Derivatives: The Risk That Still Won’t Go Away

Not too long after that, Warren Buffett tagged derivatives with the name that follows them everywhere, “financial weapons of mass destruction.” But if this description was to enter the lexicon of finance, it was not to stop derivatives’ spread. Between 2000 and mid-2008 (the peak so far), the worldwide notional value of derivatives went from $95 trillion to $684 trillion, an annual growth rate of 30%. A new form of derivatives, credit default swaps, a sort of rich chocolate to the plain vanilla of interest-rate swaps, became the rage during this period. Initially these CDS allowed institutions to insure the creditworthiness of bonds they held, and next permitted speculators—controversially, to say the least—to pressure the prices of bonds and other fixed-income securities.

The CDS growth was marked by a back-office breakdown: Unsigned confirmations proliferated and general confusion reigned over who owed what or even how many CDS had been written. Timothy Geithner, then president of the New York Federal Reserve, and one of his predecessors, Gerald Corrigan, attacked this disorder in 2005, leading a drive that has greatly improved the infrastructure of CDS the plumbing, so to speak, that connects one derivatives party with another. Corrigan, a top Goldman Sachs executive since he left the Fed, is proud of the progress that, has been made, advances that have been compared by others to taming the Wild West. Without these process improvements, Corrigan recently told Fortune, what happened over the past couple of years could have been “much worse.”

That’s a head-snapper for sure, considering that despite this progress we suffered a disaster so cosmic that it crushed the economy and brought down an appalling collection of famed U.S. financial companies. Consider the main wreckage of 2008: Bear Stearns, bought by J.P. Morgan Chase; Fannie Mae and Freddie Mac, taken over by the U.S., the parent that didn’t want them; Merrill Lynch, bought by Bank of America; Lehman, gone bankrupt; AIG, rescued by the U.S.; Wachovia, bought by Wells Fargo.

It was the earliest casualty of these, Bear, that brought a new concept—“too interconnected to fail”—to the forefront. Going in, the government really did not want to save the company. Robert Steel, a ranking member of Henry “Hank” Paulson’s U.S. Treasury team, remembers the case against a rescue: “Gee whiz, this isn’t a depository institution. It should just go out of business.” Nor was it that Bear was a colossus in derivatives: Its book at the end of the company’s 2007 fiscal year (its last) had a notional value of “only” $13.4 trillion, compared to $85 trillion for the giant among U.S. derivatives dealers, J.P. Morgan. Bill Winters, co-head of investment banking at J.P. Morgan, says that in Bear’s last week—as the firm teetered between bankruptcy and being bought by his company—he even worried less about derivatives than he did about the many billions that the firm borrowed every day on its assets in the overnight loan market. If Bear went bankrupt, Winters could imagine all those assets being calamitously dumped on the market.

Bankruptcy, of course, didn’t happen. On Sunday, March 16, 2008, J.P. Morgan agreed to buy Bear in a government-brokered deal to which the feds contributed guarantees of $30 billion (later reduced by $1 billion). And two weeks later Geithner appeared at a Senate hearing to explain this huge intervention (well, it seemed huge at the time). He didn’t talk about the overnight loan market. He stressed instead that bankruptcy for Bear could have led to the “sudden discovery” by its derivatives counterparties that hedges they had put in place to protect themselves were wiped out. The prospect, he said, would then be a “rush” by Bear’s counterparties to liquidate collateral and replicate their hedges in already fragile markets. Derivatives, in other words, had changed Bear from a broker-dealer that could have been simply the latest name on a Wall Street tombstone to an entity that the government needed to save because it was too interconnected to fail.

That dread epithet could be applied in spades to AIG. On Sept. 16, precisely six months after Bear’s rescue, AIG’s board called in lawyers and prepared to file for bankruptcy. But, as the whole world knows, the government stepped in to save the company, eventually committing $180 billion to keeping it solvent.