The Devil's in the Derivatives

It’s not students who are facing the most important financial exam this fall. It’s Wall Street.

Andrew Winton, a popular finance professor at the University of Minnesota’s Carlson School of Management, is watching. The question of the day is how credit derivatives—the complex securities that financial innovators have designed and embraced so emphatically—will weather what Winton and many others say is shaping up as their first big appraisal. As much as anything, it was these instruments that turned today’s U.S. subprime mortgage crisis into a global concern shaking international financial markets.

Financial markets have proven themselves to be resilient in recent years. They bounced back from the Long-Term Capital Management crash and the twin traumas of a U.S. recession and the September 11 terrorist attacks in 2001. But they’ve never been tested by a downturn when derivatives are so intensely used.

“Credit derivatives haven’t really had a major test yet,” Winton says. “One could be coming with the credit crunch we are seeing.”

Derivatives are contracts that call for money to change hands at some future date, with their values determined by the performance of underlying assets, indexes, interest rates, exchange rates, or other investments. They derive their value from the assets underlying them: pools of mortgages, auto loans, credit card receivables, or other income-producing assets. Issuers, such as banks, bundle this debt together to create securities, often daunting in their complexity, that spread the risk from a single investor to hundreds of them scattered all over the world.

Winton, who is chairman of the Department of Finance at the Carlson School, is less outspoken about derivatives than legendary investor Warren Buffett, who called them “weapons of mass destruction”—time bombs that encourage fanciful accounting and inordinate risk, and can lead to corporate meltdowns and severe economic stress. But Winton shares some of his concerns. He also agrees with some of the worries voiced by hedge fund operator Richard Bookstaber, whose new book, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, has whipped up a buzz on Wall Street.

Credit derivatives have been growing explosively. The New York–based International Swaps and Derivatives Association, which aims to reduce sources of risk in the privately negotiated derivatives and risk management industry, says the notional amount of credit derivatives outstanding—the value of the underlying assets on which the derivatives are based—rose to $34.4 trillion at the end of 2006 from $2.2 trillion four years earlier.

The problem is that despite their capacity to spread risk, many credit derivatives carry high risks that are little understood by investors. That hadn’t mattered much when times were good. But this summer, when bad subprime loans contaminated the quality of securities widely believed to have been high grade, uneasy investors balked at trading them.

J.P. Morgan Chase senior economist James E. Glassman, interviewed when he visited Minneapolis early this fall, underscored the difficulty by recounting a story told to him recently by the CEO of a European bank. The CEO, himself puzzled by the “derivatives of derivatives” that his bank had put money into, asked his risk managers about them. They told him that investors, too, are confused. Glassman attributes much of the confusion to the fact that “we’ve created several degrees of separation between the investments and their underlying collateral.”