DERIVING MORAL HAZARD IN DERIVATIVES

Buffett's Hathaway Trust profit was at $2bn down $1.3bn mid-2010 because of losses on derivatives. In 2008, the majority ($5bn) of JP Morgan's profit, and a third ($15bn) of Goldman Sach's in 2009 came from derivatives.
But, these will mainly be unrealised profit/loss. Banks may use paper profits to pay dividends, bonuses and fund share buy-backs, just as they may use paper losses to offset tax liabilities. This is so for all unrealised profit/loss and is treated no differently from realised profit/loss.
It would be interesting if we had a full-scale enquiry into the growth and role of financial derivatives. When derivatives profits are generated, who is bearing the counterpart losses? Is there too much concentration of derivatives among too few banks who can then bias the pricing of contracts? Would an exchange-traded system be fairer and a better market? Are derivatives far too big and dangerously so?
Derivatives are used for:
- high leverage/gearing, so a small movement in the underlying price causes a large difference in the contract value (not notional value) of the derivative, the gain to the investment price of the derivative contract (that can be a 100 times smaller than the notional value of the underlying)
- speculate to make a profit if the value of the underlying asset moves the way expected (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level) including falling in price that can be captured by short selling or an option
- hedge or mitigate risk in the underlying, by a contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out
- obtain exposure to an underlying that is not tradable e.g., weather derivatives, or without any actual connection to the underlying e.g. spread-betting
- optionability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a specific trigger price level).
A derivative is a contract between two parties with options to buy or sell (call or put) or an insurance cover or guarantee with a contract value based on the underlying's past (VaR estimate) and future price fluctuations in the 'cash market' (by which is meant any primary or secondary market trading the underlying directly), with the most notable being currency, interest rate, credit swaps, futures, and options generally. A derivative can be a derivation of any financial security, the scope is therefore endless. If we think vertically, then derivatives are the pricing and trading of contracts in all of, or only part of, underlying financial 'instruments' (tradable securities).
The underlying can have several features such as principle and interest, share and dividend, investment and return, and these elements can be separated and covered by derivatives.
Derivatives are therefore a combinations of insurance and speculative highly leveraged betting. It is the leverage available that appears to create moral hazard. When banks in the USA and UK were generating 45% of all corporate profits, some serious urgent thinking was required about the imbalance this created in the economy. and the moral hazard of any one sector making so much out of so little?
In insurance it is axiomatic that insurers have to keep an eye on the fundamentals, on the risk factors that trigger insurance claims. In banking where loans are not tradable or readily insurable, bankers also have to keep an eye on fundamentals. In both insurance and traditional bank lending a 'portfolio' risk margin is added to the cost of capital (deposit and funding rate) plus a profit margin. These margins only secure against expected 'normal' (through-the-cycle) defaults and claims and must also be competitive!
But, with the growth in reinsurance, securitisations of loan-books, loan insurance, property as collateral in a rising market, and credit derivatives, banks and some insurers could be more aggressive in their competitive pricing and ignore the fundamentals. Insofar as these 'derivatives' appeared to absorb all risks, and as decisions were increasingly automated, bankers and insurers became intellectually lazy, more specialised (narrow-focus), mere cogs, short term, and less truly customer-service oriented.
When the whole is impossibly complex and risky, the particular seems straightforward and safe.
Wholesale markets of secondary and tertiary traders and sub-insurers grew up where each would buy part of the risk and part of the premium and find ever new ways of leveraging large bets with small stakes. The portfolio principle operated in that the more any insurer or bank or investor could diversify their risks then the lower the probability of any big single loss at any one moment in time. But, on the same principle as the Adam Smith pin-factory, the Taylorist model, the Ford factory, banks and insurers divided their business into discrete specialised profit-centres where none could diversify except by use of derivatives. Since the late 1980s the fashion developed to see banking and insurance as a series of discrete processes that could learn from other industries like Fed-Ex for back office processing or Wal-Mart for retail selling or Visa for payments processing. Banks, insurers, universal banks and bancassurers became conglomerates of discrete businesses sharing an increasingly tenuous management control.
Where a management could manage one type of business such as a logistics business, a big bank's management could not manage a combination of many logistics, retail and wholesaling businesses. This is the best argument for breaking up the banks between retail and wholesale for example. But there are also counter-arguments, and these concern risk diversification. It is valid to say that a financial conglomerate is more diverse when it diversifies across all financial services. But, that does not mean it is diversified across all of the underlying economy and it begs the question of whether banking conglomerates know how to monitor and manage that diversification and if supervisory regulators and central banks know how to assess the matter.
