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?.

Why I Became Attracted To Derivatives

I studied undergraduate theoretical economics at a public university in Spain, which basically means that I graduated without knowing what a bond (let alone an option) was. Lots of microeconomics, econometrics, topology, and game theory stuff but nothing on real-world financial markets.

Back then, that was perfectly fine with me, as I had never had any interest in finance anyway. As a semi-intellectual brought up in an upper middle class environment populated by poetry-reading, opera-going, Einstein-admiring characters I grew up developing a certain disdain for anthything financial (no, I wasn´t a crazed anti-globalization activist). I read The Economist, but usually skipped the markets section and concentrated on African politics (exactly the opposite as what I do now). I read tons of books from the Business aisles but they were by Krugman, Friedman, and Dornbusch and thus dealt exclusively with economic policy and international economics. The last thing on my mind by the time I was in my early 20s was to work for an investment bank or an asset manager (mostly because I didn´t know that such things existed).

All this changed when I (luckily) travelled to the US to pursue graduate studies at the economics department of American University in Washington DC. At AU (or “Club Med”, as the place was also dubbed due to its easy-going ambiance, its pristine little campus, and the attractive and wealthy international student body) I enrolled in the “development banking” track as a way to get a job at, you guessed it, one of the development banks in town. After having spent a fruitful and deliciously eventful summer at the InterAmerican Development Bank, my goal in life had become to set up shop permanently in either the IDB or the World Bank, ideally doing some international economics stuff.

These carefully-crafted plans were shockingly derailed by my attending an AU class titled “International Capital Markets Workshop” imparted by (irony or ironies) a top finance professional at the IDB. Through this course I was introduced, for the first time in my life, to things such as options, swaps, forward curves, and risk management. This indoctrination period coincided with The Economist releasing a couple of special reports on mathematical finance and corporate hedging, which I duly devoured thus discovering the Procter&Gamble scandal and rocket scientists, among lots of other intriguing stuff. The period also witnessed the birth of several financial engineering programs at top universities, with their cutting-edge curriculums and impossibly selective admissions policies.

I became instantly and irremediably hooked by the derivatives world. I began to use my spare cash (this was before I started tutoring other students, eventually making more than $2000 a month) on buying any book with the word “derivatives” on it. I had always been a frequent visitor to bookstores, but now I was suffering from an addiction. As with any addiction, my infatuation with derivatives required its daily fix and I obliged by religiously partying with the $50-60 that each one of these specialized books demanded (it is a safe bet that I eventually ended up reading just half of these expensive tomes).

Why the infatuation? Why the sudden and unabated love affair? I mean, my attraction towards the derivatives world made Glenn Close´s obsession with Michael Douglas in “Fatal Attraction” seem like a pleasant picnic.

In one word: sophistication. Everything about derivatives seemed so cutting-edge, so new, so out-of-this-world that I couldn´t help succumbing. Derivatives products seemed far more interesting and complex than anything else out there. Derivatives pros seemed much smarter and richer than anybody else. Derivatives university courses seemed much more select and demanding than the alternatives. Here was a field were mysterious genius individuals seemed to be making millions by operating with funky financial products which handling required super sophisticated techniques such as stochastic calculus and C++ (I remember naively considering doing a masters in computer science as a way to become a derivatives superstar). The fact that several prominent companies and financial institutions had been inmersed in headline-grabbing derivatives-related scandals only enhanced the field´s attractiveness. To the complexity factor we could now also add the high drama factor.

Derivatives, in sum, were super sexy. And I desperately wanted to be sexy.

Bad Boys Running Wild

When it comes to sports, most winning teams are usually widely admired and loved and they invariable enjoy the relentless support of countless fans around the world. We are not surprised to find that the New York Yankees, Manchester United, and the Los Angeles Lakers boast higher global popularity than the Kansas City Royals, Blackburn Rovers, or the Toronto Raptors. Predictably, winning games and titles earns you more friends.

In the case of derivatives, their impressive winning streak (in the form of unparalleled growth and innovation) has not received unquestionable amounts of praise or generated uncontested support. In fact, for the past fifteen years or so derivatives have been subject to constant attacks from many different influential pulpits. Journalists, regulators, hedge fund managers, legendary investors, and former investment bankers have all launched fierce attacks on the derivatives industry, accusing its products of being “tools of the devil”, “equivalent to crack cocaine”, and “financial weapons of mass destruction”. Bizzarely enough, the fiercest attacks have coincided with periods of incredible creativity and growth, such as the exotic options revolution in the early and mid-1990s or the credit derivatives boom of the early 2000s. Whatever happened to “everybody loves a winner”?.

Derivatives are despised by so many because so many have experienced losses, sometimes huge losses, through the use of derivatives. Of course, it is true that people also routinely lose their shirts in the cash markets (bond, stock, currency) and yet no one has asked for the banning of bonds, stocks, or currencies. What makes derivatives losses special is that they can be extremely large and extremely sudden (because of the leverage factor), and that the causes for the losses can seem deeply mysterious (because of the complex payout formulas of many products). And derivatives losses have a tendency to hit the headlines in force. Hurting entities tend to loudly blame somebody else, loudly call derivatives disrespectful names, fire senior executives, and sue the counterparty, alleging that they were misled into inappropriate transactions.

By now, we are all familiar with the names that are relentlessly voiced when trying to find reasons to attack derivatives: Metallgesellschaft, Procter&Gamble, Gibson Greetings, Orange County, Barings Bank, Sumitomo, NatWest Markets, LTCM, All-First Financial, Amaranth. All of these institutions lost very large amounts of money because of their dealings with derivatives. They all occupied the front pages for many days. They all gave observers plenty of reasons to develop an unfriendly view of derivatives. They all generated toxic publicity for the industry.

Derivatives insiders have mostly suffered in silence, concentrating more on devicing ever more sophisticated tools and on making ever larger amounts of money than on engaging in a public square debate as to the merits of the products. Derivatives lobbyists have also focused their attention on other matters, such as making sure that politicians do not mess with the cherished self-regulated aspect of the industry. Some people argue that what derivatives professionals need to do is borrow from the pro-gun folks and aggresively spread the message that “derivatives don´t kill people, people kill people”. The idea here is that derivatives per se are not the problem, but rather the way in which they are used. Improperly employed, they can unquestionably cause lots of damage. Properly used, they should be Ok.

The problem with this line of thought is that it is unnecessarily complicated. Who gets to decide on what a proper use of derivatives entails? In any case, and just like with the gun issue, nothing guarantees that that simple logo would assuage critics. Simply repeating that “derivatives don´t kill people, people kill people” is probably not the best way to calm heated tempers when faced with large losses and blood-thirsty demands for explanations.

A better approach for derivatives apologists would be to calmly explain that losses, including big ones, are just one of the natural, normal, and possible outcomes of any derivatives transaction, not matter how complex or simple it may seem. With derivatives you can win big, but you can also lose big. It´s just the nature of the game. When someone suffers a derivatives-induced setback, it doesn´t necessarily mean that something fraudulent, corrupt, or inappropriate was taking place. The hand of the devil had nothing to do with it. Once you decide to bind yourself to the contract, you become exposed to the possibility of suffering losses were the underlying market to go against you. If you didn´t know this beforehand, then you have only yourself to blame. If you knew it, and you are honest, then you shouldn´t whine when things turn sour.