In Defense of derivatives: between Enron, WorldCom, and Global Crossing, the controversial financial instruments have gotten a bad rap. Here's the truth.

THREE OF THE six largest bankruptcies in American history--WorldCom, Enron, and Global Crossing--occurred between December 2001 and July 2002, shattering investor confidence and helping to knock 22 percent off the Dow Jones Industrial Average. The failures had more in common than just timing and size: All to varying extents involved the use of the controversial and poorly understood financial instruments known as derivatives.

In the season of finger pointing that followed, derivatives trading was singled out for abuse. "If you deep enough into any financial scandal," BBC business reporter Emma Clark claimed in February 2002, "you can usually find a derivative or two to take the blame." Howard Davies, chairman of the U.K. Financial Services Authority, told a conference the month before that an investment banker described to him one popular type of derivative (collateralized debt obligations) as "the most toxic element of the financial markets today." Even famed investor Warren Buffett warned that derivatives posed a grave threat to the global financial system. "We view them as time bombs, both for the parties that deal in them and the economic system," Buffett wrote in his 2002 annual report for Berkshire Hathaway. "Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

What are these Wall Street WMDs, and what should be done about them? Technically, derivatives are financial products whose value is "derived" from that of an "underlying" asset. For example, stock options, perhaps the best-known derivatives, are based on the underlying value of the stock that the option enables the purchaser to buy at a later date. Futures contracts--used extensively by farmers to protect themselves from poor crop yields and fluctuating prices--are derived from the root value of the good to be bought or sold in the future.

Derivative products are not just a sophisticated way for investors to gamble. They also give producers a crucial tool for hedging against risk and uncertainty. And they have played a central role in the flowering of innovation that the financial markets have enjoyed during the last two decades. There are derivatives betting on the likelihood of a natural catastrophe; consumer credit card debt has been converted into bonds; futures markets have been established for such things as barge rates; and options allow investors to speculate on the temperature, wind chill, and amount of rainfall in many cities.

The common denominator in all these products is that they allow companies and private investors to trade away risk with which they are ill equipped to deal and focus instead on taking risks in areas in which they specialize. Many international corporations, for example, use currency derivatives to swap out their exposure to exchange rate fluctuations. This allows them to focus on their core business while allowing professional currency traders to worry about international valuations.

This wave of financial innovation has washed into unlikely places. Glam rock pioneer David Bowie, long famous for his innovative music and embrace of the new, became the first songwriter in history to use derivatives to securitize future royalties from his own song catalog when he created "Bowie Bonds" in 1997. Bowie and his business manager, the Rascoff/Zysblat Organization, sold the royalty rights to his 25 pre-1990 albums to the Prudential Insurance Company. The singer/songwriter was able to pocket $55 million immediately, while Prudential received a 7.9 percent return on bonds that were backed by Bowie's future royalty payments. Bowie's groundbreaking move was quickly emulated by James Brown, the Isley Brothers, Ashford and Simpson, Joan Jett, and other artists, as well as the estate of Marvin Gaye. Bowie Bonds even inspired a thriller novel, Something Wild (2002), by Linda Davies.

But all has not been hunky dory for derivatives. Besides the massive bankruptcies, critics point to a number of other derivatives-related mishaps. In 1995 Nick Leeson used derivatives to establish positions for his employer, the British bank Barings, with exposure of more than $60 billion, compared to the bank's capital of $615 million. When the positions turned against Barings, the 233-year-old institution was forced to fold. The Long-Term Capital Management (LTCM) hedge fund and the government of Orange County, California, were also involved in derivatives-related meltdowns in the 1990s.

The Men Who Sold the World

Although sometimes viewed as a recent innovation, derivatives actually predate Christ. Thomas F. Siems, a senior economist at the Federal Reserve Bank of Dallas, claims that the Greek philosopher Thales created the first known derivative contract roughly 2,500 years ago. Thales, apparently an excellent prognosticator, suspected that the olive harvest would be exceptionally good one year, so he bought options securing him the exclusive use of olive presses in his area. When the harvest turned out to be much as Thales had expected, he made a tidy profit renting out his monopolized presses for high fees.

