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Friday, Nov 27, 2009
The term "derivatives" is used to describe a class of financial contracts that are derived from another asset and priced according to that asset's value. Also known as a form of "risk management," over the past 20 years derivatives trading has become increasingly popular on Wall Street as a way to "hedge" risk; to protect yourself from an investment bet that goes sour or from swings in interest rates or currency prices. Over the course of those 20 years, the debate on whether to regulate such trading has been one of the more abstruse battlegrounds between Washington and Wall Street -- and Enron has been a major player in that fight.
One of the first derivatives to gain popularity in the newly deregulated financial markets of the 1980s was the "interest-rate swap," which takes its value from underlying loans. Interest-rate swaps allow a bank that has, for example, a majority of variable rate loans to protect against the risk of falling interest rates -- which would decrease borrowers' payments and thus bank profits -- by "swapping" the loans for fixed rate debts held by another bank. The actual loans never change hands; the contract allows the banks to trade only the interest-rate risks, with the price of the deal being determined by the size of the loans and the probability of interest-rate fluctuations. If it looks like the Federal Reserve will raise rates, the fixed-rate bank will pay a higher premium. But if the Fed signals a cut, the bank with a high level of variable rate loans will pay a larger fee.
New kinds of derivatives are constantly being dreamed up by everyone from Nobel Prize laureates to MBAs fresh from the finest business schools. It is hardly an exaggeration to call derivatives the cutting edge of capitalism, the fanciest way humans have yet devised to gamble for big bucks. Credit derivatives, specifically, are one of the more recent products of this high-finance drive to innovate. For a company like Enron, which considered itself able and willing to trade anything, bankruptcy protection was just another commodity.
Dreamed up about 10 years ago in order to protect banks from risky borrowers, credit derivatives extended the concept of risk trading to all forms of credit risk, not just interest rates. They grew from a simple mix of reality and logic: "When you have a portfolio of loans, some are strong and some are weak," says Kathryn Dick, director of treasury and market risk for the Office of the Comptroller of the Currency, a division of the Federal Reserve. "Trying to keep a good balance, that's what started the thinking that became credit derivatives."
Large investment banks, led by J.P. Morgan, began to tout the idea in the early '90s. The first "products" focused specifically on bank loans. "Credit default swaps," for example, gave a bank in the Midwest that had mostly manufacturing loans -- which are especially sensitive to business cycles -- the ability to insure its debt by paying a New York bank to take on the risk of default. If the borrower couldn't pay, the New York bank ponied up the cash.
Each player in this equation has an incentive to make a deal. The mediator, or trader, bringing both sides together picks up a percentage of the price paid; the firm buying protection gains the ability to extend more credit without holding onto the risk, while the firm selling protection brings in extra cash by agreeing to cover for loans that it thinks it won't have to cover.
Banks also enjoy other advantages from the use of credit derivatives. If a bank sells a loan to another bank -- an older way to get rid of risk -- it then must inform the borrower that the loan has been picked up by another party. But because credit derivatives are not actual assets but rather meta-level contracts, lenders can keep the loans on their books without telling borrowers what's going on behind the scenes.
"One of the reasons that banks like credit derivatives is because of the way that the financial world has evolved," says Dick. "Banks now have very large corporate clients. They don't want to keep all of that exposure, but they want to maintain a relationship with the client. Credit derivatives let them do that."
Even with these incentives, many banks at first hesitated to buy or sell protection on their own loans, bonds or other securities. The pricing models were untested. The laws surrounding the new product remained murky. The Commodities Futures Trading Commission had exempted credit derivatives and other swaps from federal oversight in 1993, but because each contract was tailor-made to the deal at hand (instead of traded on a formal or over-the-counter exchange), the language of the contracts tended to vary too much for the bankers' tastes. It wasn't clear what would hold up in court in the case of a "credit event" like a bankruptcy.
"The problem with the market then [in the mid-'90s] was that the contracts were all different," says Mickey Mandelbaum, a spokesman for Morgan Stanley, which began researching credit derivatives in 1994. "There was a big joke that the busiest person on the derivatives desk was the lawyer."
