Are derivatives the cause of a financial crisis?

Are derivatives the cause of a financial crisis? Sugat B Bajracharya Money and Banking Research Paper Abstract: This paper looks into the pros and cons of financial derivatives while at the same time glancing into past derivative-related crisis to explore the dangers of financial derivatives. It also seeks to explore and investigate the role of credit default swaps in the recent credit crisis. Overall, the paper seeks to analyze the current economic situation and past events to see if financial derivatives are the cause of a financial crisis. 1

Introduction Following the volatility in the bond and stock market in the 1970s and increasingly in the 1980s and 1990s, the financial markets became very risky as interest rate swings widened. As a result of this, new financial instruments came into existence that helped the managers assess their risks better. These instruments were in the form of financial derivatives that have been very effective in reducing risk that many financial institutions face. They are involved in hedging that is engaging in a financial transaction that reduces or eliminates risk altogether. Hedging risk involves engaging in a financial transaction that offsets a long position by taking an additional short position, or offsets a short position by taking an additional long position. (Mishkin, 2007, p. 333). A financial institution is said to have taken a long position if they buy an asset. Similarly, it is said to have taken the short position if it has sold an asset that it had agreed to deliver to another party at some future date. (Mishkin, 2007, p. 333). Be it a forward contract, financial futures contract or options and swaps, the key function that all of these instruments provide is the hedging of the risks involved in the financial transactions. It is the main purpose of the paper to analyze the pros and cons of financial derivatives while at the same time glancing into past derivative-related crisis to explore the dangers of financial derivatives. It also seeks to explore credit default swaps and its role in the recent credit crisis. Overall, the paper seeks to analyze the current economic situation and past events to see if financial derivatives are the cause of a financial crisis. 2

Literature Review Mishkin (2007) analyzes different forms of financial derivatives through a detailed discussion of each in Chapter 13 of his book. In addition to these various forms of financial derivatives like: forward contracts, financial futures, options and swaps, he provides a brief history of how financial derivatives came into being and its explosive nature that could cause a possible financial crisis. Moreover, the chapter concentrates on examining how markets of each of these derivatives work. The chapter provides a know-how of the financial derivatives which aids in my research that deals with the analysis of pros and cons of financial derivatives. It proves particularly helpful in examining various derivatives by providing detailed information on them. More importantly, the end of chapter explores into financial derivatives as a possible source of financial system collapse. This closely relates to the purpose of the paper, in that, I intend to seek out the role of financial derivatives in the recent economic collapse. The Time Magazine article by Morrissey (2008) glances into the credit default swaps market, introducing its existence and giving a brief overview of what it is and its functions. The bulk of the article concentrates on how the market started, the key players in this market and how it has the ability to create the next crisis after the sub-prime lending fiasco. Moreover, it also looks into the ramifications of the meltdown or slowdown in the credit default swap market. The article relates profoundly to my research as it discusses the credit default swap market. The final part of the article from the Arlington Institute by James Li (2007) deals with the explosive nature of the financial derivatives and its volatile market that can 3

impact the economy in never-before experienced manner. It provides illustrations of past financial downfalls originating from derivative trading markets that could serve a vital purpose in preparing for a potential financial crisis in the future. Moreover, the article deals with the volatile nature of the derivatives in detail, outlining the reasons why the market is so risky. It also looks into two of the past derivative-related events that rattled the financial world. The article provides some illustrations for the paper in the form of past events that further aids my research. Thorbecke (1995) outlines the benefits and dangers of financial derivatives, recommending policy responses to prolong the benefits and avoid the dangers posed by the derivatives market. His analysis of the derivatives goes a long way in helping generate a list of benefits and similarly point out dangers of the financial derivatives for the purpose of my paper. His analysis includes historical references of the collapse of Barings Bank and financial losses incurred by corporations like Procter and Gamble due to the derivative trading. Benefits of Financial Derivatives Derivatives are financial instruments that derive their values from underlying assets such as stocks, bonds, or foreign currencies. (Thorbecke, 1995, p. 2). Derivatives can be traded both on organized exchanges as well as in an over-the-counter (OTC) market. Typically, organized exchanges have rules that are enforced and the clearinghouse guarantees the payment if the counterparty defaults. However, OTC trading does not provide any guarantee as far as the financial transaction is concerned (Thorbecke, 1995, p. 2). 4