A regular market for such sophisticated financial instruments existed in Europe as early as the 1600s, when short sales, options, and forward contracts all were exchanged on the Amsterdam bourse. The Dutch government was so skeptical of these mysterious goings-on that it passed laws making derivative contracts unenforceable in government courts. Economist Edward Stringham of San Jose State University has demonstrated that despite such official disapproval, the Amsterdam derivatives market worked in an orderly fashion, relying on privately created law and ostracism of those who didn't fulfill their contracts.

Still, derivatives played a relatively minor role in global financial markets until fairly recently. It was not until 1973 that the Chicago Board Options Exchange began trading listed options in the United States. From 1982 to 2000, trading in listed equity options increased roughly tenfold, spurred on in part by the pioneering work on options modeling by economists Fischer Black, Robert Merton, and Myron Scholes. As sophisticated mathematical models for valuing derivatives gained currency, computers came to play an increasingly important role in trading them. The fall in the price of computing power consequently enhanced the popularity of derivatives.

While trading in stock options was increasing, both the volume and variety of other types of derivatives were growing explosively. Between 1987 and 2002, the amount of outstanding currency and interest rate swaps and options increased from $865 billion to nearly $100 trillion, according to the International Swaps and Derivatives Association. (Swaps are agreements where two parties agree to exchange some features of two assets without trading the assets themselves. For example, a bank that holds many fixed-rate loans but wishes to obtain more floating-rate cash flows might swap the cash flows on some loans with another bank that holds many floating-rate loans but desires more fixed-rate cash flows. Each bank would continue to hold and service the loans it originated, but each would achieve a more preferable cash flow structure.)

Diamond Dogs

As the above description indicates, derivatives can be tricky to explain. Although they have been around for decades, are widely used, and have many valid commercial applications, they have an undeniable image problem. In the wake of the Enron debacle, The Washington Post described derivatives as "complex, risky and largely unregulated financial contracts." The Baltimore Sun quoted Michael Greenberger, formerly an official at the Commodity Futures Trading Commission, as declaring: "Derivatives, when used speculatively, amount to nothing more than gambling" Even Linda Davies, author of the Bowie Bonds novel, argues that "derivatives are financial instruments that have no intrinsic value."

The first problem with Davies' complaint is that no goods have "intrinsic" value. The value of economic goods arises from the desire human beings have for them; it does not somehow reside in the goods themselves. Perhaps the novelist mean s that while stocks and bonds, for instance, are truly valuable to their owners, the value ascribed to derivatives is somehow less real. But such a complaint will not stand scrutiny.

Consider a simple derivative, such as a stock option. Let's assume you could buy a share of IBM stock today at $100. Alternatively, you could buy an option granting you the right to buy a share of IBM stock at $100 at any time during the next six months. It should be clear that if you are interested in owning IBM you probably would consider such an option valuable. After all, should the share price of IBM plunge in the next half a year, you need not exercise your option, saving you from taking a bath. On the other hand, if IBM rises above $100, you can exercise your option and immediately make a profit.

The essence of derivatives is that they allow investors to separate out various aspects of an asset, and trade those aspects separately, rather than in a bundle. For example, when purchasing a share of common stock outright, the buyer gets both the upside and the downside potential of the stock. But by purchasing a "call" option, the buyer acquires only the upside potential.

Or consider David Bowie's sale of his royalty income, which separated the income stream from his song rights from the rights to the songs themselves. While the singer still controlled the use of his own songs, all of the royalty income from them flowed to those who bought the Bowie Bonds. From Bowie's point of view, his financial future was too dependent on the vagaries of his popularity. By selling some of his royalty income to others, Bowie was able to diversify his investments. (We assume that he did not spend the entire $55 million on a huge shopping spree for his supermodel wife Iman.) He reduced the risk that a major shift in the public's musical taste would leave him a pauper. Meanwhile, investors who had not previously had any stake in the sales of ziggy Stardust could diversify into that area and earn a decent interest rate while doing so.

