A Return To Derivatives Phobia?

Just like a decade ago, when a group of well-known companies and public entities suffered large and widely-publicized losses, derivatives-related troubles are back in the headlines. For the past few years there has been a relatively regular stream of news describing how corporates and financial institutions from both the US and Europe have suffered setbacks due to their derivatives positions. The now legendary mid-1990s episodes of Procter&Gamble, Gibson Greetings, Orange County, Metallgesellschaft, and Barings Bank that guaranteed derivatives a place in popular culture (even if one filled with negative connotations) are finding their 21st century match in the likes of Fannie Mae, Freddie Mac, Poste Italiane, General Electric, Sears Roebuck, and many more. While it is not likely that the latter group would ever achieve the same iconic status as the former, it is undoubtful that after a lengthy absence the “wild beast of finance” is back. Derivatives and bad news are once again being associated, and the current environment risks a descent into the same unrelenting derivatives-bashing that took place some ten years ago.

There is, however, a key difference between the events of the mid-90s and those that have unfolded in more recent times: the troubles of the last few years have for the most part been of an accounting nature. That is, it wasn’t necessarily the case that the companies involved were incurring unsustainable real costs (in the shape, for instance, of very high net financing costs). Rather, they became frontpage items because of the way that they were affected by the new derivatives accounting rules, or because of the way that they reacted to such rules. Prior to the introduction of the new standards in early 2001 (FAS 133 for US-listed firms) and early 2005 (IAS 39 for Europe and Asia-listed ones), derivatives were off-balance sheet instruments. Nowadays, they must show up on companies accounts with their mark-to-market value inmediately hitting earnings (unless certain stringent conditions are met). As that value can swing wildly, given its sensitivity to highly-fluctuating variables such as volatility or forward curves, the potential for accounting malaise caused by derivatives positions is clear. Plainly stated, under the new rules derivatives can become volatility time bombs that heavily distort the income statements of end-users.

It is the unexpected and unwarranted enhanced earnings volatility (perhaps accompanied by large accounting losses) that results from the new mark-to-market regime what has placed some companies and their derivatives activities in the headlines in recent years.

But, crucially, it is not only through earnings volatility that the new accounting standards can spell trouble for companies. Given the complexity involved in the actual implementation of the rules (which have been repeatedly dubbed as the most complicated accounting guidelines ever) there is plenty of scope for reporting entities to “get it wrong” and to be later on forced by auditors and regulators to restate results, a potentially disruptive process that, as recent history shows, can get really messy.

The conclusion is that in the current enviroment, as opossed to the realities of a decade ago, it is not necessary for a company’s derivatives positions to be heavily underwater from an economic point of view for it to be the subject of bad press. Accounting troubles would suffice. That is, nowadays companies are exposed to obtaining negative publicity for two kinds of derivatives-related trouble: real and accounting. Clearly, what this directly implies is that the potential number of bad news reaching the headlines becomes much larger than in the days of Procter&Gamble. In this sense, the public reputation of derivatives could take a hit at least as spectacular as that experienced in the mid-90s. Just like in the old days, the troublesome news are not devoid of a human face, as the number of high-profile staff that has been sacked as a result is by no means insignificant. Obviously, such developments inevitably tend to draw even more public attention towards the events and, consequently, towards the “damaging” effects of derivatives. When the CEOs of Fannie Mae and Freddie Mac suddenly lose their jobs, outside attention as to the causes of such abrupt dismissals is guaranteed, and, just like it happened a decade ago, a link between disastrous corporate news and derivatives use gets unavoidably embedded in the public psyche.

The new accounting rules, which some people see as regulation in disguise, were put in place as a way to guarantee that the scandals of the past could not be repeated. The belief is that the new standards improve disclosure and derivatives use so much that they would surely put an end to derivatives-related trouble. Wouldn’t it be ironic then that as a result of the new rules a wave of scandals and bad news afflicted the derivatives industry once again?.