Are Financial Derivatives good or bad?
Warren Buffet, without any doubt one of the most famous investors of the world, once referred to financial derivatives as “Financial weapons of mass destruction” (Buffet 2002). Ed Murray, practicing lawyer and senior member of the Allen & Overy team advising ISDA (International Swaps and Derivatives Association), states that derivatives played an important role and worsened the Financial Crisis (Murray 2012). Many more influential people seem to point accusing fingers to financial derivatives, stating that derivatives may bear significant problems people are underestimating. Since the derivatives market have been growing immensely since the 1970s to todays unbelievable estimated notional value of 1,2 quadrillion US dollars, more than ten times the gross world product (107,5 trillion US dollars), financial derivatives play an extremely important and growing role in todays financial system (Smith 2013). Therefore we should be aware of the problems, risks and threats coming with the usage of derivatives instrument. In the following I will discuss some of the most important risks and threats of using financial derivatives by explaining them. I will deal with questions like: Are financial derivatives really a threat for firms and, worse, for the whole economy? Do they increase welfare? If yes, who benefit the most? Are there losers? Finally I will come to a conclusion and I am going to answer the question whether financial derivatives are good or bad.
In order to grasp some of the issues that come with the usage of financial derivatives some basic knowledge about them have to be explained. As the expression suggests, financial derivatives are financial instruments that derive their value from one or more underlying assets (Stulz 2004 P. 173). Most commonly underlying assets are stocks, bonds, commodities, interest rates, indexes and currencies. Most financial derivatives are traded over-the-counter (OTC) (Stulz 2004 P. 178) also called off-exchange because these trades are made directly between two parties without any interference of an exchange. Exactly these are associated with “financial weapons of mass destruction” by Warren Buffet because they are largely unregulated and are always bearing a counterparty risk which is a big threat as several occasions like the Subprime crisis in 2007 and the following financial crisis in the past proved (Xinzi 2013 P. 2). These two issues played a major role in these financial crisis and are still highly relevant, even more relevant considering the immense growth of the derivatives market. Derivatives have been traded for centuries, originally to hedge the risk of prices moving against some parties interest, for instance a farmer using a derivatives contract to lock in the price for crops for future deals in order to generate a security and to be able to calculate and plan his business more precisely (MacKenzie, Millo 2003 P. 112). These kind of transactions are called forwards, if they are traded on exchanges they are called futures. There is also the possibility to make a contract which gives the potential purchaser of the crops the right to buy crops for a certain price in future, so the purchaser has the option of purchasing. These transactions are called call-options. There are also put-options which gives the farmer the right to sell at a certain price. Obviously a call-option would never be exercised if the current price of the crops at the maturity is below the price determined by the call-option contract. This applies analogously to the put-option. Forwards and options are basically the only two different types of derivatives so every other derivative is either based on one of these two types or are combinations of both. Of course today there are many combinations of derivatives und many more purposes. While the actual intended purpose of derivatives were to hedge risks of transactions involving physically existent assets which the hedging person are in possession of, nowadays they are also allowed to make bets on an underlying asset (Gerding 2011 P. 5). That means investors bet for instance that one of three banks will default, the price of a certain asset will fall or that the weather will be as they predict. Notice that the investors have not to be in possession of anything they are hedging (Gerding 2011 P. 6). This can in my point of view be a very problematic feature of unregulated derivatives as the subprime crisis in 2007 demonstrated (Allen, Carletti 2009 P. 4).
Prior to the subprime crisis many banks issued an enormous amount of credits to people whose risk of default were extremely high. These risky loans were put together to a collateralized debt obligation (CDO) where the risks of these loans were evaluated and distinguished in different groups of default risk. Then these CDO were sold to a third party. Then investors were able to buy CDO stocks which due to the risks made high profits. These Investors now wanted to hedge their risky investments. At that time Insurance companies like the American International Group (AIG) supplied these securities also called credit default swaps (CDS) which meant to be a hedge against the defaults of the CDO (Gerding 2011 P. 5). Which means that if the credits of the CDO defaults Insurance companies which insured the investors now have to pay instead. Due to high possible profits, the demand for these CDS increased. Putting it differently, these CDS are basically as mentioned before bets on the default of credits. This is what by media always referred to as speculation. They basically are betting that the expectation of the insurance companies won’t be correct. If this does happen, there will be high profits for the speculating party (Xinzi 2013 P. 2).
