Decoding the Derivative Dilemma

By Matt Blackman, CMT

Derivatives have grown from a relatively small market thirty years ago to the 800-pound financial gorilla in the world today. At over $600 trillion in notional value, it’s nearly ten-times the size of total annual world economic output. So when a derivative-related “credit event” triggered the financial crisis of 2008, it shook confidence around the globe. Could another one be lurking around the next corner?

When financial markets came unglued in 2008, few had seen it coming. Lehman Brothers and Bear Stearns collapsed, Merrill Lynch had to be taken over by Bank of America, insurance company AIG was bailed out, government sponsored enterprises Fannie Mae and later Freddie Mac were taken over and programs such as the Troubled Asset Relief Program (TARP) and the FDICs Temporary Liquidity Guarantee Program (TLGP) were signed into law – all in the space of six weeks. It was the first part of an overall action plan that was to become known as Quantitative Easing 1.

Why? Financial instruments such as Collateralized Debt Obligations (CDOs), Credit Default Swaps (CDSs), Collateralized Bond Obligations (CBOs), Collateralized Mortgage Obligations (CMOs), Special Purpose Vehicles (SPVs), Structured Investment Vehicles (SIVs), Residential Mortgage  Backed Securities (RMBS) and other complex instruments whose names would forever be etched into the financial crises lexicon, had suddenly turned toxic.

But how could a market that was miniscule in comparison three decades ago, push our financial system to the brink of collapse and no policy makers or government regulators saw it coming? It was a painful demonstration of just how much risk the derivatives market posed. And since the over-the-counter (OTC) derivatives market is an unregulated and clandestine, few can assess its risks even when they understand how these complicated instruments work.

Figure 1 – Graph showing the rapid growth of the Over-the-Counter derivatives markets since the turn of the century which until 2008, was doubling every 1.9 years. Data – Bank of International Settlements.

What is a derivative anyway?

Put simply, a derivative is an asset, the value of which is derived by an underlying asset. Equity and futures options and futures contracts are better-known examples.  Underlying assets include metals such as gold and silver, commodities like orange juice, grains and cotton, energy sources such as oil, gasoline and coal, and marketable assets such as shares, bonds and currencies traded through exchanges. And then there are a host of financial derivatives products such as those used to pool mortgages and other loans that are traded directly through dealers on the over-the-counter (OTC) market.  These are generally larger and a lot more complicated.

There are four major classes of derivatives according to Andrew Chisholm author of Derivatives Demystified – A Step by step Guide to Forwards, Futures, Swaps and Options (John Wiley & Sons, 2010).

Options – Most familiar to retail traders and investors, an option of a stock (like Amazon) gives the buyer the right but not the obligation to buy the stock at a future price (strike price) by a specific date (expiry date). The price of the option is based on the price of the underlying security. Options are also popular with retail traders in currency (Forex) and bond markets.

Forwards – A forward is a private contract between two parties. It can either be on a physically delivered basis (where a commodity or asset changes hands) or cash-settled basis (where profit is the difference between the price paid and price at expiry of the contract).

Futures – Similar to a forward, except that a futures contract is made through an exchange which sets the price and terms as opposed to an agreement between private parties. Like forwards, futures contracts can either be fulfilled by physical delivery or on a cash basis. But unlike a forward, futures are generally guaranteed against default so that the risk is limited to capital loss.

Swaps – A swap is an agreement between parties for payments made on future dates, each of which is calculated on a different basis. Although considered one of the most basic derivative products according to Chisholm, a swap is actually composed of a series of futures contracts. It is used to minimize currency risk in cases where a company’s income may be in one currency but expenses or revenue is in another currency.

Figure 2 – Major components of the OTC derivatives market showing the relative dollar amount of each. Interest rate contracts with the lion’s share followed by foreign exchange contracts with a notional value of $465.3 trillion in 2010. Commodity contracts were the smallest totaling $2.92 trillion with gold derivatives equaling $396 billion of that total. Data – Bank of International Settlements.

Figure 3 – Further breakdown of derivative contract type. Interest rate contracts, forwards, swaps and options total 77.4% of the OTC derivatives market. Foreign exchange contracts, forwards, options and swaps are a distant second at 9.6% with credit default swaps third at 5% of the market. Data – Bank of International Settlements.

When It All Hits the Fan

Derivatives are well suited to speculating on prices of commodities and financial instruments because they employ leverage according to Chisholm. This allows buyers to participate in a market by investing only a fraction of the total value of the asset they are buying. Potential returns are greater but so are losses when the trades go awry causing investor Warren Buffett to declare in a 2002 letter to Berkshire shareholders that “derivatives are financial weapons of mass destruction, conveying dangers that, while now latent, are potentially lethal.” In 2007, the dangers that Buffett referenced quickly mutated from latent to very real.

But that was not the first time the use of derivatives had triggered financial crisis. Prior examples include the ₤6 billion Hammersmith and Fulham Council fiasco in 1988-9, the ₤800 million loss by trader Nick Leeson in 1995 which effectively wiped out Barings Bank, the Long-Term Capital Management differential spread trades gone horribly wrong in 1998, and the collapse of Enron in 2001 in which the company used “aggressive accounting techniques and derivative products to inflate earnings and boost asset valuations,” according to Chisholm in Derivatives Demystified.

