Wild Beasts Indeed

Excerpt from All About Derivatives, Second Edition
(McGraw-Hill 2010) by Michael Durbin

Derivatives exist because so does financial uncertainty. We don’t know what the future will bring and we certainly don’t know what things will cost, or whether or not everyone will fulfill their financial obligations. Derivatives quantify uncertainty, thereby letting us put exposures into reasonably tangible packages that can be measured, managed, priced and—most important—traded. That’s their power. Derivatives allow the efficient transfer of risk from one party to another. When applied wisely, derivatives are a powerful financial tool for doing some amazing things. When applied not so wisely, derivatives can be the most costly trouble-maker our economic universe has ever known.

For better or worse we just can’t seem to get enough of these “wild beasts of finance” to use Alfred Steinherr’s moniker. The global market is colossal and gets colossally larger every day. How big is it? Putting a monetary figure on this market is like measuring a cloud with a yardstick. Where do you put it? And when? Want to know that there are something like 100 million option contracts in effect? That the notional values of outstanding interest rate derivatives total in the hundreds of trillions of dollars—and climbing all the time? It’s a big place, this world of derivatives; trust me on this. And you’ll just get a headache googling for truly meaningful statistics.

DERIVATIVES AS ENABLERS

Most applications of derivatives, you’ll be happy to know, are remarkably safe and nothing to get alarmed over. They are, if you will, good things. They just help folks do what they otherwise might not. A farmer may want to plant wheat but fear that the price of what will decline while it’s growing, forcing the farmer to sell it for less than what it cost to grow. A commodities future, one of the oldest of all derivatives, lets the farmer lock in the price of wheat before the first seed hits the soil. A manufacturer may want to borrow money to build a plant but can only do so at a floating rate of interest, raising the possibility of financial insolvency should interest rates float too high. An interest rate swap lets them convert that debt to a fixed rate, removing that risk. And on and on and on.

The whole of derivatives affects not just individual industries and institutions. It also acts as a network of financial fibers connecting very different corners of the economy with one another: A farmer sells wheat forward on the futures market to lock in a return from their planting investment. The miller buys wheat forward on the same futures market to lock in a future profit, and does a swap with a commercial bank to convert the debt from purchasing a machine to grind that wheat from a floating rate to fixed. The bank uses long Eurodollar futures to hedge the swap. A hedge fund combines short Eurodollar futures and long U.S. Treasury bonds to arbitrage pricing discrepancies between those two instruments. A global pharmaceutical firm uses protective puts on Treasury bonds to hedge the bond portion on their pension fund, and buys Japanese yen forward on the FX market to lock in the U.S. dollar price of a future purchase from a Japanese supplier. A French commercial real estate developer sells yen forward to lock in the recent appreciation of property they hold in Osaka. And so on.

DERIVATIVES AS DISABLERS

When things go wrong with derivatives, they tend to go wrong in a big way. If there had been an Academy Award for derivative disaster spectacles—even before the global financial contagion of 2008, stoked in part by credit default swaps—there would have been no shortage of nominees each year. “And the Oscar goes to . . . Barings Bank!” Complexity and risk spell occasional disaster in many worlds, not just finance. Aeronautics and aviation come to mind, as does the practice of thoracic surgery and the manufacture of chemicals. Mistakes can be painful. Fortunately we tend to learn a lot from mistakes and sometimes—not always—we learn to avoid repeating them.

What have we learned from derivatives disasters? In 2008 we learned, painfully, the system risks associated with unbridled OTC trading of credit derivatives. The chief lesson from before 2008, which must not be ignored as time marches on, is that it’s the commonsense stuff that gets us in trouble, stuff like not anticipating future cash flow requirements, giving managers too much power, and lending gamblers obscene amounts of money to fund their bets. And those aren’t just hypotheticals. Those three mistakes were spectacularly demonstrated by three names destined to go down in the history of derivatives: Metallgesellschaft, Barings Bank, and Long Term Capital Management.

