Some say that derivatives rank right up there with antibiotics and the microprocessor chip as one of the great innovations of the modern era.
Derivatives are financial instruments that are used to reduce financial risk, just as a fire insurance policy is used to reduce the risk of a fire by compensating possible damage in the event of one.
Why did, then, Warren Buffett, whose financial acumen is legendary, describe them recently as "weapons of mass destruction"? Where did they come from and how did they become such objects of veneration as well as hate?
In downtown Chicago stands the 45-storey building that houses the Chicago Board of Trade, the institution that gave birth to the derivatives business. Beautiful as its art deco architecture is, there is nothing much to set it apart from the many other tall buildings that surround it. Except for one thing. Right at its very top there is a two-storey tall statue of a Greek goddess. This is Ceres, the Greek goddess of grain from who the word "cereal" comes.
This is where it all started. A group of merchants trading in the food grains grown in the surrounding Midwest came up with the ingenious and useful idea of offering farmers a firm "future" price for their crop many months before it came to the market reducing the risks that farmers took during their long season of labour. Grain "futures" prospered for decades till the US government, in the 1960s, started offering a minimum price for the crop.
This considerably slowed down the grain futures trade. The Chicago grain future traders sat around their trading pits for a while, smoking cigars and reading newspapers with nothing much to do till one of them thought of the idea of starting trading in another kind of futures: using the Dow Jones Industrial Average of equity shares in the New York Stock Exchange as the "underlier" instead of grain.
But, before starting off this new line of business, they had to solve a problem: how to put a price on this new form of "future". An out-of-the-box thinker among them, Mathew Gladstein, asked for help from a group of local Chicago economists, Merton, Black and Scholes.
The mathematical model they came up with, the Black-Scholes model, did its job of pricing options so well that Gladstein made tons of money using it, Merton and Scholes won the Nobel Prize in Economics for it, and started the rush of mathematicians to the stock market.
Soon, other enterprising people thought up other "derived" financial instruments based on many other "underliers": bonds issued by companies and municipalities, mortgages that people took out on their homes.
It is not hard to see why such "derived" securities or "derivatives" have become so popular. A bank that makes a loan, for example, for a house, faces many different types of risk. The borrower, for instance, may not be able to return the loan on due date. Or, he may not be able to keep up with interest payments.
Or, the market interest rate may rise far above the rate the bank has given the loan, leaving the bank stuck with a loan at a low interest rate. Or an earthquake might hit the area demolishing the borrower's business. Or, high inflation may reduce the value of the loan by the time it gets repaid. Derivatives are a way to "hedge" against these risks. For example, a housing loan to a borrower in, say, Cochin can be combined with a housing loan in Mumbai and another one in Bangalore under one common instrument and this combined "derivative" can be sold to an investor.
This combination reduces the risk of disparate housing markets such as Cochin, Mumbai and Bangalore all suffering downturns at the same time. The investor in this derivative rightly believes that the instrument he holds has a balanced risk.
If derivatives can diversify risk, as just described, what can go wrong? For one, the borrowers may have mis-represented their income. Or, the loan issuer may not have verified their incomes. Or, they may have borrowed 95 per cent of the value of their houses such that if property prices decline by, say, 20 per cent, the asset cover may become inadequate.
In all of these cases, should interest rates rise sharply, from say, 6 per cent to 10 per cent, these borrowers may no longer be able to meet their monthly payments. When Greenspan, who was chairman of the US Federal Reserve Board, was told about similar issues developing in the US mortgage securities market he believed that such problems in the housing sector would be restricted to a city and could never become a national, let alone an international problem.
This would normally have been true, but mortgaged-backed securities were sold not only nationally in the United States but also throughout Europe and Asia. When the US housing bubble burst and borrowers started defaulting on their mortgage payments, the value of the mortgage securities fell precipitously.
The shock waves were transmitted throughout the world. What started as a crisis in some specific parts of the US now became a worldwide financial crisis.
In the next and final part, we'll examine why so many smart people in storied investment banks like Morgan Stanley, Lehman Brothers and Bear Stearns, in powerhouses such as Citigroup and Royal Bank of Scotland found these derivatives so attractive that they just couldn't resist them.