Similarly, a farmer who does not wish to concern herself with the dynamics of the wheat market can sell her crop "forward" (i.e., sell it at a specified future date for a price determined today), she can gain even more flexibility by purchasing a "put" option on the wheat--buying the right, but not the obligation, to sell her crop at a certain price (the option's "strike price") over a specified period of time. If the spot wheat price falls below the strike, she can exercise her option and protect herself from losses. If the price rises above the strike, she can let the option expire and sell her crop at the higher price. Naturally, such flexibility has value to the farmer, and she must pay a price to others to persuade them to take on some of her risk.

"It is widely recognized that OTC ["over-the-counter" i.e., not traded on an exchange] derivative instruments are important financial management tools that, in many respects, reflect the unique strength and innovation of American capital markets," said Arthur Levitt, then chairman of the Security and Exchange Commission, in 1998 testimony to Congress. "OTC derivative instruments provide significant benefits to corporations, financial institutions, and institutional investors by allowing them to manage risks associated with their business activities or their financial assets. These instruments, for example, can be used by corporations and local governments to lower funding costs, or by multinational corporations to reduce exposure to fluctuating exchange rates."

How important are derivatives to multinationals? Consider this passage from IBM's 2002 annual report: "The company operates in approximately 35 functional currencies and is a significant lender and borrower in the global markets. In the normal course of business, the company is exposed to the impact of interest rate changes and foreign currency fluctuations, and to a lesser extent equity price changes. The company limits these risks by following established risk management policies and procedures including the use of derivatives and, where cost-effective, financing with debt in the currencies in which assets are denominated."

For the economy as a whole, the benefit of such activities is a simple extension of Adam Smith's 227-year-old insight that the division of labor increases overall productivity. By employing derivatives, David Bowie can focus on making music, the farmer can concentrate on farming, IBM can specialize in computer manufacturing, and financial market traders can worry about pricing assets and evaluating their risk.

Scary Monsters

Still, derivatives are newfangled enough that traders, CFOs, accountants, and investors remain on the learning curve for properly using and analyzing these instruments. We can expect these specialists to make miscalculations, occasionally serious ones. The media and general public, meanwhile, are a few steps further behind in understanding.

Take Enron. Derivatives did play a role in what was the second-largest bankruptcy in U.S. history (behind only WorldCom), but not in the way most people think. The Houston energy company did not go bankrupt because it lost money in derivatives trading. In fact, Enron was tremendously successful in its trading operations, racking up billions of dollars in profits. As documented by economic historian Frank Partnoy, the company went trader not because it was losing money but because it tried to use these profits to disguise heavy losses in its consulting and technology businesses. When the accounting shenanigans were exposed, the company's credibility evaporated, as did its sources of credit and cash. The company was killed by a lack of cash flow, not a lack of profits.

But there are other troubling aspects of derivatives. For one thing, they may be used in what is called "regulatory arbitrage." Partnoy notes, in his financial history Infectious Greed (2003), that "bank regulators, by tightening their focus on banks to reduce their risks and prevent a banking crisis ... pushed credit risks onto other, less regulated institutions." in other words, while it may have made sense in other ways for banks to retain more of their own credit risks, the regulatory environment prompted them to trade that risk away. Similar types of regulatory arbitrage have motivated other economic actors, such as insurance companies, to enter into derivative contracts that otherwise would have been unattractive to them.

It's clear that the legal system has a role to play in preventing financial scares. It is also clear that if a particular regulation is desirable, the use of derivatives to dodge it is not. If the regulation is not desirable, it is simply generating transactions that serve no purpose other than evasion, thus creating superfluous costs and transferring risk from specialists (such as banks and insurance companies) to the less experienced.

