Derivatives, unintended consequences, and perverse incentives

A boom in the use of derivatives is giving creditors strong incentives to push troubled companies into bankruptcy rather than help rescue them, according to new research and industry experts.

A study by academics Henry Hu and Bernard Black concludes that, thanks to explosive growth in credit derivatives, debt-holders such as banks and hedge funds have often more to gain if companies fail than if they survive. The study suggests this development could endanger the stability of the financial system.

The findings highlight a crucial problem in corporate restructuring when more and more companies are facing financial difficulties. According to the research and industry practitioners, creditors have a strong interest in voting against a restructuring plan if they have bought credit or loan default swaps, which trigger payments when a company fails.

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The problem is compounded by creditors not having to disclose derivatives positions, making it very difficult for companies and regulators to find out their real intentions.

Financial Times (ft.com): Derivatives boom raises risk of forced bankruptcy for companies (28 Jan 2008)

A "derivative financial transaction" is one that has no inherent value in and of itself; its value is derived from some aspect(s) of the underlying instruments or commodities.

The very first derivative transactions were options and futures in the agricultural commodities market: allowing a farmer to lock in a sale price for a crop that was still in the fields, for instance.

Derivatives transactions are, by their very nature, designed to transfer risk from one party to another at an appropriate price. Even as they have grown more exotic and incorporated vast amounts of leverage, it is arguable that their presence in the financial markets has been a net positive for the world.

But leverage is a tricky thing. The notional value of the world OTC derivatives market as of December 2007 was over $500 trillion (half a quadrillion) dollars, and the "gross market value" (the cost of replacing all open contracts at the prevailing market prices) was over $11 trillion; by way of reference, the annual GDP of the United States was "only" $13.3 trillion in 2006.

Even a small change in the underlying value that a derivatives contract is based on, under the right circumstances, can have massive repercussions.

And as derivatives become more and more abstracted from the instruments of underlying value, unintended consequences seem to be the sure result.

It's arguably good for the economy to allow counterparties to use credit default swaps to insure against payment-default risk.

But does anyone think it's good public policy that--as a net result of some of these complex transactions--we encourage creditors to force possibly-viable companies into bankruptcy because they (the creditors) are holding markers for a bet that will only pay off if that happens?

Wikipedia master article on derivatives

Articles on specific subtypes:

• Futures/Forwards, which are contracts to buy or sell an asset at a specified future date.
• Options, which are contracts that give a holder the right (but not the obligation) to buy or sell an asset at a specified future date.
• Swaps, where the two parties agree to exchange cash flows.

"Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses -often huge in amount- in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)." -- Warren Buffett, Annual Report to Berkshire Hathaway shareholders, 2002