So there were more and more people starting to bet on the default of these risky credits. Since CDS are over-the-counter derivatives which aren’t regulated, insurance companies were able to sell synthetic securities. That means that also individuals who are not in possession of risky CDO stocks, were able to buy securities or rather bets on the default of these CDO credits (Xinzi 2013 P. 2). Explained simply, there were more than one default security contract for one house. These deals were highly profitable for both sides, but also a big threat if the risks were misvalued like it happened to AIG in the subprime crisis 2007. It is a big threat if the risky credits start to default at the same period of time, which were in this case obviously correlated, meaning that the banks which issued credits to not creditworthy individuals did this in the same period of time, so later on also the defaults began to take place also in the same period of time (Xinzi 2013 P. 5). Now as it is not bad enough that number of credits start to default and the insurance company now have to pay the investors, no, as explained before there were usually more than one insurances respectively bets or to put it differently the synthetic insurances on the default of these credits. That of course means that the insurance company has to pay all bets respectively securities in a short period of time. As you would expect in the case of the subprime crisis of 2007 AIG wasn’t able to pay because they didn’t put up initial collateral, put aside enough capital reserves and they particularly didn’t hedge their exposure properly. In a short period of time AIG wasn’t able to pay and was then bailed out by the federal government for 180$ billion.
Interesting fact that not even two years later in 2009 AIG paid out 170$ million in bonuses to its employees (Baker 2013) while in Chicago there have been cuts to the pensions (Baker 2013). According to the city they simply can’t afford these pensions and workers and retirees have to accept these reduced benefits (Baker 2013). Yet this fact, that people in charge of the misery haven’t been punished, in the contrary, they even got their bonuses with up to six figures per head, justifying it with the statement “contractual obligations had to be honoured”. Well maybe contractual obligations don’t apply for an average worker who thought that his pension payments were protected by the constitution. This, without any doubt sets perverse incentives for people who are dealing with high risk derivatives. The dilemma here is: High profits, even if there are big threats vs. lower profits, with less risks. Of course it’s a no-brainer that high profits will be chosen if banks, insurance companies do not have to fear substantial consequences. Furthermore derivatives contracts like credit default swaps are often made for longer periods like 20 years. This adds additional fuel to the fire, meaning that this causes additional perverse incentives and further insecurities, because if an executive banker has to decide over these long period derivatives, it is more likely that he will allow more risky transactions if he can benefit from it. The explanation is fairly simple: It is unlikely that if there should be a financial misconduct someone could call the person in charge of that financial misconduct to account because at that time he is able to misvalue and underestimate the risk to benefit from it at the same time assuming that if these misvalued derivatives cause damage he probably won’t be there anymore. To price a derivative correctly is difficult enough but these long periods worsen this problem immensely.
Warren Buffet basically referred to exactly these problems I mentioned above and called therefore financial derivatives ‘financial weapons of mass destruction’. You could argue about the terminology and the comparison, but indeed there are major dangers and perverse incentives coming from financial derivatives trading.
Furthermore, another issue of financial derivatives in my point of view, relates again to financial derivatives being largely unregulated. To generate high profits with very little payment, financial derivatives, due to being unregulated, can be tremendously leveraged (Allen, Carletti 2009 P. 31). Assuming an investor wants to generate very high profit with little money, say, he has got 100$. ‘There are leveraged financial derivatives with an enormous leverage which promise a benefit if for example the value of the financial derivative increases by 10% not as you normally would expect 10$ payoff instead it pays off for instance 1000 times the payoff, so it would be 10000$ with input of 100$. But what happens if the value of the financial derivative decreases by say 20%? Depending on the contract you will lose a lot of money for instance 20000$. Obviously this would be a great deal if the value would increase but also would cause tremendous losses if the value decreases. How much the actual potential benefits and losses are can be adjusted by the ratio. A further problem of leveraging is that it stresses the issue of the large notional value of the financial derivatives market. Warren Buffet also criticizes in the Berkshire Hathaway Annual Report for 2002 that institutions using leveraged financial derivatives won’t be able to pay the investors if they make losses because there simply cannot be any sufficient amount of reserves, because, remember the notional amount of the financial derivatives market is estimated as more than ten times the world gross product. Also AIG had a significant amount of leveraged financial derivatives, which later on made things, as you would expect a lot worse (Allen, Carletti 2009 P. 31). The example illustrated above is of course a very simplified and constructed example. In reality theses financial instruments are much more complicated and should be traded carefully, because as Warren Buffet said: “…when people stretch and they get rewards for it, they inclined to stretch more…”. By stretching he refers to leveraging and points out, that leveraging may be profitable for some time, but if markets crash like in 2007, leverages will cause big problems, especially if linked to the incentives problem I mentioned before. Executives who do not fear any consequences if they make bad decisions will naturally tend to take more risks by leveraging financial derivatives, which will certainly worsened the whole scenario.