Another problematic aspect of derivatives is their often unmonitored use by government agencies. While there has been increased legal and social pressure on private corporations to be transparent in their use of derivatives, politicians have shown little interest in similar standards for government derivatives trading.

Some of the biggest users of derivatives are government-sponsored enterprises (GSES) such as the mortgage-lending institutions Fannie Mae, Ginnie Mae, and Freddie Mac. Doug Noland of PrudentBear.com, a site that advises investors from a bearish perspective, notes, "We have Fannie Mae, Freddie Mac, and the Federal Home Loan Bank system with total holdings [of derivatives] approaching $2.2 trillion and guarantees for another $1.5 trillion of securities."

This year, FM Watch, a coalition of financial service and housing-related organizations dedicated to monitoring GSEs, reported: "One of the GSEs was able to make its RBC [risk-based capital] virtually disappear through use of derivatives and other risk-hedging devices." FM Watch recommends that GSEs' "disclosures should be at least as complete as those provided by other publicly-traded companies and issuers."

The lack of transparency in governmental derivatives trading has resulted in the loss of billions of tax dollars in a string of mishaps spanning a decade. The largest municipal bankruptcy in U.S. history ($1.6 billion) occurred in Orange County, California, in December 1994, when the county treasurer used derivatives to bet that interest rates would stay low. A significant portion of the county's funds were invested in interest-rate-sensitive two-to-five-year notes and structured notes issued by GSEs such as Fannie Mae and Freddie Mac, in addition to other derivatives. Through such instruments, the county's $7.6 billion general fund was leveraged to control more than $20 billion in assets.

The Orange County treasurer was managing a pool of money from nearly 200 California municipalities and government bodies, according to congressional testimony. The treasurer's services were in great demand by other governmental units, because he delivered returns nearly 2 percentage points higher than a similar pool run by the state of California. Local officials increased their leverage by issuing bonds to invest in the pool.

But in 1994 the Federal Reserve raised short-term rates, causing the treasurer's strategy to backfire, with disastrous results for Orange County taxpayers. An effective internal controls system would have made clear what the treasurer was up to. The structured notes involved were government securities subject to government regulators, who also missed the treasurer's misuse of leverage.

Arkansas taxpayers also suffered after the state lost an estimated $30 million from derivatives trading despite repeated warnings from auditors. A 1997 independent audit by the private accounting firm Deloitte & Touche LLP made the following observation about the Arkansas Teachers Retirement System (ATRS): "Alternative investments are becoming an increasing segment of the ATRS portfolio and, currently, ATRS does not have procedures in place to obtain or monitor the market values of these instruments and consequently cannot monitor related investment returns." The "alternative investments" described in this prophetic warning included many derivatives. Deloitte & Touche recommended that Arkansas "develop procedures to ensure that market values are periodically determined for their investments and that these market values are supported by verifiable data. "A 2000 audit made similar recommendations.

ATRS officials clearly did not understand the derivatives they were trading, and ATRS became the only state pension system in the U.S. to lose money in the offshore limited partnerships at the center of the Enron bankruptcy. As of mid-2001, more than 5 percent of ATRS' investments were considered "alternative," a high proportion.

In 1995 the Wisconsin Investment Board, which oversees the state's investment fund, lost more than $95 million through positions in leveraged derivative instruments linked to Mexican interest rates and currency. When the Mexican peso plummeted in value in 1994, the Investment Board incurred $35 million in losses. That same year, Independence Township in Michigan lost $2 million through its misuse of domestic swaps.

Legislatures in two Midwestern states responded to these government failures. Wisconsin has become one of three states (along with Kansas and Missouri) that restrict derivatives holdings by government units, prohibiting the instruments except when used "for the purpose of reducing risk of price changes or of interest rate or currency exchange rate fluctuations with respect to investments held" by the Investment Board. The state of Michigan, meanwhile, passed a law requiring government derivatives to be reported in audits, subject to the Michigan Freedom of Information Act.

