The age-old derivatives conflict

Ravi Kalia on how a niche financial product became a giant killer.
Investment banking
Commercial awareness

"The more things change, the more they stay the same"

Recent reports tell us that PhiBro (for now Citi's commodities trading unit) and Morgan Stanley have shown interest in entering the commodities storage business. The reason for this interest - the rewards they aim to reap from arbitrage using a class of derivatives known as futures. There is a contango (a term used in the futures market to describe an upward sloping forward curve) in oil futures now. (It is possible to buy oil now and sell it for delivery in a year's time, for example, for a profit ahead of storage costs in a tanker)

Much of the current doom and gloom is being blamed on bad lending practices fuelled by unregulated credit, or loan based, derivatives. Whilst that is something of an exaggeration, however, they have undoubtedly contributed to the current economic climate.

What and why?

Using derivatives to profit from market changes is not a new game. It is one of the reasons for their existence. In fact, looking at the history of derivatives innovation we see that each modification is followed by a financial crisis. Derivatives are contracts, or financial instruments, that agree trades, or equivalent cash-flows, between obligated parties derived from the value of some reference entity, called the underlying. In simpler terms, they are bets between two or more gamblers where the bookie and gamblers usually have a danger of going bust before the bet is settled.

The other side of derivatives is that they provide ways for individuals to bring stability to their income streams; multinational corporations will use them to stabilise FX risk. Legitimate use allows firms to take only the risks that they specialise and move others to specialists. Vodafone could be viewed as a FX investment given its revenue streams, were it not for FX options.

The history and varieties of derivatives innovation is as convoluted and as derivatives themselves. Certainly contracts between Arabian traders and their suppliers were known to exist at least one thousand years ago.

Modern financial markets history begins with Chicago. Farmers agreed prices for their goods with their customers in advance of delivery. These trades, known as forwards, carried considerable credit risk of one party failing to honour the contract. To deal with this, the Chicago Board of Options Trade (CBOT) was formed as an intermediary to counterparties. It required that all contracts be settled at the value of prices of goods at the close of the day or else have the contract cancelled. Building a pool of reserves CBOT trades are now indemnified against non-performance of counterparties. To ensure liquidity, commodities and contracts are standardised. This is currently what is being sought for certain classes of credit derivatives, so that government bailout of corporations such as AIG won't be needed in the future.

Credit as a derivative? Mortgage backed securities

After the 1930s depression and the waves of migration to the new world, the US government sought a way to provide cheap housing credit to its increasing population. Fannie-Mae (Federal National Mortgage Association) was born. The government corporation existed to put the explicit seal of the US government on home loans issued to US citizens. The agency bought mortgages from depository institutions and encouraged them to lend more. These pools of mortgages were then packaged as bonds and sold to investors. That is, homes could be purchased on credit to borrowers, financed by investors who could buy pools of these loans with the guarantee that defaults would be made good by the US government.

The original credit derivative had been created. Except it wasn't. These Mortgage Backed Securities (MBSs) became as good as US Treasury bonds with the full support and money printing capacity of the US government. (There were contingent events that affected their value but not default risk.) The market for MBSs was difficult to trade because borrowers could redeem their mortgage at any time, returning cash to investors when they might least want it, say when interest rates are low. That all changed when Solomon Brothers entered the market. Their bankers recognised that if the redemption issue could be resolved there was substantial appetite for these bonds. Furthermore, hikes in interest rates meant that Thrifts were willing to sell at significant discount. An innovation in the structure of MBSs split the repayments on the pool of loans into interest and capital. Investors wanting interest repayments could purchase a certain class of shares in the MBS. Others could hold on to the capital repayment with the associated redemption possibility. This opened the market for MBSs to a wide audience looking for yield enhanced Treasuries. All fine while the US government ran Fannie Mae, however following its privatisation and subsequent pressure from the Clinton administration in 1999 for it to lend to lower income families, the guarantee on MBSs became implicit and the quality of the loans deteriorated. These were contributing factors to the nationalization of Fannie Mae and Freddie Mac(Fannie's government engineered competitor).

