Analysis managing the derivatives risk: 'weapons of mass destruction'? In the wrong hands, sure. But also essential financial tools - Finance

Chief Executive, The,  Jan-Feb, 2004  by Gregory J. Millman

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There will be another derivatives disaster, and it could happen in 2004. With interest rates and inflation at historic lows, someone, somewhere is probably using swaps or options to make a dumb bet on what looks like a sure thing. And history shows that bets on "sure things" can be some of the riskiest of gambles. But derivatives themselves aren't the problem. In fact, properly used, they're part of the solution.

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True, some very smart people are very worried about derivatives. Warren Buffett, in his annual letter to Berkshire Hathaway shareholders a year ago, famously called derivatives "financial weapons of mass destruction." Frank Partnoy, a former derivatives broker turned law school professor and author of the critically acclaimed Infectious Greed, raised an equally red flag. "A lot of corporate executives are scared to death of their derivatives exposure," he said in a recent interview with Chief Executive.

If Partnoy is right, there must be a lot of knees knocking in the C-suite. According to the International Swaps and Derivatives Association, 92 percent of the world's 500 largest corporations use derivatives. The trade group announced in September that the volume of basic interest-rate derivatives, the most widely used form of derivatives, had grown by roughly 25 percent during the first half of 2003, to what experts call a "notional principal" of $123.9 trillion. (The Swiss-based Bank for International Settlements, which also tracks the derivatives industry, reports a slightly lower figure; see charts, next page.)

The term can be misleading. Notional principal isn't actually money at risk, but rather a factor in determining the amount of protection a derivative provides. Suppose a bank sells an interest-rate protection to a corporation by offering to swap a fixed rate for a floating rate on a $10-million debt issue. The notional principal will be $10 million, but the only real risk is the difference between the fixed and floating rates. Even so, that bank will usually hedge its own risk by entering a swap with another bank. So instead of one swap with a notional principal of $10 million, there are two swaps with a total notional principal of $20 million. What's more, the second bank will probably hedge all or part of its risk. With rare exceptions, every participant in the derivatives markets is trying to take as little risk as possible.

There may be a lot of derivatives outstanding, but they haven't made the world a riskier place. In fact, thanks to derivatives, the financial world is a lot safer than it used to be. Most companies that use derivatives do so to protect themselves against potentially ruinous currency and interest-rate fluctuations. No one has even begun to quantify the potential damage these risks can inflict. But in the past they have wiped out entire companies, savaged whole industries, even sent sovereign nations down the financial drain.

Unlike some derivatives, these risks aren't remote or hard to understand. Any CEO whose company has a major Japanese or European competitor knows that a strong dollar poses a business risk. Any real estate or home-improvement company CEO knows that interest rates matter to the bottom line. Hedging of such interest-rate and currency risks accounts for the lion's share of corporate derivatives use. With all these derivatives sloshing around, it's reasonable to assume someone may be using derivatives to speculate recklessly. But, as Tanya Azarchs, managing director of financial services rating at Standard & Poor's, puts it: "It's a lot like a gun. The risk depends on the user."

In fact, derivatives have become so much a part of the global financial system that it is hard to imagine the system functioning without them. Sophisticated derivatives tools allow both financial and nonfinancial companies to examine their risks and make decisions about which ones to take and which to ensure against. In the past, a bank that offered a 30-year fixed-rate mortgage took an enormous risk. If rates fell, the borrower could prepay. If rates rose, the borrower could keep the low-interest-rate mortgage--and the bank would have to pay more for capital. That kind of mismatch helped cause the savings and loan crisis of the 1980s. Now, thanks to derivatives, lenders can hedge.

Derivatives also have made it possible for companies to tap new sources of capital at favorable rates. Corporations can issue bonds in the country or market whose interest rates are most favorable, and use derivatives to swap the debt into the currency they need. Recently, the emergence of credit derivatives has meant that a banker never has to say no to a corporate borrower, and may not even have to syndicate a big loan. The bank can make the loan and hedge the risk by using credit swaps--essentially, insurance against default. Who provides the insurance? Insurance companies are the market's biggest players; others include regional banks that might want a piece of a major company's credit but can't get through the door.