But politicians usually have been far more interested in passing laws that regulate corporate use of derivatives than in examining governmental use. Forty states have legal definitions or other acts regulating the percentage of portfolios that insurance companies and other firms may invest in derivatives, while only Michigan has mandated transparency for government units dealing in them.

Ch-ch-ch-ch-changes

In response to the various derivatives disasters, many have suggested that the government should become more active in regulating these new markets. Sen. Dianne Feinstein (D-Calif.), following the Enron bankruptcy, proposed giving the Commodity Futures Trading Commission regulatory oversight over all derivative transactions. (Her proposal was defeated in roll-call votes in 2001 and 2002.) State agencies should certainly pay more attention to their own derivatives trading. But there are a number of pitfalls in increasing the regulation of private derivatives trading.

For one thing, as pointed out above, many of the current uses of derivatives are ways to dodge existing regulations. It seems probable that a new round of regulation will spur the development of new derivatives designed to bypass its restrictions. As the Securities and Exchange Commission's Paul Atkins said at a Cato Institute policy forum in March 2003, "every decade sees some sort of financial crisis, followed by new cries for regulators to 'do something.' Yet the new regulations invariably fail to prevent the next crisis."

Partnoy notes that many of Enron's dubious maneuvers involving derivatives were designed to enhance the company's "accounting reality" at the expense of its true economic condition. But the divergence between accounting and economic reality is itself chiefly a product of the regulatory environment in which publicly traded companies exist. The existence of legal "safeguards" to protect the investing public encourages companies to focus on the safeguards at the expense of the actual financial health of the company. That does not excuse the behavior of executives who violated their responsibility to shareholders, but the motivation to do so would not have existed without regulations that create a divergence between economic reality and accounting reality.

Then there is the question of how to clean up after a derivatives meltdown. When, after some gamble has gone horribly wrong, the government intervenes to soften the blow to investors, it creates a moral hazard. Once people expect that someone else will pick up some of the cost of their speculative failures, they are more likely to undertake risky actions than they would if they had to bear the cost themselves. The amateur mountaineers who venture into places they would never go if there were no park rescue services are a case in point--the existence of a free rescue service prompts people to take risks they wouldn't otherwise, necessitating even more rescues.

Government bailouts of failing investments create a similar moral hazard. The stronger the expectation of a government safety net, the less investors will concern themselves with the risks inherent in the investment. When the average private corporation makes a mistake with derivatives, it suffers a loss. After a few mistakes, it either goes out of business or learns its lesson and changes its practices. But large private hedge funds and money-center banks know that they are "too big to fail," at least in the government's eyes. In the event of a financial catastrophe, they expect to be bailed out by government deposit insurance and the Fed. Such bailouts came to be commonplace under Federal Reserve Chairman Alan Greenspan, especially when he was teamed with Treasury Secretary Robert Rubin.

After the October 1987 market crash, after the savings and loan collapse of the early '90s, and during the crises in Mexico, Russia, and East Asia, the U.S. government rode to the rescue of investors. In September 1998, when the large Long-Term Capital Management (LTCM) hedge fund faced a severe financial crunch, the government stepped in again. The Fed cut rates three times, and the New York Federal Reserve brokered a controversial de-leveraging of LTCM'S derivative trades, which had gone south when the Asian and Russian financial crises unfolded. Large money-center bank were on the other side of many of these trades. "If Long-Term defaulted ... the banks ... would be left holding one side of a contract for which the other side no longer existed," Roger Lowenstein explained in his book, When Genius Failed: The Rise and Fall of Long-Term Capital Management (2000). "In other words, they would be exposed to tremendous ... risks."

The Fed's actions sent a clear signal to markets--and the European central banks that had invested in LTCM--that large, politically connected banks with exposure to losing derivatives trades would be protected. There is some evidence that this action contributed to the Enron debacle. For instance, a U.S. district judge in New York ruled that some Enron derivative trades were actually "disguised loans" from a bank previously involved in the LTCM affair.