Financial derivatives perform many useful functions that benefit the economy as a whole. They provide hedging of market risks, aid in increasing the value of firms; improve efficiency of price signals, and increase profitability of the banking system. Hedging market risk is one of the major benefits of financial derivatives. In today s market of fluctuating prices and interest rates, it is important for many to be aware of such sudden changes. In order to protect individuals and businesses from these fluctuations, derivatives are used to lock-in fixed prices or rates. This has the effect of acting as an insurance against adverse situations in the future. Similarly, they also allow for risks from a given cash flow to be unbundled, which increases the value of the asset in question. For instance, Thorbecke provides an example of a 30- year bond that pays the holder a fixed payment twice a year and the principal after 30 years. He points out that it can be broken down into 60 coupons plus the principle that can all be sold separately. This allows for individuals to purchase the duration and risk that they prefer. Hence, unbundling of the asset into component parts increases the value of the cash flow significantly. So, a firm can use the derivative instrument in distributing the risks and increasing shareholder value. The pricing of assets are also influenced by the use of derivatives and computer-assisted valuation strategies. In a market economy, asset prices and interest rates are vital signaling factors that lead to the use and allocation of resources. The market prices do not necessarily just reflect the fundamental factors. The computer assisted strategies allow investors to pinpoint interest rates and asset prices that are inconsistent with fundamentals. (Thorbecke, 1995, p. 5). Therefore, by purchasing the underpriced assets and short-selling assets that are overpriced, the asset prices move towards the fundamental values. (Thorbecke, 1995, p. 5). Last but not the least; 5

derivatives can help in increasing the profitability of the banking system. Historically, banks made profit on the spread between the interest rate they receive from assets and the interest they pay on the liabilities. However, with the innovation of the financial derivatives, banks now have the ability and potential to increase their profits significantly. Although derivatives can have various beneficial functions, it is not prone from misuses and dangers of failure. The next section deals with the dangers of financial derivatives: Dangers of Financial Derivatives There are many major concerns that come up when dealing with financial derivatives. First, derivatives allow financial institutions to hold an underlying asset that is many times greater than the amount of money they have invested. An increase in leverage enables them to take huge bets on currency and interest rate movements. These can be very hazardous to the institution if they go wrong. This was the case for Barings Bank collapse in 1995 where a young trader lost $1.5billion in Singapore derivatives market. Hence, although the financial derivatives can be used to hedge against risks, they can also be used to take excessive risks that have the capacity to bring down the whole institution. The second concern is that the financial derivatives are just too sophisticated for average managers to interpret and understand its use. They frequently use complex mathematics and sophisticated computer technology that managers are unable to understand. (Thorbecke, 1995, p. 6). As a result of this, the managers are often making decisions that they are not too sure about themselves. As long as the transactions are profitable, they do not bother about how the derivatives operate and are managed. This 6

can be seen as one of the possible causes of the Barings Bank collapse of 1995 as well. Thorbecke (1995) points out that Barings manager sent $550 million to a Singapore exchange when the 27-year old trader, Leeson requested it. Immediately following the trade, the bank went under. A third dangerous concern is that the whole economy is prone to the systemic risks caused by derivative trading. Systemic risks are typically domino effects of a firm or financial institution failing that affects other firms and even the whole economy. Systemic crises can be disastrous as seen in the 1930s when banking panics occurred as frequently as banks went under. As depositors turned up in large numbers to withdraw their money, the banks could not find enough funds to cover them all. This led to the gloomy financial days of the 1930s. Similar to the banking panic, financial derivatives could also pose systemic risks if credit exposures are too concentrated among a few dealers or parties. The situation could be further exacerbated if derivatives market are illiquid and that they quickly transmit shocks from one market to another. The danger of the credit exposure increases for the dealers because they mostly deal OTC derivatives with each other. By avoiding the organized exchange, they miss out on the clearinghouse guarantees which ensure that the counterparty is paid off if the other party defaults. (Thorbecke, 1995, p. 8). Therefore, by trading outside of the organized exchange, the probability of a firm defaulting and losing is high. This could cause other firms to follow suit which can threaten the stability of the financial system. Moreover, the presence of illiquid derivatives poses a danger that the hedging strategies could fail if assets held to offset risks cannot be sold or can be sold only at deep discounts. This also has the effect of making the firm involved in the transaction insolvent, spreading its losses to other 7

