Derivatives Nightmare
The irony of derivatives is that when markets are booming, they can generate huge returns. This is why corporate managers love them. But equally large are the potential losses that can be incurred - losses that could explode like hundreds of ticking time bombs.
dailyreckoning.com
Martin Weiss, PhD
PALM BEACH GARDENS, Fla - As many nasty surprises lurk off the balance sheets of US companies as on the balance sheets. I'm talking about derivatives - typically high-leveraged transactions buried in the footnotes to financial statements.
It was mostly derivatives that took Enron down, transforming it from the country's seventh largest company into a bankrupt turkey. And it's these same transactions that now threaten to rip apart critical segments of our financial system.
Derivatives can be used to place side bets on virtually anything - interest rates, stocks, stock indexes, oil and gas, foreign currencies, and more. Or they are the pieces of traditional investments - such as mortgages - that have been split apart.
The irony of derivatives is that when markets are booming, they can generate huge returns. This is why corporate managers love them. But equally large are the potential losses that can be incurred - losses that could explode like hundreds of ticking time bombs.
Right now, the best estimate is that $24 trillion in derivatives lurk off the balance sheets of thousands of US companies. But the fact is, no one knows the exact figure - let alone how much money is actually at risk.
Derivatives trades are often not regulated. So it's almost impossible to know what's going on. That's truly unfortunate. Because derivatives trading affects everyone - whether you're directly involved or not. Examples:
* When Enron went bust, an estimated 45 companies felt the effects, absorbing tremendous losses. J.P. Morgan Chase lost $1 billion from Enron. Bank of America and Citigroup - $500 million each. Hartford Insurance Group - $92 million. Principal Financial Group - $171 million. Dallas-based electricity and natural gas producer TXU - $20 million. The list grows daily.
* Separately, GM was carrying a net open loss of $392 million on derivatives in the third quarter, according to a recent financial release from the company. This is the last thing GM needs as it slashes prices and auto loan rates to lure in reluctant shoppers.
* Upscale hotel operator Wyndham International lost over $37 million on derivatives in the third quarter, compounding its $82 million loss for the period.
How The Derivatives Time Bomb Can Explode
According to the US General Accounting Office (GAO), there are three major risks that can sour derivatives trades; and all three could surface in the months ahead.
Suppose you bet with your neighbor that Microsoft shares are going up. You each put up $10,000.
Three things can go wrong: First, Microsoft shares could go down, and you'd lose. Second, your neighbor could go broke and never make good on the bet. And third, the stock market mechanism itself could be impaired, making it impossible to trade Microsoft shares. Major derivatives players face the same kinds of risks:
1. Market Risk
If the market goes the wrong way, the investor loses. Period. And in highly leveraged derivatives, the risks are multiplied. What appears to be a promising, paper profit can suddenly turn into a giant loss, almost overnight.
In 1994, a large Canadian insurer, Confederation Life, was playing with high-risk derivatives, supposedly as a routine hedge for its investments. But when the market moved against its trades, the losses drove the company out of business in a matter of weeks.
In that same year, Orange County, California, was forced to file for bankruptcy after losing $2 billion in a derivatives strategy.
In 1998, a private hedge fund, Long-Term Capital Management, was betting on the debt of emerging nations. When Russia defaulted, gargantuan losses drove the company into a fatal tailspin, disrupting every major financial market in the world.
Today, the risk of sudden and unexpected market turns is probably the greatest ever. Stocks are experiencing some of their wildest swings since the 1930s. Foreign currencies are going haywire.
Long-term interest rates are also swinging wildly. Witness, for example, the recent 11-point plunge in long-term US Treasury bonds, the worst since 1996.
All of this adds up to a rash of possible derivatives losses in 2002.
2. Credit risk
When you buy or sell on a regulated exchange, the exchange takes care of the due diligence to ensure that the buyers and sellers are creditworthy. Not so in the derivatives markets where trillions are traded on largely unregulated, over-the-counter markets!
In these transactions, the contracting parties are largely responsible for the risks - directly and privately. They do what they can to check the credit of their trading partners, but it is never enough.
If the other side defaults on a trade, all heck breaks loose, leading to a possible chain reaction of losses, defaults, and bankruptcies. Enron alone affected dozens of companies that were on the other side of its derivatives investments, and the estimated losses may stretch into the billions of dollars.
Look. Right now, we are already experiencing the worst debt debacles since the 1990s recession. The credit ratings of a whopping 616 companies were downgraded last year. It's a downright dangerous time to take on big market risk.
And yet, that's exactly what large corporations and banks are doing. Many see speculation in derivatives as the only way to compensate for big losses in operations. So instead of cutting back on the risk-taking of their traders, they actually encourage more.
3. System Risk
In a worldwide crisis, when prices begin to fluctuate wildly, the risk can be so great that even the strong, well-capitalized players withdraw from the derivatives market. And when that happens, they can virtually shut down the system.
The key is the large banks and brokers that literally make the market for derivatives. Without them, there is no market. It just goes dead, potentially trapping the other players into unwanted positions for which they can find no takers.
This Disaster Has Happened - Or Came Close To Happening - Several Times Before
In 1980, long-term US Government bond prices were falling so dramatically, most major government securities dealers withdrew from the market. Suddenly, it became next to impossible for the US Treasury to raise the money it needed to finance the government.
During the European currency crisis of 1985, the Crash of 1987, the Asian crisis of 1997, and the Russian debt default of 1998, we saw a similar phenomenon.
These events involved more than just a collapse in prices. The actual market structure itself was on the verge of collapsing.
The players feared losses on a rash of "busted transactions." So they recoiled in horror and moved to the sidelines. This can happen again, very soon.
If, for example, the derivatives market for Latin American currencies shuts down, major exporters would not be able to hedge their business against devaluation, such as in Argentina's peso. They'd have to refrain from all new business, dooming much of Latin America to a fate equal, or worse, than Argentina's.
If the derivatives market for US money markets is paralyzed, it would be far worse.
Banks, insurance companies, mortgage lenders, and financial institutions of all kinds would be hard-pressed to hedge against the next swing in interest rates. New lending would come to a standstill. Credit-starved companies would go bankrupt like a row of dominoes.
The Nation's Leading Advocate For Financial Safety
Martin D. Weiss, PhD, is the nation's leading advocate for financial safety. He has helped millions of Americans with his ratings of stocks, mutual funds, insurance companies, banks, brokerage firms and HMOs. And he has testified before Congress repeatedly, advocating full disclosure of risk to investors.
That's why Forbes has called Martin Weiss "Mr. Independence," the Wall Street Journal says he runs a "feisty firm," and the Esquire noted that his is "the only company ... that provides financial grades free of any possible conflict of interest." |