In the early 1990s, MGRM, a division of the large industrial complex Metallgesellschaft, sold oil forward to OTC counterparties for terms going out as long as 10 years. At fixed prices. They hedged their short forward contracts with stacks of long futures contracts—with terms often going out only a few months. And this extreme difference in terms is what got them into trouble. As the futures did what futures do, their payoff neutralized any loss or gain from buying oil spot to make good on their forwards. Basic hedging. And every month they would put on new futures hedges for future obligations, as part of their “stack-and-roll” hedge. The strategy was theoretically sound over the long run, but when oil prices dropped sharply they simply didn’t have enough cash on hand to satisfy margin calls on their futures positions. Recall that long futures positions lose money when prices decline, and the MGRM positions were huge. The corresponding gains on the oil forwards just weren’t sufficient for making up the difference. Before long there was simply not enough cash to keep the thing going, so they shut it down. But the size of their positions made doing so all at once very costly, as it involved numerous “unwinds” at a substantial loss. In the end they watched something like $1.5 billion U.S. dollars go down the proverbial toilet.

In the mid 1990s, the venerable Barings Bank suffered the “rogue trader” syndrome. This is where a trader puts on speculation trades that exceed reasonable risk tolerances, trades that turn out to be bad bets. Plenty of places have suffered from rogue traders. But Barings suffered with particular pain because the trader, Nick Leeson, was also in essence his own manager— approving his own speculation on the Japanese stock market from his base in Singapore and hiding the losses from his managers. Normally, firms strictly separate their “front office” (where trading happens) from their “back office” (where settlements, accounting, and related functions take place). According to government studies of the debacle, Mr. Leeson apparently employed a short straddle on the Nikkei 225 stock index. Recall that the payoff of a short straddle is like an inverted “V” with unlimited losses possible should the underlier go above or below a certain level. When the Nikkei fell more sharply than he expected, the position lost money. Lots of it. When he placed an equally aggressive bet that stocks would rise—in hopes of compensating for his straddle losses before anyone found out—things just got terribly worse. By the time the parent company found out what their wayward child was up to, the losses on the Nikkei trades exceeded the entire capital of the bank by something like a billion U.S. dollars. The 250-year-old bank was forced to declare bankruptcy. Leeson spent a few years in jail, after which he gave speeches on the dangers of rogue traders for a reported $100,000 a crack. Barings is gone for good.

In the late 1990s, the hedge fund Long Term Capital Management was having a grand time, showering their investors with annual returns of close to 40 percent. Their principle strategy appears to have been arbitrage, using sophisticated analytical models to detect the subtlest of pricing discrepancies in the government bond markets. Some of those bonds were issued by Russia, which just happened to default on their bonds. Oops. Now LTCM had hedged their long bond positions with short positions on the Russian currency the ruble because in theory those currency positions would increase in value when the long bond positions tanked. But the ruble tanked so hard that their currency counterparties basically shut down. And Russia itself suspended all trading in its currency.

Now this ruble issue was a decidedly bad thing for LTCM, but what really made matters bad—not just for LTCM but for the system as a whole—was that LTCM had borrowed nearly all of its money to do this cool arbitrage. At one point LTCM had a stake in the market of well over $100 billion U.S. dollars. And their equity was something like half a billion dollars. This is an extraordinary leverage ratio and is not unlike buying a million-dollar house with a down payment of 5 thousand dollars. So now you’ve got all these lenders with a great deal of skin in the game. And then you’ve got something called a “flight to liquidity” in the global fixed-income markets, such as the U.S. Treasury markets, where everyone seemed to be putting their money in response to the Russian bond crisis. The intricacies of LTCMs position were such that it was not “hedged” against the negative effects of the flight to liquidity, so it found itself against the ropes with no hope of recovery. But the system couldn’t just let this fighter die because they had lent it all that money, and besides they too were exposed to the ill effects of the same liquidity crisis. And with all the interdependencies among players in the capital markets game, if every lender simply tried to call in its debts, you’d have defaults and bankruptcies rippling through the system like cracks in a shattering piece of glass.

So what happened? The Federal Reserve Bank of New York, for all intents and purposes an arm of the U.S. government, got a bunch of banks together in a conference room and convinced them to write checks totaling $3.5 billion dollars. This “gift” was injected into the system to prevent a catastrophic meltdown but still did not cover everyone’s losses. Nobody can say for sure, but banks took additional write-offs totaling another billion or so of losses that year, so it’s not a stretch to put the overall price tag of the LTCM folly at around $5 billion dollars. Not exactly chump change.

As demonstrated colorfully by the LTCM disaster, and then colossally by the credit crisis of 2008, the sheer web of interdependency spun by derivatives is perhaps the cause for greatest concern when it comes to these wily financial instruments. Checks and balances, whether from industry sensibility or government mandate, are clearly essential to keeping these things from enabling more nightmares like 2008.