The Derivatives Mess

I meant to post this earlier. This WSJ article highlights the problems of the growth of derivatives on Wall Street.

Derivatives allow banks, companies and investors to transfer financial risk, much as homeowners buy insurance to shift the risk of repairing fire damage to an insurer. In the simplest form, Joe’s Manufacturing Inc. borrows $5 million at an interest rate that moves up and down with market rates, and then cuts a deal with Frank’s Investment Bank in which Joe promises to pay a fixed rate and Frank pays the variable rate.
The subspecies known as credit-default swaps allow banks that have lent money to, say, General Motors Corp. to shift risk of default to a risk-loving investor for a fee. As the market has evolved and drawn speculators, as well as banks looking to lay off risk, investors now place bets not only on individual firms, but on baskets of credits and on risks sliced and diced in increasingly complex ways.
You would think that Wall Street would have computerized this when the market started taking off a few years ago. But deals were, and often still are, done by telephone and fax. Detailed confirmations, important in avoiding nettlesome disputes later, weren’t completed. One firm confessed in June that it had 18,000 undocumented trades, several thousand of which had been languishing in the back office for more than 90 days. It wasn’t unusual.
That’s not all. One party to a two-party deal was routinely turning obligations over to a third party without telling the first one. It was as if you lent money to your brother-in-law and later learned that he had passed the debt to his deadbeat cousin without so much as an email. “When I realized how widespread that was, I was horrified,” says Gerald Corrigan, a former New York Fed president now at Goldman Sachs. “What it meant was that if you and I did a trade, and you assigned it without my knowing it, I thought you were my counterparty — but you weren’t.”
In LTCM’s case, each player knew the dimensions of its exposure; no one realized how exposed other firms were and how fragile LTCM’s strategy was. In the case of credit derivatives, the problem has been worse: Record-keeping, documentation and other practices have been so sloppy that no firm could be sure how much risk it was taking or with whom it had a deal. That’s a particularly embarrassing problem for an industry that has resisted regulation of derivatives by arguing that big firms would police each other.
Stocks, bonds and options traded on exchanges go through clearinghouses, which pick up the pieces when something goes awry with a trade. In this market, there’s no clearinghouse yet. Until recently, dealers didn’t even enter most credit-default-swap trades into a computer database to be sure both sides agreed on the terms.
Mr. Geithner, the Paul Revere of this story, began shouting about all of this before the end of his first year on the job. In an October 2004 speech, he noted that inadequate financial plumbing was “a potential source of uncertainty that can complicate how counterparties and markets respond in conditions of stress.” That’s central-bank speak for: The car is careening down the highway at 85 miles an hour and the lug nuts aren’t tight. If we hit a pothole, look out!

Posted by on February 28th, 2006 at 10:02 am

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