The Failed Promise of Derivatives

Bond insurers MBIA and Ambac were downgraded today. Bank regulators again warned that banks should raise more capital since they will be facing more losses. Even though the stock market jumped today (over 200 points for the Dow), the financial sector remains weaken and may be weakening.

It wasn't supposed to be this way. Derivatives contracts were supposed to take risk and disperse it across a broad spectrum of investors, thus dampening the ups and downs of the financial markets. But they didn't. They created an illusion of risk management, which led Wall Street to discount the potential for losses. Normally, risk and reward walk hand-in-hand down Wall Street. The riskier the investment, the greater the chance of a big payoff. But if you can somehow offload the risk, then you can make big money with little chance of losses.

At least, that was the way it was supposed to work with derivatives. As things turned out, however, just about the entire Street wound up making a great, big, unhedged bet that real estate values would keep rising indefinitely. This was an easy bet to make if you don't think you can lose, and an enormous volume of very bad loans were made. Wall Streeters thought they had their risks covered--or dispersed, rather. But it turned out that the risks just slipped back to them in the complex network of exposures that the big financial players have with each other. Thus, the Street in actuality faces the really large amount of losses that are inevitable when one makes an enormous volume of very bad loans.

One crucial lesson to learn from this is that derivatives are nothing special. They have no magical qualities. They cannot lift the financial world out of the dust from whence it came. They are simply another financial product, as pedestrian as common stock and insurance. Common stock is an important element of corporate finance today. But its advantages and disadvantages are well-understood, and companies will borrow from banks or issue bonds if the cost of capital from borrowing is lower. Insurance is also an important financial product, one that transfers risk from a single insured to a pool of premium funds paid by all customers of an insurance company. But no one sees insurance as a panacea for the financial world's ills. Since premiums paid and risk transferred are normally closely connected, insurance usually can't be used as a means to make big money.

Derivatives will continue to have a market. Appropriately constructed, marketed, and priced, they can serve bona fide needs to transfer risk among informed and consenting market participants. But they can't effectuate an overall net reduction of risk and do not protect the financial system as a whole. The costs of risk have to land somewhere; derivatives, at best, only change the identity of the bearer of those costs. When derivatives are used to justify increasing the aggregate risks in the financial system, the financial system as a whole will pay the price. That is what has happened during the last year, and what is continuing now.

So the next time someone offers you an opportunity to buy a derivative, see it as nothing more exciting than another insurance product, or another potential stock investment. And, as far as regulation goes, regulating derivatives isn't any more controversial than regulating the stock market or insurance companies. Derivatives are just another financial product that aren't deserving of any special treatment or insulation from rules. If we stop viewing derivatives as some sort of magical elixir and use them only within the limits of their logic, they can continue to be valuable financial tools.