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

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The Fed's actions sent a clear signal to markets -- and the European central banks that had invested in LTCM -- that large, politically connected banks with exposure to losing derivatives trades would be protected. There is some evidence that this action contributed to the Enron debacle. For instance, a U.S. district judge in New York ruled that some Enron derivative trades were actually "disguised loans" from a bank previously involved in the LTCM affair.

"In the short run the intervention helped the shareholders and managers of LTCM to get a better deal for themselves than they would otherwise have obtained," economist Kevin Dowd has commented. "It implies a return to the discredited doctrine that the Fed should prevent the failure of large financial firms, which encourages irresponsible risk taking."

As Auburn economist Roger Garrison has put it, the Federal Reserve under Greenspan attempted to build a "firewall" protecting the "real" economy from financial shocks. But firewalls work both ways: To the extent that the rest of the economy is protected from financial shocks, the financial markets are also disconnected from the rest of the economy. With apparent protection against falling asset prices, investing on Wall Street began to look better and better compared to investing on Main Street, where one might lose one's money and not be bailed out. Wall Street trader James Canevari told us that the attitude on the street in the late '90s became: "With Easy Al and Trader Bob at the helm, you can take the risk factor out of your models."

It is unsurprising that investors would pay less attention to the exact nature of the risks they undertook as they came to believe they were protected on the downside when making risky, high-yield investments. Unsophisticated investors bought stock in a complex company like Enron, whose business they did not understand. If they tried to learn more from Enron's financial reports, they probably found the documents too abstruse to grasp, partly as a result of the very regulations designed to protect those ordinary investors. The government seemed to be offering a dual assurance -- that since it was keeping tabs on the markets, everything must be on the up and up; and that should any real disasters occur, it would step in to save the day.

It is telling that when the Enron scandal finally surfaced, the first reaction of many involved was to look to the government for help. Enron founder Ken Lay "called Treasury Secretary Paul O'Neill, Commerce Secretary Don Evans, Federal Reserve Chairman Alan Greenspan, and Robert McTeer, president of the Dallas Federal Reserve," according to Partnoy. Even Robert Rubin, now back in the private sector, attempted to intervene on Enron's behalf. Given the string of government bailouts in the wake of other financial collapses, it is not surprising that Enron's executives assumed their company would also be rescued.

Sound Vision

Derivatives meet important needs in the global economy. Like all financial instruments, they carry risk, and there can never be a guarantee that such risk will not have adverse consequences on a large scale.

But government regulators are not, generally speaking, in a better position than private investors to evaluate such risks. When regulations prevent or hinder transactions for which there is a genuine demand, they encourage the creation of securities designed simply for the purpose of dodging those regulations, in order to fulfill that demand.

In addition, when the government attempts to encourage the belief that financial markets are "safe" places to invest, it ends up attracting investors who are not prepared to properly evaluate the risks. This creates an interest group that will demand government redress when the investments don't work out. If fulfilled, those demands will encourage a new wave of risky speculation based on the seeming existence of government insurance on the downside. It is as though the government were granting investors free put options!

As in any innovative venture, there are significant risks involved with the fantastic voyage finance has undertaken in the last 20 years. But increased government intervention is likely only to heighten that risk.