The Economist reports on Derivatives

It just so happens that The Economist included a briefing on the derivatives market in this weeks print edition at the same time which my financial planning curriculum is covering the subject.

In studying these instruments for financial planning purposes I know first hand that these tools are difficult for most people to wrap their heads around.  However, they are incredibly important to the functioning of our economy.  How are they useful?

In the mortgage industry derivatives make it possible for consumers to “lock” an interest rate.  When we lock a rate for a customer we notify the lender that we would like them to reserve an amount of money for a specified number of days at a specific interest rate.  This allows the consumer to rest well at night knowing that they will be able to afford their mortgage payment.  However, the only reason this is even available to consumers is because lenders use derivatives to hedge interest rate changes from the time of lock to the time of funding.

But lets be honest, derivatives can also be the cause of great peril.  Much of the expansion of credit which ultimately led to the credit crisis was made possible because of derivative contracts.  As a result regulators are now looking at the derivatives market and some analysts are even calling for severe limitations to be placed on the derivatives market.

The Economist article does a good job of explaining how the availability of derivatives helps the economy but also concedes better oversight is needed.  Here are some notes from the article:

*What are derivatives? “Futures are agreements to trade something at a set price at a given date.”

*What are some examples? “Derivatives come in many shapes. Besides futures, there are options (the right, but not the obligation, to buy or sell at a given price), forwards (cousins of futures, not traded on exchanges) and swaps (exchanging one lot of obligations for another, such as variable for fixed interest payments). They can be based on pretty much anything, as long as two parties are willing to trade risks and can agree on a price: commodities, currencies, shares or bonds.”

*Who uses them? “…businesses use derivatives to shift risks to other firms, chiefly banks, that are willing to bear them. An airline worried about fuel prices can limit or fix its bills. A bank concerned about its credit exposure to the airline can pass some of its default risk to other banks without selling the underlying loans. About 95% of the world’s 500 biggest companies use derivatives.”

*The article goes on to talk about how derivative contracts are exchanged.  One problem is that a majority of derivatives are sold “over-the-counter” (OTC) as opposed to over an exchange.  One problem with OTC transactions is that they are typically done with very little margin (greater leverage) and counter-parties (the two parties who engage in a derivative contract) may not be fully aware of the others risk exposure.

*The article suggests that requiring higher capital charges for entering OTC derivative contracts would be a good policy but exempting firms from participating is a bad idea.

The Oracle and the Derivatives market

The NY times wrote an excellent article this morning about the legacy of Alan Greenspan and the derivatives market.

Derivatives are insurance contracts which one party can sell to one another party (aka “counter-party) which protects against significant losses for a specific financial security.

The article points out that the simplest form of a derivative is home insurance.  A homeowner purchases home insurance to protect against significant losses on the value of their home.  Similarly, during the credit boom investors could purchase derivative contracts to protect against losses in the mortgage-backed bond investments they were making.

In the early part of this decade many (including Warren Buffett) called into question the concentration of risk around such derivative contracts.  At issue was the fact that so many of these derivative contracts were being issued by the same financial institutions (i.e. AIG, Bear Sterns, etc.).  If a catastrophic event were to occur they did not have the capital to back all of their commitments.

Unlike home insurance the derivatives market is unregulated so the buyer of the contract is left to do their own due diligence regarding the financial strength of the derivative issuer.  In 2003 Greenspan and other “free market” proponents advised congress to pass a law to keep these securities unregulated arguing that the market would be able to properly price risk.

However, as we now know this is not the case.  It is true that derivative contracts play a crucial role in the management of risk.  However, we may want to re-think whether or not these contracts should come under the oversight of a government regulator.

Derivative market failure could lead to higher rates

MSN Money writer Jim Jubak wrote a great article today about the importance of the derivative market.  Little is known about derivatives outside of Wall Street but he makes a compelling case for government intervention because of the role that these financial instruments play in encouraging foreign investors to invest in US based financial securities.

Put simply, derivatives are insurance contracts that an investor can purchase from a “counter-party” which would require the counter-party to pay the investor a sum of money should a specific event occur.  For example, a sovereign wealth fund who was purchasing a large pool of US mortgage-backed bonds could purchase a derivative contract from a financial institution which would pay out a sum of money should defaults on mortgage increase past a certain level (say 5%).

These derivatives then act as hedges for the sovereign wealth fund should this pool of mortgages go bad.  In essence, they reduce the risk involved for foreign investors in making investments into an economy they may not be familiar with.

Without derivatives foreign investors who we rely on to buy up mortgage-backed bonds and other US financial securities would be far less likely to invest in the US.  Without their demand for our securities we would sit back and watch mortgage rates and other interest rates rise.