Credit default swaps (CDS) are a basket of securities whose value depends on the creditworthiness of the product (like mortgages) and the entity that backs it (like AIG). Similar to an insurance policy, CDSs are used to transfer risk from one party to another in exchange for the payment of a risk premium by the buyer.  But there are some big differences.

Normally an insurance policy involves three parties, the insurer, the insured and the beneficiary. But a CDS can be purchased by multiple parties (buyers) on the reference entity, all of which must be paid by the seller in the event of default or bankruptcy (called a credit event) by the reference entity.  The other big difference is that unlike an insurance policy, the seller of a CDS does not need to prove sufficient reserves (ability to pay) in case of a credit event since this market, unlike the insurance industry, is unregulated.

It became painfully obvious that few bankers, regulators, central bank chairs or even credit rating agencies understood how derivatives worked before 2008 when AIG needed an eleventh hour $85 billion bailout from the government due to a raft of CDS losses to avoid bankruptcy. Lehman Brothers filed for bankruptcy on September 15, 2008 with $639 billion in assets and couldn’t be saved. One investor, the Norwegian government pension fund, which had over $800 billion in Lehman’s stocks and bonds, lost a bundle according to Gary Shilling in his book, The Age of Deleveraging (Wiley 2011).

In 2004, which is the first year credit default swap data is available, the market totaled $6.4 trillion according to data from the Bank of International Settlements. In 2007 just three years later, the CDS market had ballooned more than 800% to nearly $60 trillion.  By 2010, this market had been cut in half to less than $30 trillion as Figure 3 shows.

But CDSs are just one of dozens of complex financial instruments whose sudden decline in value threatened global financial stability three years ago.

Could It Happen Again?

How could a 2008 crisis that came dangerously close to financial Armageddon have been primarily caused by derivatives worth just 10% of the OTC market?  Could it happen again?

CDSs are making a comeback but this time they’re being used to insure nations like Greece, Japan, Italy, Spain and Portugal against default. Together Greece, Spain and Italy have government debt totaling more than $4 trillion. But this is dwarfed by government debt of more than $10.7 trillion owed by Japan and more than $14 trillion by the U.S. Concerns about the ability of the governments to repay creditors have risen after the U.S. lost its AAA credit rating in August and Italy was downgraded by Standard & Poor’s in September. Five-year CDSs for Germany soared to new heights on September 26 and competitor Moody’s Investor Service cut Japan’s credit rating to Aa3 August 24.

On October 7, we learned that rating agency Fitch Ratings had again cut the Spanish credit rating from AA+ to AA- citing the “intensification” of the euro crisis, slower Spanish growth and regional finances as risks to the nation’s debt outlook according to Bloomberg. Moody’s Investors Service warned on October 4 that “all but the strongest euro-area sovereigns” are likely to see further downgrades, when it cut Italy’s rating for the first time in almost two decades.

Investors are buying CDSs on these and other nations hoping for whopping payouts should one or more default. But assessing the risk posed to financial systems of derivative market failures like we experienced in 2008 is nearly impossible since without much regulation or transparency, we only learn of failures after they have happened. According to the latest data from the U.S. Comptroller of the Currency, more than one-third of all derivative risk or $249 trillion (notional value) is held by U.S. insured banks as of Q2-2011. The majority of this is held by two banks – JP Morgan Chase and Citigroup. Derivatives held by U.S. banks increased $28.9 trillion in the last year or roughly twice the size of U.S. GDP. Credit default swaps totaled $15.2 trillion.

Is it any wonder investors are getting nervous about the potential risks posed by sovereign defaults in Europe?  What other “latent” and “potentially lethal” risks are waiting to unravel in the huge derivatives market?

Suggested Reading:

Chisholm, Andrew – Derivatives Demystified – A Step by step Guide to Forwards, Futures, Swaps and Options (John Wiley & Sons, 2010).

Lancaster, Brian, Shultz, Glenn and Fabozzi, Frank – Structured Products and Relative Credit Derivatives (John Wiley & Sons, 2008)

Shilling, Gary – The Age of Deleveraging (John Wiley & Sons, 2011).

Default Swaps Reach Record on Bonds Still Beloved by Banks: Japan Credit

http://www.bloomberg.com/news/2011-09-21/default-swaps-reach-record-on-bonds-still-beloved-by-banks-japan-credit.html

Author’s Bio

Matt Blackman, CMT is the host of TradeSystemGuru.com. Matt’s articles have appeared in publications such as Technical Analysis of Stocks & Commodities magazine, SFO (Stocks, Futures & Options) Magazine, Trader Monthly, Working Money, Physicians Money Digest, Laffer Economics, The Wellington Letter, Traders.com Advantage, Traders Mag (Europe), Active Trader and Investopedia.com. Matt is a member of the Market Technicians Association (MTA) and the Canadian Society of Technical Analysts (CSTA). He earned the Chartered Market Technician (CMT) designation and a B.Sc. (Honors) degree from Simon Fraser University. He can be reached at [email protected]

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