How Banks Took Derivatives Too Far

We’ve recently learned that major banks guaranteed the value of some of the derivatives they sold. Hedge funds were promised that if CDO interests that they bought fell below a certain value, the bank selling the interests would buy them back at a guaranteed price. Asset-backed commercial paper issued by bank-affiliated SIVs was 10% to 50% guaranteed by the banks sponsoring the SIVs.

More recently, it was reported in the Wall Street Journal (11/1/07, P. C3), that some money market funds that invest primarily in tax-exempt securities (i.e., municipal securities) bought short term, tax-exempt investments through so-called “tender-option bond programs.” These investments were derivatives synthesized from long term municipal bonds into short term investments that money market funds could purchase. Some of these synthetic instruments, however, were given low investment ratings, and Merrill Lynch, which underwrote these puppies, guaranteed to pay them if the underlying municipal bonds didn’t pay in full. Some money market funds, nervous about Merrill’s recently announced losses, have sold their holdings back to Merrill, not wanting to find out later whether its ability to honor its guarantee will hold up.

CDO interests; asset-backed commercial paper; now synthetic tax-exempt investments. All of a sudden, this isn’t very much fun any more. How much of the derivatives market have the banks guaranteed? Have they guaranteed other types of derivatives? Are their balance sheets and income statements accurate? Have they fully disclosed the risks from these guarantees? With all these contingent liabilities, are there questions about the safety and soundness of some major banks?

This adds to the cognitive dissonance already abundant in the financial markets. The Norman Rockwell version of the derivatives market is that it consists of a bunch of freckle-faced kids sipping frappes and trading contracts that repackage and shift risk to parties that choose to bear it. Volatility is supposedly damped. Market efficiency is supposedly enhanced. Smiles spread across many faces.

But these guarantees don’t shift risk. They retain it. The banks offering the guarantees were, in essence, giving the investors a put option, the ability to offload the derivative in case it turned out to be a turkey. Risk wasn’t shifted. Volatility, as we now know, has been exacerbated. Market efficiency, as we now know in spades, has been undermined by the credit crunch. Smiles are few and far between.

If these deals were so bad for the banks, then why did the banks do them? In a word: fees.

The banks got underwriting, advisory, servicing and perhaps other fees for doing derivatives offerings. Fee income came into vogue for commercial banks over the last 15 years, as risk-based capital requirements were gradually implemented. Banks were encouraged to offload the risks of commercial lending and make their money as intermediaries in the credit process. Fees were supposed to be a low risk way of making profits. That’s one of the reasons why you’re clobbered with charges for being one hour late in paying your monthly credit card statement, going $1 over your credit limit, and bouncing a check even one time after 10 years as a loyal customer. Banks love fee income, much more than they love having you as a customer. Investment banks love fee income, too, especially if they aren’t proprietary trading powerhouses.

Smackdowns of retail banking customers generate fees at a clip of $20 or $30 at a time. If you trample a large enough number of customers, it becomes real money. But derivatives deals provide millions of dollars of fees and other compensation per deal, a seemingly more efficient way to make money. Like moths drawn toward a flame, the banks moved into the derivatives market in their usual herd-like fashion, and did deals in abundance.

Evidently, they found the going tougher than expected. Some money managers, it would appear, realized that there were worms in them thar cans they were buying, and negotiated guarantees. The guarantor-banks, instead of selling derivatives, wound up selling put contracts for derivatives. This was a good deal for the money managers, who wound up with heads I win, tails you lose investments. But the guarantor-banks got lost on the way to Lake Wobegon.

Derivatives contracts can serve bona fide and valuable purposes when used in ways for which they were intended. But altering them so that they don’t really pass a lot of risk—transferring the upside, but not the downside isn’t much of a risk transfer—undermines the purpose of having a derivatives market. Suspicions arise that risk management got lost in the rush to record entries in that nice fee income category that would please stock market analysts and regulators. But risk, if unmanaged, remains coiled up, perhaps hard to see against the leaf cover on the forest floor, but ready to strike if the opportunity arises.

Derivatives have been taken too far. They’re not a magical instrument that will solve all problems in the financial markets. Like a socket wrench or a pair of pliers, they are tools, and nothing more. Like all tools, they must be used properly and wisely. Some shrinkage of the derivatives market, along with standardization of products and much greater transparency, would be a good thing.

Crime News: pet sitter that overfed potbellied pig charged with animal cruelty (no, we're not kidding). http://www.wtop.com/?nid=456&sid=1283269.