Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial
system. They have made it almost impossible for investors to understand and analyze our largest commercial
banks and investment banks. They allowed Fannie Mae and Freddie Mac to engage in massive misstatements of
earnings for years. So indecipherable were Freddie and Fannie that their federal regulator, OFHEO, whose more
than 100 employees had no job except the oversight of these two institutions, totally missed their cooking of the
books...
Improved “transparency” – a favorite remedy of politicians, commentators and financial regulators for
averting future train wrecks – won’t cure the problems that derivatives pose. I know of no reporting mechanism
that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives.
Auditors can’t audit these contracts, and regulators can’t regulate them. When I read the pages of “disclosure” in
10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don’t know what is
going on in their portfolios (and then I reach for some aspirin).
For a case study on regulatory effectiveness, let’s look harder at the Freddie and Fannie example.
These giant institutions were created by Congress, which retained control over them, dictating what they could
and could not do. To aid its oversight, Congress created OFHEO in 1992, admonishing it to make sure the two
behemoths were behaving themselves. With that move, Fannie and Freddie became the most intensely-regulated
companies of which I am aware, as measured by manpower assigned to the task.
On June 15, 2003, OFHEO (whose
annual reports are available on the Internet) sent its 2002 report to
Congress – specifically to its four bosses in the Senate and House, among them none other than Messrs. Sarbanes
and Oxley. The report’s 127 pages included a self-congratulatory cover-line: “Celebrating 10 Years of
Excellence.” The transmittal letter and report were delivered nine days after the CEO and CFO of Freddie had
resigned in disgrace and the COO had been fired. No mention of their departures was made in the letter, even
while the report concluded, as it always did, that “Both Enterprises were financially sound and well managed.”
In truth, both enterprises had engaged in massive accounting shenanigans for some time. Finally, in
2006, OFHEO issued a 340-page scathing chronicle of the sins of Fannie that, more or less, blamed the fiasco on
every party but – you guessed it – Congress and OFHEO...
A normal stock or bond trade is completed in a few days with one party getting its cash, the other its
securities. Counterparty risk therefore quickly disappears, which means credit problems can’t accumulate. This
rapid settlement process is key to maintaining the integrity of markets. That, in fact, is a reason for NYSE and
NASDAQ shortening the settlement period from five days to three days in 1995.
Derivatives contracts, in contrast, often go unsettled for years, or even decades, with counterparties
building up huge claims against each other. “Paper” assets and liabilities – often hard to quantify – become
important parts of financial statements though these items will not be validated for many years. Additionally, a
frightening web of mutual dependence develops among huge financial institutions. Receivables and payables by
the billions become concentrated in the hands of a few large dealers who are apt to be highly-leveraged in other
ways as well. Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal
disease: It’s not just whom you sleep with, but also whom they are sleeping with.
Sleeping around, to continue our metaphor, can actually be useful for large derivatives dealers because
it assures them government aid if trouble hits. In other words, only companies having problems that can infect
the entire neighborhood – I won’t mention names – are certain to become a concern of the state (an outcome, I’m
sad to say, that is proper). From this irritating reality comes The First Law of Corporate Survival for ambitious
CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply
won’t do; it’s mindboggling screw-ups that are required.
