Main Sections

Americans May Have To Add “Derivatives” To Their Vocabulary

Tuesday May 23, 2006

By Ed Barna

    Do you remember the savings and loan crisis, where the failure of banks that had engaged in dubious financial practices brought a Congressional bailout so the infection could be stopped from threatening the whole economic system?

Do you remember the concern in 1998 about the failure of a “hedge fund” that has made the wrong speculations, and because of its size threatened to set off a chain of negative consequences?

Don’t be surprised if those historical examples get mentioned again in press reports, to help give some perspective on the effects of speculation in derivatives--especially if they threaten to bring down this country’s whole debt-built house of economic cards. (If the word “derivatives” draws a blank, go to paragraph 11.)

The derivatives issue came up at a recent Middlebury College conference on outsourcing. Shifting production “offshore,” mainly to China these days, has cost millions of manufacturing jobs--but also has helped Americans maintain their standard of living, according to the conference’s panelists, who were all involved in businesses that had little choice about going with that flow.

A recent press report on oil price increases observed that in the past, such an escalation would have caused a spike in inflation, which then would have cut out consumption. But outsourcing has buffered us from that, said the energy economist.

Briefly, the chief threat to New England from outsourcing may be in the financial services industry, one of the area’s leading sectors. Stay tuned.

But toward the end of the session, the point was made that outsourcing wouldn’t have been possible without the network of fiber optic cables linking the world, and other high-level communications infrastructure. Not only does this system allow masses of information to go back and forth between continents, it also makes possible the transfer of immense sums of money.

And that, said Panton intellectual property attorney Michael Hermann, has created a danger that is beyond the control of United States financial regulatory bodies. Trillions of dollars are being traded for options, futures, swaps, forwards, and other more complicated financial instruments, he said, and if losses in such markets cause a series of related losses, the effects might be hard to stop.

“The financial state of the world has gotten so complex, and the people who are policing this are rarely trained to do it,” Hermann said. A bright young college graduate looks at the chance to earn $100,000 working for the government, and the chance to earn millions working for a big investment bank, and picks the private sector--so the derivatives traders are constantly outsmarting those who are supposed to be supervising them.

Was this true? The Internet suggested it might be.

But first: what the heck are derivatives? Technically, to start with, something that derives its value from the value of something else.

Here’s the BBC’s explanation: “Derivatives are financial instruments that allow investors to speculate on the future price of, for example, commodities or shares - without buying the underlying investment.  Derivatives like futures, options and swaps were developed to allow investors hedge risks in financial markets - in effect buy insurance against market movements - but have quickly become a means of investment in their own right.”

“Outstanding derivatives contracts - excluding those traded on exchanges such as the International Petroleum Exchange - are worth close to $85 trillion, according to the International Swaps and Derivatives Association,” the BBC said.

Interestingly, Addison County’s farmers may understand this better than any other group, except perhaps gas station owners. Say a farmer needs a lot of corn each year, and is worried that by harvest time the price will escalate. He or she can buy an option to purchase that much corn at an affordable price, if someone is selling such a contract.

If the corn price is higher at market time, buying at the option price saves money--or if the farmer’s own crop came in especially well, the option is worth something and can be resold. If the option price stays higher than the market price until the option period expires, it’s worthless--but so is unused fire insurance.

That’s the original, basic use of a derivative. It’s speculation in derivatives that has many people worried--including legendary investor and Berkshire Hathaway company chairman Warren Buffett.

In his 2003 annual letter to his stockholders, Buffett said the derivatives market poses a “mega-catastrophic risk.” Traders in them “generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years.” When the truth comes out, sometimes it’s in the form of “a spiral that can lead to a corporate meltdown,” he said.

Buffett called such highly complex financial instruments “financial weapons of mass destruction.”

For more perspective on the situation, we turned to Scott Pardee, a professor of monetary economics at Middlebury College who previously spent “many years” on Wall Street and “have been involved with many of these products.” He agreed about the possibility of traders outsmarting regulators, at least some of the students he has seen headed for investment careers.

But the Federal Reserve in New York, and the Federal Reserve generally, are “trying to get everybody on the same page,” he said. In particular, they are looking at credit derivative swaps, whose use has grown “exponentially in recent years.”

“The explosion of derivatives has everyone concerned,” Pardee said. As the returns from other types of investment like stocks, bonds and real estate have decreased, people with little experience have moved into things like options and futures, “and we will have more” types of derivatives as experts keep inventing them, he said.

In a free market system, people have the right to invest as they want, and take the risks they choose, Pardee said. The concern is for the “cascading” consequences if one type of loss leads to others, he said.

“You never know what the next big crisis is going to be,” Pardee said. “The authorities are always playing a catch-up game.”

“My hope is that we can attract enough good young people to work at the Fed, the Treasury and the other institutions, who have learned enough to understand what’s happening,” he said. He mentioned one Middlebury 2003 graduate who is now with the New York Federal Reserve in an important role.

Here in Vermont, he said, one thing that’s happening is that Wall Street people are moving up, but are keeping their big city contacts and using telecommunications to keep working. “It used to be bed-and-breakfasts; now they’re setting up hedge funds and financial management operations.”

“Unfortunately, they don’t create a lot of jobs,” he added. That’s the way a free market system works, he said--”as long as they don’t take the whole system down with them.”

Printer Friendly

Top

Advertisements

Search our Archives