Derivatives: No need to worry about?

Michael Lewis does not think very highly of the worrywarts at the World Economic Forum in Davos last week. From his latest Bloomberg article entitled "Davos Is for Wimps, Ninnies, Pointless Skeptics":

It's become almost obligatory for the world's most important economic people, at the beginning of each year, to travel joylessly to the base of a Swiss ski slope and worry. And to worry not privately, with dignity, but publicly, to anyone who will listen...

Derivatives seem to be this year's case in point. Davos had hardly been up and groaning about the dangers of being alive before Bloomberg News reported what appears to be the general Davosian view: "The surging demand for derivatives is making financial markets more vulnerable to any slowdown in the global economy."

The piece came with supporting quotes from European Central Bank President Jean-Claude Trichet, Bank of China Vice President Zhu Min and the deputy chief of India's planning commission, Montek Singh Ahluwalia -- but not a worrisome fact in sight. None of them seemed to understand that when you create a derivative you don't add to the sum total of risk in the financial world; you merely create a means for redistributing that risk. They have no evidence that financial risk is being redistributed in ways we should all worry about. They're just -- worried.

But the most striking thing about the growing derivatives markets is the stability that has come with them. More than eight years ago, after Long-Term Capital Management blew up and lost a few billion dollars, the Federal Reserve had to be wheeled in to save capitalism as we know it.

Last year Amaranth Advisors blew up, lost more than LTCM, and the financial markets hardly batted an eyelash...

But perhaps Lewis should spend less time insulting Davos attendees and spend more time understanding the true risks involved. Felix Salmon's post at the Economonitor could be a start.

[A]s the number of entities playing in the derivatives market increases, the total counterparty risk in the system surely increases at the same rate.

And finally, when banks use derivatives to move risk off their balance sheets, that generally just frees them up to take on even more risk.

Or this article from FT by Richard Beales and Paul J Davies:

Steven Smith, head of restructuring at UBS, says credit problems can creep up unnoticed. He recalls a character in Hemingway's novel The Sun Also Rises being asked how he had gone bankrupt. "Two ways," came the response. "Gradually and then suddenly."

That sudden turn has not yet happened in the global credit cycle...

In fact, the opposite happened. By the end of 2006, companies could borrow more cheaply than ever before, with those lending them money apparently almost oblivious to the credit risk they were taking on...

Meanwhile, a wave of innovation in debt markets has produced new, often complex products that have brought new investors into the market... On top of that, the use of credit derivatives...has exploded... But some believe such developments have created complacency about risks - leading investors to employ ever-higher levels of leverage and pumping up global liquidity even further.

Now a number of pundits even speak of the end of the credit cycle, arguing that the new breadth and depth of credit markets means future booms and busts will be more muted than in the past. Others fear that the upswing in the cycle has simply been extended artificially by the glut of liquidity and, when the cycle does turn, the impact will be more painful than in the past...

Martin Fridson, publisher of the Leverage World research periodical, believes financial institutions and hedge funds are managing risks better than they did, helped by the new tools available in the market. But he stresses that complex new products only redistribute credit risk, albeit more widely than in the past.

"Financial engineers want you to believe they have reduced the risk," he says. "That's preposterous." Mr Fridson doubts the next credit downturn will by softened much by the apparently changed structure of the market.

In fact, he raises the question of whether the next downturn could even be worse than on previous occasions, driven by the unusually high proportion of failure-prone companies - rated triple-C or lower, just a few notches above default - that have secured financing in recent years. In 1990, that rating category accounted for just 2 per cent of junk-rated debt in the US; today, it makes up nearer 20 per cent, according to Mr Fridson...

With credit markets seemingly priced with no room for surprises, the likelihood of a rocky patch can only grow. Mr Smith warns that markets are likely to overshoot when a downturn comes. "These things tend to move too far in one direction and then revert."

Distressed-debt specialists are hoping that happens. Anecdotal evidence abounds that specialist funds and banks have been staffing up and raising money in anticipation of the next wave of corporate defaults...