Derivatives: The Risk That Still Won’t Go Away

AIG’s particular burden was $80 billion of credit default swaps it had sold that exposed it to subprime mortgages (see “AIG: The Company That Came to Dinner” on fortune.com). When real estate caved, AIG’s financial products operation (FP) received calls for collateral from its CDS counterparties and at first complied. But the next round of calls exhausted AIG’s resources, and bankruptcy loomed. The feds essentially decided at this point that it was better to save AIG than to risk a domino effect among its counterparties, which were about two dozen prominent financial institutions in North America and Europe. The government’s decision quickly got the prize for most-hated-by-the-aver-age-citizen. Moreover, FP is still stuck with about $1.5 trillion in derivatives contracts (more than half of what it originally had) and is looking at large costs of exit. At a Senate hearing in May, Treasury Secretary Geithner described a pressing need for AIG to avoid defaults that might even at this date bring it down: “I do not believe,” Geithner said intensely, “that the system today can withstand the effects of a failure of this institution to meet its obligations.”

Derivatives certainly did not cause the earthshaking failure of Lehman on Sept. 15 last year. The blame can be laid first on out-of-control leverage and bad investments in commer­cial real estate, and second on the U.S. government’s decision not to save the company. But the Lehman saga illustrates another toxic aspect of derivatives: They are often a mess to value. That can lead, intentionally or not, to misreported profits and assets. It turns out that the files of this biggest-ever bankruptcy prove the accounting complexity in quite bizarre ways.

Basic facts first: Lehman had a derivatives book of only $730 billion as it neared bankruptcy. Even so, when Lehman’s U.S. entities filed for Chapter 11 in September, this not so-big figure translated into about 900,000 derivatives contracts. The great bulk of them have been “terminated” by derivatives counterparties which under industry protocols had the right to immediately “net” their accounts with Lehman in the event it declared bankruptcy. A handful the last reported number was 18,000—are still open.

Each of these contracts has a “fair value”—an amount that one-side owes the other. Lehman, in fact, has a lot of open contracts that have been going its way. In a droll sign of how derivatives have come to be viewed as indispensable, Lehman has received permission from the court to buy them to hedge some of its open contracts, so that it can lock in the profits it has made since filing for bankruptcy.

Move now to the accounting problem. While sometimes the fair value of a derivative can be precisely determined, at other times it must be derived from murky markets and models that leave considerable room for interpretation. That gives the holders of derivatives a lot of bookkeeping discretion, which is troubling because changes in fair value flow through earnings—every day, every quarter, every year—and alter the carrying amounts of receivables and payables on the balance sheet.

Calling for more surveillance of derivatives are Obama’s economic adviser Lawrence Summers (Left) and Treasury Secretary Timothy Geithner. Summers came late to the party in seeing the need.

The subjectivity involved in derivatives accounting also means that the counterparties in a contract may come up with very different values for it. Indeed, you will be forgiven if you immediately suspect that each party to a derivatives contract could simultaneously claim a gain on it which should be a mathematical impossibility. In fact, we have a weird tale, gleaned from court documents, supporting that suspicion. It involves Lehman, Bank of America, and J.P. Morgan, and suggests how far some of those “terminated” contracts are from being truly settled.

When Lehman failed, one of its subsidiaries was holding (sort of, which is a point we’ll get back to) $357 million of BofA collateral—an amount that was roughly related to the fair value of Lehman’s derivatives contracts with the banking giant. Presumably BofA had delivered the collateral because it thought Lehman had a legitimate claim to it.