firms and counterparts. So, the danger of close linkages between markets means that a major financial firm in the world could affect other firms throughout the world. Furthermore, with the advancement of many financial instruments and everchanging trend, the derivative market has become very volatile and can impact the economy like never before. This is pointed out from the article by Li (2007) which reveals an interesting piece of information about the volume of derivative trades. The report predicts that more than 99% of total dollar volume of derivative trades is based on the monetary sector of the economy rather than on the real sector (i.e. production of assets, goods and services). The direct implication of this is that the risks involved with derivatives and speculation is no longer tied down to the limits of real assets and commodities. (Li, 2007). As a result of this, the derivatives market has become a speculators paradise with traders and dealers capitalizing on volatility and instability of the markets. Furthermore, there seems to be no real limit to the size of the financial derivatives market as they are now free from constraints of production. Hence, financial derivatives can be a risky venture in itself that can cause adverse repercussions if not taken seriously. The recent financial credit crisis in the U.S. has stemmed from the financial derivative that came into being in the 1990s Credit Default Swaps. The next section deals with the credit default swaps, its origin and role in the recent credit crisis that has engulfed the whole economy. Credit Default Swaps Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default. (Morrissey, 2008). It originated in the 1990s with the first credit default swap done by JP Morgan bank. In the mid 90s, JP Morgan 8

had tens of billions of dollars in loans to corporations and foreign governments which required them to maintain huge amounts of capital and reserves in case the loans went bad. JP Morgan essentially took 300 different loans that totaled to $9.7 billion which included various big companies like Ford, Wal-Mart and IBM. By creating this financial derivative, they were able to remove risks from their books and free up their reserves. The CDS market has grown quite significantly since then and continues to grow at a faster pace. According to the International Swaps and Derivatives Association, the CDS market accounted for about $45 trillion in mid-2007 increasing from $6.4 trillion in 2004. Corporate blowouts like Enron and WorldCom further encouraged the use of the credit default swaps which contributed in this rapid increase in the market. Initially, the CDS market primarily dealt with municipal bonds and corporate debts in the 90s. The CDS market gained continuum as investors were very confident and believed that the big corporations would not go bust in the flourishing economic times. Gradually, the CDS market began expanding into structured finance that mostly consisted of collateralized debt obligations (CDO). These mostly contained pools of mortgages. This was generally due to the housing boom as mortgage-backed securities became the hot new investment. Many of these mortgage-backed securities were backed up by credit default swaps to protect against default. At the same time, it gained its dominance in the secondary market as well. There were speculative investors, hedge funds and others buying and selling CDS instruments. They were betting on whether the investments would succeed or fail without being directly involved with the underlying investment. However, the economy soured and the paradise for speculating investors during the economic boom ended rather sadly. The sub-prime credit crunch started and slowly 9

