Contracts So Complex They Imperil the System
February 24, 2002
By DANIEL ALTMAN
Can what we don't know hurt us?
Though trading in those devilishly complex financial tools known as derivatives did not contribute much to Enron (news/quote)'s collapse, the contracts did allow the company to conceal the aims of its financial dealings. The veil of complexity, whose weave is tightening as sophisticated derivatives evolve and proliferate, poses subtle risks to the financial system — risks that are impossible to quantify, sometimes even to identify.
"This Enron situation poses a challenge to the traditional notion of systemic risk," said Henry T. C. Hu, a law and finance professor at the University of Texas who serves on the legal advisory board of the National Association of Securities Dealers. Traditionally, Professor Hu said, worries about derivatives centered on the intricate "daisy chain" of linkages they constructed among banks, brokerage firms and other financial institutions — a potential danger in times of crisis. Now, he said, "complexity provides cover for people who may be tempted by the wrong motives."
Enron certainly used complexity to its advantage, as regulators, investors and, yes, journalists have discovered while trying to disentangle its financial web. And as they stepped through Enron's looking glass into this new world of risk and dissimulation, they raised awareness of yet another potential problem for the financial system.
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Unlike markets for stocks, bonds and commodities, where the assets traded and the details of those trades are easy to understand, the derivatives market is hardly transparent. The terms specified in a derivative contract can take up scores of pages of text, and trading is not always public. Yet abuse of derivatives could still have real and widespread effects, even for people with no money in the markets.
When companies that rack up huge hidden debts and traders who illicitly amass mountains of risk are exposed, Wall Street's big players rush to cut their losses and collect on their debts. If that kind of rush were ever to result in a shortage of cash, it would paralyze the financial system. Stock markets would tumble and banks would close, putting the savings of households at risk.
In their simplest definition, derivatives are contracts that promise payments from one investor, or "counterparty," to another, depending on future events. Those events can be as ephemeral as changes in the prices of securities or commodities from which the contracts are derived — hence the name — or as concrete as weather changes (which Enron turned into a booming business).
The contracts' payments are usually calculated in relation to the value of some underlying asset, like a bond or a shipment of oil. In June, according to the Bank for International Settlements, the over- the-counter market for derivatives consisted of contracts based on $100 trillion in underlying assets — about twice the value of all the goods and services produced by the entire world in a year, and a 38 percent increase in size since 1998.
Billions in derivatives contracts can hang on the share price of a single stock, and a single firm's portfolio of derivatives can link the fortunes of all the world's major financial institutions.
For those reasons, market watchers sometimes worry about the risk that a crisis in one company or sector could bring the entire financial system to its knees.
The world last awakened to worries about systemic risk when Long-Term Capital Management, the star-studded hedge fund, lost some big bets and had to be rescued by a coalition of banks in 1998. Since then, the dozens of banks that have a stake in most derivatives trades have become more careful to balance their risks, often using still more derivatives.
"The banks do diversify their positions," said Robert H. Litzenberger, an advisory director at Goldman, Sachs who recently retired from overseeing risk policy at the firm. "The big counterparties where you'd be concerned about systemic risk are able to use credit derivatives to protect themselves."
Banks and other financial institutions are alone in having to disclose their derivative positions. Their internal monitoring cuts down on the traditional kind of systemic risk, said Timothy S. Wilson, an executive director at Morgan Stanley responsible for risk policy. "Derivatives are generally subject to more rigorous risk management than most traditional banking products," he said.
Most banks risk less in derivatives markets than by lending money, he asserted: "The exposures of each firm are carefully monitored by its credit risk department, and limits are set to prevent those exposures' becoming large relative to capital."
Moreover, said Larry Promisel, a finance expert who worked at the Federal Reserve Board for 30 years, derivatives trades — when used in moderation — pose little risk of destroying entire markets because they always have winners as well as losers. "If one person loses, another is gaining, unlike pure credit risk," he said. "If you're taking a bet on a price movement, and it goes the wrong way, it's going the right way for someone else."
Complexity has added to derivatives' usefulness, he said. "It allows people to take on precisely the risk they want," he said. But complexity could be a double-edged sword.
Michael R. Darby, a finance professor at the University of California at Los Angeles, puts it this way: "Do the products have the ability to offset risk through a true hedge? Yes. Do they have a potential for accounting abuses or trading abuses? Yes."
Those abuses may add up to a new kind of systemic risk. "Complexity allowed Enron to hide the true picture from the capital markets," Professor Hu said. For example, derivatives can replace traditional transactions in the name of secrecy. Enron took advantage of that, using derivatives trades to hide loans from Wall Street banks in inscrutable parts of its balance sheet.
"They're setting up these Rube Goldberg-like contraptions to do very simple things," Professor Hu said of the financial engineers who create new derivatives. Individuals and firms that design and sell different kinds of derivatives have an incentive to make them as complicated and confusing as possible, he added. "The more bells and whistles you have, the more you can charge."
Those bells and whistles also hurt the financial system by reducing the transparency of a company's activities for outsiders. Yet even a company's own directors might not understand its derivatives portfolio, Mr. Promisel said. "Boards shouldn't allow transactions they don't understand," he said. "That doesn't mean people don't do it."
With a loss of transparency comes a loss in confidence, as evidenced by the fallout from Enron's downfall. Outside the financial sector companies' use of derivatives is mostly unregulated and is believed to have increased sharply in the last few years. Such companies have deservedly received more scrutiny from analysts of late, Professor Darby said. "Nonfinancial firms that convert themselves into financial firms are at probably the biggest risk, because they don't have the traditional enforcement, and the board may be particularly ignorant."
Enron, in fact, prided itself on being "asset light," and during its fall was even tagged by some analysts as being more a hedge fund than a company dealing in real goods.
Still, Professor Darby said, nonfinancial companies can run their derivatives portfolios responsibly. General Electric (news/quote), he said, has done a better job of monitoring and managing its trades than Enron did.
Mr. Promisel offered a simple test for whether a company's derivatives trading could pass muster: "If a chief financial officer can't understand a transaction that one of their people brings to them, they shouldn't be doing it."
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Another component of the incentive problem, Professor Hu said, is the enormous amount of money that can be reaped from a single transaction using derivatives. For the health of the financial system, he said, "you cannot have a system where you could create a lifetime wealth through one or two transactions."
Ethical conduct therefore occupies the central role in stemming systemic risk in derivatives markets. "In most cases, the accidents and negative fallout that have surrounded some derivatives episodes have been due to a lack of risk controls in the firms that have precipitated the events," said William C. Hunter, director of research at the Federal Reserve Bank of Chicago.
Mr. Hunter said he believes that the derivatives market will continue to grow and develop new kinds of contracts. But after Long-Term Capital's fall, companies put limits on trading volumes and exposure to specific types of risk. Those limits, he said, along with a shift in the focus of bank regulation from rule-making to risk-monitoring, should minimize crises. Each transaction involving a complex derivative should undergo careful examination, he added. "The more complex the set of transactions, the more due diligence that's going to have to be applied both by internal management and external counterparties," he said. "It does make for more complicated systems that are needed to monitor and appraise the risks."
Institutions that did business with Enron, Mr. Litzenberger said, overestimated its trustworthiness: "The biggest problem with Enron was the credibility of your counterparty."
Because Enron was an unregulated derivatives trader, its activity was limited only by what the market allowed. And, as Professor Hu said, "market discipline works less well when you're talking about a company that seems to be not only assets- light but ethics-light."
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