Day the time bombs went off

If this is the death of Wall Street as we know it, the tombstone will read: killed by complexity.

The complexity lies in modern markets’ love affair with derivatives — the financial contracts sold to the world as a way to reduce risk. Got too many mortgages on your balance sheet? No problem, slice them up, package them, sell them on. Worried about your trading partner defaulting? Buy some insurance. The possibilities are almost endless.

The gross value of outstanding derivatives is now counted in tens of trillions of dollars. A traditional backwater of the investment banking business has become a principal activity.

The underlying philosophy behind derivatives sounds terrific. The weak can get rid of risks they can’t handle and the financial system should be stronger as a result. In the right hands, derivatives can perform this role.

But the general practice is very different, as the great investor Warren Buffett worked out years ago. His 2002 letter to his Berkshire Hathaway shareholders made headlines by condemning derivatives as “financial weapons of mass destruction”. They were “time bombs, both for the parties that deal in them and the economic system”.

The passage comprised only a couple of pages of a lengthy letter but read it again today — it is the best guide to understanding how Wall Street has arrived at today’s mess.

Here is Buffett on General Re Securities, a derivatives dealer that Berkshire inherited with its purchase of insurer General Re. “At year-end (after 10 months of winding down its operation) it had 14 384 contracts outstanding, involving 672 counterparties around the world. Each contract has a plus or minus value derived from one or more reference items, including some of mind-boggling complexity. Valuing a portfolio like that, expert auditors could easily and honestly have widely varying opinions.”

Now take a look at Lehman Brothers’ balance sheet. On page 62 of last year’s accounts, under the heading “off balance sheet arrangements” you will find a staggering figure. Lehman had derivative contracts with a face value of $738-billion. The notes, fairly, make the point that the fair value is smaller than the notional amount — Lehman believed the figure was $36,8-billion. Even so, “mind-boggling complexity” perfectly describes Lehman’s accounts. How can you hope to sell such a business over a weekend? You can’t, unless the state is willing to underwrite the risk. This time, the US treasury said no.

Complexity breeds other faults, as Buffett described. Derivatives, because they are so hard to value, make it easier for traders and chief executives to inflate earnings. They exacerbate problems if a company, for unrelated reasons, suffers a credit downgrade that requires it to post collateral with counterparties — “a spiral that can lead to a corporate meltdown”, he wrote. They create a “daisy chain” of risk as the troubles of one company infect another because, ultimately, the value depends on the creditworthiness of the other party.

Buffett made a gloomy prediction half a decade ago. “The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear,” he said. “Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.”

That event has duly arrived. Lehman has declared bankruptcy, Merrill Lynch has rushed into the arms of Bank of America and the fate of AIG lies in the hands of the Fed.

Unwinding a big derivatives book is no easy task — like Hell, derivatives are easy to enter and impossible to exit, said Buffett. That is why the failure of a firm the size of Lehman presents such a risk to the financial system — we don’t know how many other firms will be brought down as the body is extracted from the financial web.

Financial regulators have huffed and puffed for years about the possible dangers posed by derivatives. Timothy Geithner, the Fed’s man in New York and the official who chaired the crisis summit on Lehman, wondered a couple of years ago whether their use might make financial crises less common, but more severe. He was right about the second bit.

There are, of course, many other contributors to the current financial crisis — years of cheap money, a housing bubble, and so on. But derivatives have helped to inflate these pressures because they have grown without proper rules on disclosure. They have allowed junk to accumulate in the system.

But financial regulators must now know what must happen in the long term. It’s time for them to force better disclosure. They didn’t last time, when hedge fund Long-Term Capital Management collapsed in 1998. This time really has to be different. —

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