crept into other credit areas over the past year or so. It made the situation worse as there were credit default swaps written on sub-prime mortgage securities. It was bad enough that these sub-prime mortgage pools that the banks, investment banks, insurance companies, hedge funds and others bought were overrated and resulted in falling in value as foreclosures mounted. (Gilani, 2008). To further exacerbate this situation, the speculators bought and sold trillions of dollars worth of insurance betting if these securities pools would or wouldn t default. A lot of what is happening on the stock and credit markets is a direct result of what is occurring in the CDS market. The series of events started with the bailout of Bear Stearns which would be the first of many bailouts that were going to take place. Bear Stearns had trillions of dollars of credit default swaps on its books that letting it fail would have meant billions and billions of dollars worth of loss write offs for banks and institutions insured by Bear. The counterparty risks that Bear s trading partners faced were so deep and widespread that letting it fail would have taken years of sorting out losses and recovery. Similarly, the same thing happened to American International Group (AIG). As of June 30, 2008, AIG had written $441 billion worth of swaps on corporate bonds and mortgage-backed securities. (Gilani, 2008). They had to incur massive writedowns as the values of the swaps fell which made the situation worse. As one default happens, it starts a chain reaction that increases the risk of others going bust as well. Moreover, many institutions are tethered to one another through deals consisting of swaps which increase the risk of going bust. For instance, Lehman Brothers had more than $700 billion worth of swaps, among which most of them were backed by AIG. As 10

the mortgage-backed securities started going bad, AIG had to come up with billions of dollars of credit default swaps. Eventually, AIG had to be bailed out by the Fed. The main problem that the CDS market poses is the lack of regulation and transparency. As a result of the heavy trading volume of the instruments and secrecy surrounding these deals, occurrence of default makes it hard for the insured party to know who is responsible for making up for the default and if they have enough funds to cover it. Prakash Shimpi, managing principal at Towers Perrin, is all too familiar with the flaws in the CDS instrument. He points out that there is no standard contract, capital requirements or a way of valuing securities in these transactions. This has triggered ramifications that have affected our economy through a credit crisis that has taken the U.S. into a state of a recession. Conclusion Through the study of the benefits and dangers of financial derivatives and analysis of the role of credit default swaps in the recent credit crisis as well as historical derivative-related events, it is very obvious that they are very dangerous instruments that can have adverse consequences if they go wrong. The disastrous and explosive nature of the derivatives can be seen from the recent credit crisis brought on by the credit default swaps that had nationwide ramifications on many financial institutions. Clearly, that is why Warren Buffet calls the financial derivatives financial weapons of mass destruction. (Mishkin, 2007, p. 355). There have been calls for greater regulations and oversight on the activity of the derivatives market as a result of many financial institutions going under. In the case of the credit default swaps, it is likely that the federal government will start regulating them. 11

However, no matter what regulations are set forth, the analysts are going to find a way to go around the regulation to create new financial instruments. Moreover, the financial derivatives are quite effective tools in hedging risks. But, when fallen into wrong hands and irresponsive traders, they have unforeseen consequences that have the capacity of taking the whole economy down. Therefore, financial derivatives have the capacity of creating a financial crisis which has been proven first-hand this year. The major part of the credit crisis was all driven through the CDS market that resulted in many financial institutions failing and needing bailouts like AIG, Bear Stearns and others. The Barings Bank collapse in the 90s proved that derivatives trading in the wrong hands can prove disastrous. So, it is essential to recognize the dangers that derivatives can pose as failure to do so can have global adverse ramifications. 12

References Gilani, S. (2008). The Real Reason for the Global Financial Crisis the study no one is talking about. Retrieved June 2, 2009, from World Wide Web: htpp:// www.moneymorning.com/2008/09/18/credit-default-swaps/. Li, J. (2007). Economic collapse overview. Retrieved May 20, 2009, From World Wide Web: http://www.arlingtoninstitute.org/wbp/economiccollapse/450#. Mishkin, F.S. (2007). The Economics of Money, Banking and Financial Markets. Pearson Education, Inc. Morrissey, J. (2009). Credit default swaps: the next crisis? Retrieved May 20, 2009, from World Wide Web: http://www.time.com/time/business/article/0,8599,1723152,00.html. Thorbecke. W. (1995). Financial Derivatives: Harnessing the benefits and containing the dangers. George Mason University and The Jerome Levy Economics Institute of Bard College. 13