone else. For example, the company could switch back to a floating rate position by agreeing to pay floating and receive fixed from a third party. The company is now both receiving fixed and paying fixed, and they tend to cancel out (apart from some interest rate change that may have occurred). The company is back to paying floating again as its main debt.
The bottom line is that swaps are issued over and over and over on the same underlying assets. Over a period of 5 years, if everyone makes one new swap for each one they already have, the notional amount of swaps doubles in 5 years. This is why the notional amount of swaps is so large and seems to be growing so fast. But huge amounts of the payments net out or cancel.
To get an idea of the true value of swap contracts, we look at a different figure. When swap contracts are entered into, they are typically at a rate of interest that creates a fair exchange between the two parties. No money changes hands when the agreements are made (ordinarily). This means the initial swap contracts have no money value. As time passes, interest rates change. The contracts then gain and lose value. Suppose the corporation swapped floating for fixed payments. If interest rates rise, the company has locked in a lower fixed rate. The contract gains value for the company. The counterparty has an equal and opposite loss. The BIS estimates the total amount of these accrued gains (or losses) at $9.1 trillion, far less than the $285 trillion outstanding of all types of derivative contracts. This number can be compared with the total amounts of underlying assets, which include stocks, bonds, precious metals, commodities, and foreign exchange. The latter total is hard to estimate, but it is at least 10 times the accrued gains on all derivative contracts. Furthermore, $9 trillion is the present value of all the prospective gains and losses on the contracts. At each payment date of a swap contract, payments are exchanged that are a fraction of the total values of the underlying assets.
Going back to the concern over default cascades, the worst that can happen in a given swap contract is that the counterparty defaults on an interest payment. If that occurs and the contract is terminated, the loss is held to the difference between floating and fixed rates on that one payment. This is a manageable risk. If participants are unsure of the abilities of counterparties to pay, that is, if default risk is an issue, then the payment rates can be adjusted to reflect default potential. Other means of controlling default risk are to participate in credit default swaps and to obtain guarantees from insurers. Counterparties are aware of default risk just as they are when they buy bonds of varying qualities that have different bond ratings. No one claims these markets are perfect or that the institutions developed to cope with risk are perfect, but neither should observers fear that the markets are unable to deal with default risk.
Leverage worries are overdone
Two other worries or fallacies concerning these markets are that derivatives allow a great deal of leverage and that unrealized profits in the contracts are available to finance further purchases of contracts. The fears here are that speculators routinely build up unstable mountains of leveraged contract holdings that can crash the whole financial system if the positions go against them. This scary picture reflects ignorance of how the institutions of these markets work. If those with these views will buy or sell futures contracts, they will quickly find out that this is not how the markets work. One can enter a futures contract (buy it or sell it) with no money down. This requires deposit of a Treasury bill. The brokers call this "margin" but it is not. Margin in a stock margin account is a loan used to buy the actual underlying stock. A T-bill is a good faith deposit. There is no loan and no underlying is purchased. Buyers and sellers can enter a great many contracts without having profits in their existing contracts. They don't need profits to finance further purchases or sales. There's no money down. The market owners need to control default risk, however. One way they do this is by contract limits. Another is that member firms demand credentials and minimum capital from participating speculators.
Now, if the contract price rises, a buyer makes money. The market has an institution called "marking to the market." It is there to control default risk. Those making the market are not silly enough to let anyone buy or sell any number of contracts without making good on their bets. This means that the contract is settled every day. If a buyer has made money, the money goes into his account that day. Those who lose have to pay money that very day, and it is removed from their accounts. Profits and losses are not unrealized. They are realized on a daily basis. The buying power of the winners is enhanced, but the buying power of the losers is lowered (unless they make fresh deposits). The speculators who have the largest positions (and they are limited by market rules) tend to be the most savvy and successful. The losers tend to exit the market. If large speculators start to lose, they must pay up that day. That means that other speculators or hedgers are gaining. The marking to market stabilizes the system. If a large speculator cannot or does not pay what he owes, the broker will sell out his position. This can drive price down temporarily. If the speculator actually defaults, the loss falls upon the Clearing Corporation, not upon other market traders. The Clearing Corporation is basically a consortium of brokers and dealers who run the market. All trades are with the Clearing Corporation, not directly with other traders. This is yet another institutional invention to control risk.
