When a debt downgrade at GM took a bite out of several hedge funds last month, part of the blame fell on their participation in the credit derivatives market, a world of high finance that most investors know little or nothing about and that many simply don't understand. Ignorance, however, may not be bliss.Warren Buffett is on record as calling complex derivatives "financial weapons of mass destruction."
Credit derivatives are, in essence, insurance policies against the possibility that a corporation will default on its debt. They are traded by large investors like banks, insurance companies, pension funds, and hedge funds. For a premium, one investor assumes some of the default or credit risk in another investor's loan or bond portfolio. But just as many hedge funds do more than hedge, instead opting to take more-aggressive positions, credit derivatives are about more than just managing risk; they are also about speculating on it and trading it.
I'm not a financial expert of any kind, but I did work for about four years for a company that wrote software to trade and manage derivatives portfolios, so I had to learn a little bit about modern capital markets.
In my view, derivatives, even highly complex instruments, are neither a panacea nor a Pandora's box. The key thing to remember is that they help you package different kinds of financial risks up, slice them and dice them and move pieces of them around, but they don't eliminate risk (not by a long shot!), and if you're not very careful the putative cure can wind up being much worse than the disease.
Some very smart businesspeople have gotten very badly burned in complex credit derivatives transactions. If you approach them from the point of view of careful hedging against risk, you will generally do okay; if you're bellying up to the craps table and hoping to hit your point before you roll sevens, well...