Wednesday, July 25, 2007

The Derivatives Problem Wall Street Might Have Fixed

One of the largest, and least visible, of the financial markets is the derivatives market. Financial derivatives are contracts that "derive" (or measure) their value by reference to something else. A simple example is the stock option. The option gives its holder the right to purchase the stock on which it is based for a specified price within certain time parameters. The option's value is based primarily on the value of the underlying stock. If the stock increases in value, the option will generally increase in value. And if the stock decreases in value, the option will generally decrease in value.

A more sophisticated kind of financial derivative is the credit derivative. This is a contract that gives the holder protection against loss from defaults in the debt of a company or a country. For example, let's say an investor (usually a large institution) holds bonds of Company A. The investor decides to get some protection in case Company A can't repay its bonds. The investor can engage in a "credit-default swap," which is a transaction where another financial market participant (the "counterparty") agrees to take the risk of a default on Company A's bonds. In other words, the investor buys a kind of insurance against a default by Company A. In this sense, the credit derivatives contract resembles the credit life insurance that many mortgage borrowers are required to buy (if their downpayments are less than 20%)--if the borrower passes away, the credit life policy pays the mortgage loan.

Credit derivative transactions, until recently, were done largely by phone. There is no stock exchange floor, with people running around frantically and dropping slips of paper. There was no electronic quotation system, where bid and ask prices are displayed, and trades are reported. Setting aside the fact that many of the phones have new and strange ways of ringing, the credit derivatives market was much like the over-the-counter stock market of the 1920's and 1930's.

The credit derivatives market was virtually nonexistent ten years ago. Today, it is big--very big. It's reported to involve trillions of dollars of risk coverage, like maybe $35 trillion. Even at $5 a pop, that buys a lot of cups of coffee.

The credit derivatives market has had a wee problem stemming from its rapid growth. Recordkeeping wasn't given exactly the highest priority. Why does recordkeeping matter? After all, enough trees are being killed as it is. But the reason why recordkeeping matters is that records let you figure out who owns what. Today, almost all financial assets consist of entries on paper records or in computerized recordkeeping systems. The green stuff in your wallet is becoming less and less important. If the records aren't good, you don't know what you own. Think about how p.o.'d you'd be if you steadily and patiently saved and invested 10% or 15% of your income each year for 40 years, and then, upon reaching retirement age, found that your financial records were all messed up and you couldn't tell what you had. As boring and painful as it may be, recordkeeping is essential to a sound financial system.

What impact could recordkeeping problems have in the credit derivatives market? Recall the essential purpose of credit derivatives. If a company defaults, the bondholder or other debt holder who bought the default protection would turn to the counterparty on the contract (the insurer, if you will) and smile while extending an open hand. If, however, the counterparty says, "you can't prove I owe you anything because there's no record of the credit derivative transaction," then the bondholder enters a deep vat of yogurt. Lawsuits may be filed, but the only sure winners are lawyers.

In the fall of 2005, Federal Reserve officials got nervous about the recordkeeping in the credit derivatives market. Apparently there were something like 97,000 transactions that were unresolved more than 30 days after they supposedly occurred. As reported in the Wall Street Journal (9/15/05, p. C1), the Federal Reserve Bank of New York convened a meeting and invited 14 major financial institutions to attend. If you're an American financial institution, you never turn down an invitation from the Fed. The Fed had a little credit derivatives coffee klatsch. At the gathering, everyone agreed that they would do better about recordkeeping. Here's how they did, as reported in the press.

Wall Street Journal, Dec. 13, 2005 (P. C6): the 14 major financial firms aim to resolve at 30% of the backlog of open trades by January 31, 2006.

Wall Street Journal, Feb. 17, 2006 (P. C5): the New York Fed said that a 54% reduction in the open trades had been attained.

Wall Street Journal, Sept. 28, 2006 (P. C5): the New York Fed said that 70% of all open trades had been resolved and 85% of the open trades that hadn't been settled for over 30 days had been resolved.

It sounds pretty good. But it isn't entirely clear that all the open credit derivatives trades have been settled. If the counterparties for a small number of large credit derivatives trades cut and run when they should step up to the plate, large amounts of default insurance evaporate and things can become rather unpleasant. Further, there was also a problem of recordkeeping in the equity derivatives market (reported in the Wall Street Journal, Nov. 22, 2006, P. C4). Equity derivatives, as you might guess, are contracts where the risk of a stock, or a basket or index of stocks, falling is covered for a price. If the underlying stock or stocks fall, the counterparty has to compensate the holder of the equity derivative. The New York Fed had began pushing the financial firms to begin straightening out recordkeeping in the equity derivatives market, but it's not clear if those problems were resolved.

The bond markets are getting shakier, with the economy slowing, inflation threatening, consumers running out of home equity to spend, and the mortgage markets having fits. Some companies might not make it. There have been major companies that declared bankruptcy in recent years, which meant defaulting on their bonds. Collins & Aikman Corp. and Delphi Corp., two car parts manufacturers, are examples. One interesting vignette reported in the Wall Street Journal (Dec. 13, 2005, P. C6) is that when Delphi declared bankruptcy, it defaulted on $2 billion of bonds, but the resulting claims on credit derivatives contracts covered $28 billion. That suggests that a lot of people were using credit derivatives to speculate on whether or not Delphi would go in the tank. The ability to use these derivatives to speculate leverages the risks to market players and even the financial system from a big event like a major bankruptcy.

The stock market has been manic-depressive, being irrationally exuberant one day and jumping with a frayed bungee cord the next day. There's a lot of stress in the financial system and the stock market may be more likely to go down than up in the near future. If the market drops significantly or there are more bond defaults, some investors may end up trying to collect on their credit and equity derivatives contracts. If the recordkeeping isn't good, though, they may be in for some bad tummy aches. Recordkeeping cuts into Wall Street's profits. But a loss of investor confidence cuts much deeper. Time will tell whether we'll have a problem.

Strange News: If you're having a bad day, walk by the compliment machine.

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