In Defense of Derivatives

Between Enron, WorldCom, and Global Crossing, the controversial financial instruments have gotten a bad rap. Here's the truth.

Gene Callahan & Greg Kaza from the February 2004 issue

(Page 3 of 4)

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 re-sponded 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 banks 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."