The risk diversification of the whole has to be organised by the executive with effective oversight by the supervisory boards, followed by that of regulatory law, supervisors, and to some extent mutual members or shareholders and bondholders.
Derivatives grew at first with 'hedging'. Buyers of commodities could insure future prices they would get by buying simultaneous contracts to buy and to sell a commodity at or by a future date. Such contracts later developed for 'smoothing', rarely discussed, to place a limit on the impact on a firm, a long term contract, a project or a portfolio of interest or currency exchange or other price movements.
A big development since the 1990s was to use derivatives as a way of trading in or out of large 'cash' positions in the equities and bonds markets. To protect against triggering a large price change when selling a lot of shares of one stock or of many stocks the price impacts could be hedged in derivatives, or alternatively a loss in the cash market compensated by a profit in derivatives.
Once this awareness took root and institutions could use derivatives, hedging became matched and then eclipsed by speculative use of derivatives. Stock lending and repo swaps grew, and margin collateral to leverage loans, trade and investment volumes. And, just as odds on horses in a horse-race are directly influenced by punters' perceptions of the favourites to win, so too were prices of derivatives influenced by speculation as much as by hedging.
This is the only argument for not making over-the-counter derivatives exchange-traded unless you believe that just like in horse-races the market knows best and the balance of speculation is therefore intelligent pricing information.
In time the pricing of derivative in what appeared to be far more liquid markets came to influence the prices of the underlying instead of the other way about. Financial markets are not like horse-races, and not because in horse-racing you lose all of your stake, because you do that in derivatives, but because financial markets trade in price movements directly and this is equivalent to the flow of betting becoming a large determining factor in who wins the races.
But, unlike organised horse-races or fictional stories, financial markets do not have a beginning, middle and end, other than quarterly and annual reporting; punters can enter and leave with profit or loss at any time they choose!
Derivatives are like insurance, but also insurance that can dictate the price of the insured asset. As the cost of insuring certain loans rises or falls, such as in the Credit Derivative Spread, the value of those loans at market prices falls or rises. Rating Agencies have a major role in grading the riskiness of assets but are also led by perceptions in the markets, not what they are trusted to do, to focus only on fundamentals, hard when forecasting risk is required.
One of the outcomes of banks and others buying derivatives as insurance and as speculation is a growing disinterest in fundamental risk drivers.
If the price of buying insurance or the financial risk of derivatives speculation appears low relative to potential saving or gain, then why worry about fundamental micro or macro economic forecasting.
This is why banks have eshewed the advice of applied macro-economists in favour of mathematicians - all very well until there is a recession, and not a problem then unless there is a systemic collapse in the finance sector as a whole causing the great complexity of derivatives and derivatives of derivatives to fail to be honoured and fall apart, which is the Credit Crunch, but also The Great Wall Street Crash and several other spectacular collapses in economic history.
At a bank with an equally large insurance business where I was head of credit risk for both, I recall being asked a year before the Credit Crunch started and feeling perplexed by the board to evaluate all the bank's major insurers and reinsurers; are they sound, are we diversified or over-concentrated with any one firm, and what are our exposures to insurers individually and collectively? I'd known the problems at Lloyds of London in the 1990s, but the scale and risk of credit derivatives were at that time unknown to me. My view was that so long as we are aligned with what everyone else is doing and trusting we are not doing anything foolish - until I looked more carefully into the matter.
Derivatives are not stand-alone, but many other financial assets that are 'stand alone' have their prices influenced by the relative prices of other assets. In some respects all financial instruments are in part derivatives of each other, just as all assets are variously derivatives of loans or liabilities are derivatives of deposits, and assets and deposits influence each other.
The commonplace derivatives are swaps, futures and options, but in credit it is a form of insurance. My main concern at the bank and insurer was exposure to property and to the credit and economic cycle. I did not foresee the collapse of the wholesale funding market, partly because my bank did not operate on a highly leveraged balance sheet with a large funding gap and it did not have share-holders. But it did have 3% of the UK banking and 3% of the UK insurance markets, which is sufficiently substantial that it could not hide or withdraw from macro-economic consequences. It survived the credit crunch unscathed and coped well with recession, doubling its size with a judicious takeover.