Derivatives (Part two)

Another problem on derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger some more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off most of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. A participant may see himself as prudent, believing his large credit exposures to be diversified and thus not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from company A to go bad will also affect Company B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.

In derivatives, it is unlike banking where there is the Central Bank like the Fed to insulate the strong from the troubles of the weak. If the Central Bank does not exists, the failure of weak would sometimes put sudden and unanticipated liquidity demands on strong banks. Thus, in derivatives, there is no regulatory function assigned to the job of preventing the dominoes from toppling. In this business, firms that are fundamentally sound can be troubled simply because of the travails of other firms further down the chain. When a "chain reaction" threat exists within an industry, it pays to minimize links of any kind.

Large amount of risk, particularly, credit risk, have become concentrated in the hands of relatively few derivatives traders, who in addition trade extensively with each other. The troubles on one could quickly affect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties as mentioned, are linked in ways that could caused them to comtemporaneously run into a problem because of a single event. Such linkage which suddenly surfaces, can trigger serious systemic problems

Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term Capital Management, caused the Federal Reserves anxieties so severe that it hastily orchestrated a rescue effort. In later Congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM - a firm unknown to the general public and employing a few hundred people - could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair, though it paralyzed many parts of the fixed-income market for weeks, was far from a worst-case scenario.

One of the derivatives instruments that LTCM used was total-return swap, contracts that facilitate 100% leverage in various markets, including stocks. For eg, Party A to a contract, usually a bank, puts up all the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date, it will receive any gain or pay any loss that the bank realizes.

Total-return swaps of this kind makes a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and othe financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivative contracts. I will find it amazing if any one can understand how much risk the company is undertaking when one is to read all the long footnotes detailing the derivatives activities of a major bank or likewise.

The derivatives genie has long been out of the bottle, and has certainly mulitplied in both variety and number. Until some event that makes their toxicity clear, many market participants will still be dancing at the party intoxicated by the effortless money they had gained. What comes easy, goes easy. Like cinderalla at the ball, no one wants to miss a single beat.

Derivatives is very much like the weapon of mass destruction of the financial world, carrying dangers that, while now latent, are potentially lethal.

Suggested reading - When Genius Failed.