"In the short run the intervention helped the shareholders and managers of LTCM to get a better deal for themselves than they would otherwise have obtained," economist Kevin Dowd has commented. "It implies a return to the discredited doctrine that the Fed should prevent the failure of large financial firms, which encourages irresponsible risk taking."

As Auburn economist Roger Garrison has put it, the Federal Reserve under Greenspan attempted to build a "firewall" protecting the "real" economy from financial shocks. But firewalls work both ways: To the extent that the rest of the economy is protected from financial shocks, the financial markets are also disconnected from the rest of the economy. With apparent protection against falling asset prices, investing on Wall Street began to look better and better compared to investing on Main Street, where one might lose one's money and not be bailed out. Wall Street trader James Canevari told us that the attitude on the street in the late '90s became: "With Easy Al and Trader Bob at the helm, you can take the risk factor out of your models."

It is unsurprising that investors would pay less attention to the exact nature of the risks they undertook as they came to believe they were protected on the downside when making risky, high-yield investments. Unsophisticated investors bought stock in a complex company like Enron, whose business they did not understand. If they tried to learn more from Enron's financial reports, they probably found the documents too abstruse to grasp, partly as a result of the very regulations designed to protect those ordinary investors. The government seemed to be offering a dual assurance that since it was keeping tabs on the markets, everything must be on the up and up; and that should any real disasters occur, it would step in to save the day.

It is telling that when the Enron scandal finally surfaced, the first reaction of many involved was to look to the government for help. Enron founder Ken Lay "called Treasury Secretary Paul O'Neill, Commerce Secretary Don Evans, Federal Reserve Chairman Alan Greenspan, and Robert McTeer, president of the Dallas Federal Reserve," according to Partnoy. Even Robert Rubin, now back in the private sector, attempted to intervene on Enron's behalf. Given the string of government bailouts in the wake of other financial collapses, it is not surprising that Enron's executives assumed their company would also be rescued.

Sound Vision

Derivatives meet important needs in the global economy. Like all financial instruments, they carry risk, and there can never be a guarantee that such risk will not have adverse consequences on a large scale.

But government regulators are not, generally speaking, in a better position than private investors to evaluate such risks. When regulations prevent or hinder transactions for which there is a genuine demand, they encourage the creation of securities designed simply for the purpose of dodging those regulations, in order to fulfill that demand.

In addition, when the government attempts to encourage the belief that financial markets are "safe" places to invest, it ends up attracting investors who are not prepared to properly evaluate the risks. This creates an interest group that will demand government redress when the investments don't work out. If fulfilled, those demands will encourage a new wave of risky speculation based on the seeming existence of government insurance on the downside. It is as though the government were granting investors free put options!

As in any innovative venture, there are significant risks involved with the fantastic voyage finance has undertaken in the last 20 years. But increased government intervention is likely only to heighten that risk.

Gene Callahan ([e-mail]) is the author of Economics for Real People (Ludwig von Mises Institute). Greg Kaza ([e-mail]) is the executive director of the Arkansas Policy Foundation. Rob Bradley, president of the Institute for Energy Research, provided research help for this story.

When computer programmer turned writer GENE CALLAHAN began to date his future wife, he was surprised to learn that in her job as a financial analyst, she traded in derivatives. "Is this woman in some sort of scare business?" Callaban wondered--and then read up on derivatives to convince himself she wasn't. Callahan is the author of Economics for Real People (Ludwig von Mises Institute, 2002). His coauthor, Arkansas Policy Foundation chief GREG KAZA, served for six years in Michigan's state legislature. When a local municipality lost millions of taxpayer dollars in derivatives, Kaza persuaded fellow legislators that the problem was a lack of transparency, not derivatives as such. The duo's article, "In Defense of Derivatives" (page 32), explains this much-maligned risk-management tool.