Derivatives: The Risk That Still Won’t Go Away

Derivatives: The Risk That Still Won’t Go Away By Carol J. Loomis

Washington wants to step up regulation of these complex instruments, hut new rules may not be enough to tame them.

Since it is chillingly clear that U.S. financial institutions have for a good while been regulated no more stringently than, say, demolition derby drivers, Washington has belatedly locked the garage door and begun to debate strict new rules. The blueprint at hand is President Obama’s sweeping proposal in mid-June to revamp the responsibilities of government agencies and impose new regulations on the financial establishment. Nothing about this plan will fall easily into place: Too many government agencies will dig in their heels. Too many financial companies will battle every aspect of reform that threatens their bottom lines.

Inevitably the center of controversy is going to be the complex instruments called over-the-counter derivatives. These are contractual arrangements between two parties—at least one of which is likely to be a giant financial institution that transfer risk. They typically have notional values (par values, essentially) in the millions of dollars, are often long in duration, and go by such names as swaps, forwards, and options. And they are, not incidentally, a source of lush profits for banks.

Perhaps for that reason, it is the amazing contention of some in the financial world that derivatives sailed quite smoothly through the financial crisis. One banker said recently that the derivatives problem at AIG was mainly that management wasn’t paying attention.

This article will present a different view. We’ll start with re­minders of how derivatives contributed to the collapse of Bear Stearns and AIG, in the process delivering a large, and detested, bill to the U.S. taxpayer. We’ll also go behind the scenes of the bankrupt Lehman Brothers, whose 900,000 derivatives con­tracts are proving once again that the sheer complexity of these instruments is itself an enormous problem. So is regulating them, which does not mean we shouldn’t be trying.

A basic reason for favoring regulation is that derivatives create a kind of mirage. They don’t extinguish risk, they simply transfer it to a different party—a counterparty, as the term goes. The ultimate outcome is millions of contracts and an endless, virtually unmapped, web of connections among financial institutions. That maze exists today, and so does the systemic threat it raises: that some major counterparty will go bust and drag down other institutions to which it is linked.

We came perilously close to such a chain reaction in the past 18 months, as both the economy and the financial system buckled in distress. Derivatives cannot be called the central villain in this drama. That dishonor belongs to some combination of bad management and a real estate world gone crazy. But derivatives elevated the stakes, as they seem constantly to do. Today, as the financial system goes about digging itself out of the muck of trouble, no one imagines that the risks of derivatives have diminished. That’s what the regulatory clamor is all about.

We did not get to this juncture without red flags flying. In a 1994 cover story by this writer, Fortune called derivatives, then relatively new on the scene, “The Risk That Won’t Go Away” (see fortune.com). Roughly a year later, there was a rash of derivatives problems that punished companies like Procter & Gamble and American Greetings and supported the notion that most nonfinancial CEOs didn’t have a clue about the intricacies of these instruments. That conviction endures today, as one story after another emerges of derivatives bets gone wrong: Harvard (at the behest of its then-president, Lawrence Summers) entrapping itself in an interest-rate swap that drained its cash; Alabama’s Jefferson County entering into swaps that have helped push it toward bankruptcy (see “Birmingham on the Brink” on fortune.com). In 1998 derivatives even helped usher the managing savants and Nobel Prize principals of Long-Term Capital into disaster.