Junk bonds

Then came the next innovation. Michael Milken. Specifically, he was able to identify fallen angel junk bonds. When ratings agencies downgraded corporate bonds to below investment grade, their prices fell to make some cheap enough to be profitable. Recovery rates and likelihoods of default gave higher profits than their short term credit rating would justify. Milken used this and returned substantial profits to investors. His reputation allowed him to issue large amounts of high yield debt to finance LBOs which exploited the tax benefit of restructuring cash generating companies by loading them with debt. At Drexel, the seeds for the current crisis were sowed in the form of Collateralised Debt Obligations (CDOs) - derivatives on junk bonds. CDOs allowed bonds to be issued on pools of corporate debt slicing the risk into tranches so that depending on the tranche or share owned a higher return could be expected with the acceptance of higher risk of loss. Pricing these risks was complicated and it didn't take off until the late 90s.

As interest rates increased and cash-flows dried up, default rates increased accordingly, and junk bonds lost their allure. Regulations also meant that institutional investors were required to control their exposure to high-yield, high-risk investments.

Portfolio Insurance

The market crash of 1987 (Black Monday) has been blamed on program trading and portfolio insurance. Program trading allowed Wall Street to sell stock automatically if they fell below a threshold (stop loss) without intervention. The problem being that if everyone started to sell then prices would fall and all programs would sell, swamping the market and taking out all buyers.

The brainchild of California finance professor Hayne Leland, portfolio insurance sought to use equity derivatives to provide insurance on portfolios of stocks using a process called dynamic hedging. In theory at least, it was possible to guarantee the value of a portfolio over a specified period of time, using futures or put options for a fee. This encouraged speculation and when liquidity vanished, the strategy failed with no liquidity in the market. For some years since portfolio insurance has lost its appeal.

Long term capital management (LTCM)

The LTCM hedge fund was formed by the legendary team that arbitraged US government securities using financial models. By writing programs and using smarter traders the team was the largest profit centre at Salomon Brothers for some time. Set up with Nobel Prize winners, it worked well early on, offering significant returns. However, due to lack of discipline and using leverage in the form of derivatives the firm had to be taken over by a cadre of banks and wound down slowly with federal oversight.

At the heart of its collapse was the devaluation of the Russian rouble, a possibility that derivatives innovation hadn't factored in. Although derivatives can provide protection in the right quantities, their excessive concentration without careful risk management has been likened to picking up pennies in front of steam roller; it's great when the goings good, but the medical bills will be huge when you get hit.

Credit derivatives - Portfolio Insurance 2.0

Now we come to the latest craze to have blown up in the derivatives world. As mentioned earlier, credit derivatives had been created since Milken's time, but were difficult to value and trade. Also, the risk of default kept the investment community away.

All that changed in 1999 when technology innovation 'coupled' derivatives with debt, available at high speed on any PC. It now became possible to take pools of corporate debt and price the risks associated with them. It was a small step from there to tranching the risk into levels of risk preference and offer risk-related returns. These products were able to offer higher returns than individual corporate debts given the 'diversification credit' of sharing risks.

In addition, the market for Credit Default Swaps (CDSs) gained traction. Clients could pay a premium to insure the corporate bonds they purchased. For example, when MCI-WorldCom went down, bondholders had insurance from CDSs which provided payout the face value of the bonds in return for the defaulted bonds. In theory a great idea, persuading regulators that risk-averse institutional investors should be allowed to invest in high-yield debt. That wasn't all. When MCI WorldCom defaulted, its bonds prices were squeezed up because there were more CDS holders than bonds. The comparison is like buying home insurance, a sensible strategy, vs betting on the neighbours' house being burgled.

CDSs brought down AIG too. The company needed to be saved because it was the largest insurer of Lehman Brothers debt. When the US government let it fail, they had to step in to protect AIG, because PIMCO (the world's largest bond fund) had insured AIG debt and was deemed too big to fail.

The future of innovation

The FSA, Sec and associated regulators are working through credit derivatives innovation to control the problems that have occurred in the past. One thought is to bring in a clearing house and tightly regulate credit derivatives so that counterparty risk is minimized and bubble formation in these markets is not possible.

However, it is unlikely that regulators can foresee the next development in the use of derivatives. There are some candidates areas in that have yet to 'derivativised'. Pensions, catastrophes and the weather are possibilities. Be on the lookout for bankers and finance professors reinventing themselves.


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