Newsletter for w/c 13th October 2008: “Derivatives are financial weapons of mass destruction” is a famous Buffett aphorism and one with which many are familiar. What may not be so familiar is that he first coined the phrase back in 2003 in his annual letter to shareholders. He went on to argue that these highly complex financial instruments were time bombs which could harm not only their buyers and sellers, but the whole economic system. Having experienced the most frightening and hectic week since the second world war we can say that these bombs have now well and truly exploded. Exchanges as far apart as Brazil and Russia simply closed down, as governments attempted to stem the panic and fear. Interest rate cuts, bank bailout plans, the rush to safe haven assets all continued while the markets raged. As mentioned before economic data is irrelevant as the markets will continue their hysteria until at least the end of this month as governments and regulators try to prevent a complete meltdown of the global economy.
Despite the financial firestorm it is important to understand that derivatives such as futures, options and credit default swaps were originally developed to hedge risks in financial markets – that is – to buy insurance against market movements. Most traders and investors are familiar with futures and options but maybe less familiar with credit default swaps or CDSs. These were pioneered by J P Morgan back in the mid 1990s as insurance on debt, guaranteeing the holder his money in the event of a company going under. Typically they are bought to protect default on bonds, corporate debt and mortgage securities. The cost is priced as a percentage of the debt, and is measured in basis points (one-hundredth of a percentage point). Just like any other insurance product the riskier the debt the more expensive to insure that debt. By the middle of 2007 the market had grown to$45 trillion.
Crucially CDSs can also be used to measure the financial health of a bank or company. For example the price of a 5 year CDS in HBOS shot up when rumours began circulating that the bank was in trouble, the price only falling once it was announced that the Bank was to be taken over by Lloyds TSB. Until their recent collapse the three riskiest banks in Europe were the Icelandic trio of Landsbanki, Glitnir and Kaupthing. CDSs in Landsbanki were being priced at 3,000 basis points – the market view was that in order to insure £10m of debt investors would have to pay an additional £3m! It is hardly surprising these banks had to be nationalized by the Icelandic government.
Unfortunately, the problem does not end here because the entire CDS industry may be on the point of collapse. The reasons? First, unlike the banking sector, options and futures, this industry is unregulated and what started as a quick way to make stupendous amounts of money when economies and markets were booming, has now become a financial liability which will change forever the financial and political landscapes. As contracts were traded no one was making sure that the original holder actually had the assets to pay up in the event of a default and the fear now is that the insurers themselves may not have enough money to payout anyway. AIG’s recent write down of $11 billion was the biggest loss in the company’s history.
The impact of this problem will be felt by all of us because if this insurance disappears or becomes too expensive any kind of lending will become even more difficult to obtain for individuals and companies alike. The banking crisis is therefore far from over. It explains the frantic attempts of governments to shore up their national banks and the banking system with taxpayer funds. The restoration of confidence and, more importantly, the banks’ coffers has superseded any criticism of this plan of action. There is no Plan B. As individuals our priority must be to protect and preserve – shame this advice was not heeded by the banks, regulators and ultimately the politicians.
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