The main point here is really that free markets develop institutions to control risk. The major futures exchanges have done this. The over-the-counter markets have also done this. The International Swap Dealers Association is a prime example. The institutions evolve as experience accumulates. The biggest problems, as I mention below, occur when government interferes with this evolution and chills it. Even a little bit of meddling can change the way a market develops and turn it away from a creative course of handling problems by itself.
Futures and underlying stocks
Most critics of derivatives and futures markets do not understand that in some respects they are tantamount to spot markets (the markets for the actual underlying assets). Take the futures contracts for stocks. It costs nothing to enter a contract for $1,000 worth of stock. Alternatively, one can buy stocks outright. That requires putting up the full purchase price, shall we say. Suppose that one borrowed $1,000 to buy $1,000 worth of stock. The net cash flow at the time of purchase is $0 (receive $1,000 by the loan and pay out $1,000 for the purchase) which is like buying a futures contract. These two alternatives have the same worth in a perfect market. The return on the portfolio of stock plus loan is less than the return on the stock by the interest rate paid on the loan. A futures contract has to give the same return as the portfolio of stock plus loan. And in fact futures contracts have prices that exceed stock prices by the rate of interest, so that the futures buyer ends up getting a lower return than if he had bought and held stock outright.
It's six of one and a half dozen of the other. Buying stock means you lay out money. The expected stock return has to be enough to make that amount of interest. Or buy a futures contract on the stock in which you do not lay out any money. In that case, you expect a return lower than what the stock delivers, lower by the rate of interest. They are two different ways of buying the same thing. They differ only in the financing methods.
The bottom line is that worries about leverage are misplaced. People can explicitly borrow in all sorts of ways and buy stocks outright. Or they can borrow implicitly when they enter a futures contract.
Long-Term Capital Management
If a financial or economic meltdown transpires, look for monetary causes as the first prime suspect. Don't look for derivatives. Our authorities, especially our monetary authorities, will never admit this. Mr. Greenspan shifted attention to Long-Term Capital Management in 1998. The company made some big bad bets that unraveled when Russian bonds defaulted (another basic monetary cause). They went beyond conventional arbitrages and incurred undue risk. In this sense, they were like rogue traders. Their counterparties erred too. They didn't properly assess the risks of dealing with LTCM. Markets make mistakes. They have to learn. The Fed helped organize and provide liquidity for banks to take over LTCM and liquidate the company. LTCM should have been allowed to fail without Fed actions. Whatever its defaults were, some losses would have been spread to others who deserved to incur those losses. The market participants would have been properly chastened and disciplined by their mistakes. They would have instituted better controls. They would have done better to limit the size of speculative positions or discover if they were hedges or naked speculations. They would have audited the traders better. They would have assessed the default risks of their counterparties better. They would have learned. The Fed short-circuited the natural development of better market institutions. LTCM had assets and, as in many bankruptcies and liquidations, these assets were substantial. They needed to be worked out over time (they were), but better that the markets had done this on their own. By its interference, the Fed made "too big to fail" a market byword. It roped the free market institutions into its monetary game even further, allowing itself and other central bankers more leeway to destabilize the world economy. At the same time, its actions encouraged taking undue risks by market participants. Some will, and they will do so using derivatives. When new troubles occur, derivatives may again occupy center stage. The Fed and others will be sure to blame them rather than to acknowledge their own culpability. Government can corrupt anything, even something as neutral and useful as a derivative contract.
August 12, 2006
Michael S. Rozeff [send him mail] is the Louis M. Jacobs Professor of Finance at University at Buffalo.
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