A Financial 'Time Bomb'?
By Robert J. Samuelson
Wednesday, March 12, 2003; Page A21
SourceSince the 19th century, governments have tried to prevent financial panics, which led to economic slumps and depressions. In 1873 Walter Bagehot, editor of the Economist, published his landmark book "Lombard Street: A Description of the Money Market," which advised the Bank of England about how to stop bank runs. When the Federal Reserve disregarded his advice in the 1930s, the Great Depression ensued. Congress later enacted deposit insurance as another protection against panics. To the list of financial threats can now be added "derivatives" -- sophisticated securities that are used mostly by big investors (banks, insurance companies, corporations).
Just last week, legendary investor Warren Buffett denounced derivatives as "financial weapons of mass destruction" that could cause economic havoc. By contrast, Federal Reserve Chairman Alan Greenspan says derivatives have improved economic stability. Who's right? This is an important debate, because derivatives have exploded and are implicated in two recent financial scandals -- Enron's bankruptcy and the near-bankruptcy in 1998 of Long-Term Capital Management (LTCM), a private investment fund.
About derivatives' growth, there's no debate. From 1990 to 2002, their face value rose from $2.9 trillion to $127.6 trillion, says Randall Dodd of the Derivatives Study Center, an advocacy group. These figures, based on data from the Bank for International Settlements, can be misleading. The amounts at risk are much smaller than the face value -- probably less than 10 percent. Still, the numbers are huge and reflect two realities: (1) Derivatives are one way to make a fast buck; and (2) they allow companies and others to hedge against unfavorable economic developments -- changes in interest rates, for instance.
Derivatives are so named because they "derive" their value from the future price movements of some commodity or financial asset: oil, wheat or stocks. Small swings in prices can mean huge profits and losses, because investors have to commit only tiny amounts of cash compared with the contracts' face value. Buffett's fears start with this explosive arithmetic. In an extreme case, LTCM used about $5 billion of investment capital to control more than $1 trillion of derivatives, according to Dodd.
But trading isn't just gambling by speculators. In economics texts, farmers provide the classic illustration of the advantages of hedging. Suppose you raise wheat. When you plant in the spring, the price is $3 a bushel. You can make a profit at that. The trouble is that you sell in the fall, after the harvest, and if the price drops to $2.50, you can't cover your costs. To reduce that risk, you invest in wheat futures contracts. If wheat prices decline, you offset losses on your crop with profits from your futures contracts. Thus reassured, you plant in the spring.
Hedging has spread far beyond the farm. Four-fifths of derivatives now involve interest rates; another 10 percent or so involve currency exchange rates. These provide protection for companies whose businesses involve lots of debt or foreign trade. One benefit, Greenspan has argued, has been the mortgage-refinancing boom. Investors in mortgage-backed securities face the risk that, if interest rates fall, homeowners will refinance. Investors lose. To minimize that risk, they can hedge against lower interest rates. If they couldn't, they might impose larger prepayment penalties or charge higher interest rates.
Similarly, Greenspan has noted that despite $1 trillion in worldwide lending to telecommunications companies from 1998 to 2001, the subsequent telecom bankruptcies have not caused any major bank failures. One reason, he contends, is that banks spread their lending risks to other investors (say, insurance companies) through "credit derivatives." Dispersing risk has made the financial system sturdier, he argues.
Buffett doesn't deny derivatives' theoretical benefits. Indeed, he's not worried by standard futures contracts such as wheat (traded on exchanges, such as the Chicago Mercantile Exchange). What frightens him is the possibility that newer derivatives (traded "over the counter'' -- between one customer and another) could trigger a panic. Financial markets require trust. Without it, people won't deal with each other. Credit and confidence shrivel. To Buffett, derivatives are "time bombs" that could shatter confidence in three ways.
First, a few big banks dominate the market. Among U.S. banks, seven (led by JPMorgan Chase, Citibank and Bank of America) account for 96 percent of derivatives holdings. "The troubles of one could quickly infect the others," he writes.
Second, weakness could feed on itself. A company whose credit rating is lowered -- for whatever reason -- typically has to put up more collateral against its derivatives contracts. A "corporate meltdown" and defaults could ensue because the company needs more cash just when cash is least available.
Third, complex accounting rules for derivatives can lead to overstatements of profits (this was true of Enron) and confusion. All the "long footnotes" on derivatives convince Buffett "that we don't understand how much risk" is involved.
Although Buffett could be wrong, his record in spotting financial excesses -- in tech stocks and executive options -- commands respect. What can be done? He doesn't say. One thing that can't be done is to outlaw "speculators" (customers trading for profit) and allow only "hedgers" (customers trying to protect themselves). The markets need speculators to counterbalance hedgers. But as Dodd suggests, some steps might improve financial safety. Capital requirements could be imposed on all dealers (banks have them, but non-banks -- such as Enron -- typically don't). Reporting requirements could be increased.
Even Greenspan concedes "the remote possibility of a chain reaction, a cascading sequence of defaults" that would impel the Fed, heeding Bagehot, to try to rescue the financial system -- an outcome that no one should want.
© 2003 The Washington Post Company