Will derivatives kill us or make us stronger?

Commentary about business and finance.
May 13 2003 6:04 PM

The Root of All Evil?

Will derivatives kill us or make us stronger?

Complex securities rarely lend themselves to a Crossfire-style debate, in which two guests ardently advocate diametrically opposed positions in a coherent and un-nuanced manner—without really engaging each other.

But that's precisely what's happening with derivatives. Against: Frank Partnoy, former derivatives salesman turned law professor and author of Infectious Greed, which largely blames derivatives for the financial excesses of the 1990s. For: Robert Shiller, Yale economist and author of The New Financial Order: Risk in the 21st Century. Shiller, the best-selling author of the 2000-market-top-calling Irrational Exuberance, argues that derivatives are the key to rooting out global income inequality, averting urban blight, and generally smoothing out the volatility inherent in today's interconnected global economy.

Partnoy says derivatives allow Wall Street sharpies to gull naive clients and investors. Shiller says, "[W]e need to democratize finance and bring the advantages enjoyed by the clients of Wall Street to the customers of Wal-Mart."

If Maxim is no longer appropriate for Wal-Mart customers, are derivatives? And what the hell are derivatives, anyway?

Simply defined, a derivative is any security that derives its value from that of another security or asset. It can be a call on Dell, or a put on General Electric, futures contracts on oil, sugar, pork bellies, presidential candidates, the price of oil, gold, coffee, or platinum, an interest-rate swap, or any of number of hybrid securities marketed under obtuse acronyms.

Sounds innocuous. But as Partnoy argues, "[T]oday, the risk of system-wide collapse is greater than ever before," in large part due to their widespread and cavalier use. Why? Derivatives have been used extensively by corporate managers and investment bankers to hide risk, evade regulation, and manipulate earnings. He starts with the story of a now-obscure late-1980s currency trader named Andy Krieger—who used options to effectively short the entire money supply of New Zealand—and leads us through a parade of 1990s horribles: the Salomon Brothers Treasury trading scandal, Orange County's derivative-investment-induced bankruptcy, Joseph Jett's near destruction of Kidder Peabody, Long-Term Capital Management, and Enron. The common denominator in each of these episodes was the abusive use of derivatives.

While Partnoy looks to the past, Shiller looks only to the future. He argues that applying the highly useful principles of risk management that we already apply to necessities like life and auto insurance can make the world a more just place. In essence, Shiller envisions the creation of new derivative securities that relate to broad social and economic phenomena. As part of the "electronically integrated risk management culture" he envisions, Shiller proposes livelihood insurance, through which people could essentially guard against potential income declines. To mitigate the effects of periodic Third-World economic collapses, he envisions "macro markets," in which individuals, companies, and central banks could buy and sell securities based on, say, Peru's 2008 Gross Domestic Product.

Oddly, it's Partnoy—and not the futuristic economist—who overreaches. Much as Regnery authors find the malevolent hands of Bill and Hillary Clinton behind every disaster of the past decade, Partnoy stretches to find derivatives at the heart of every woe of the past 15 years. He miscasts accounting frauds, for example, that have nothing to do with derivatives and everything to do with flat-out cheating. Of course, Partnoy is not alone in the tendency to demonize derivatives. Warren Buffett, whose Berkshire Hathaway owns large insurance and reinsurance companies—which are, at root, risk management businesses—has called derivatives "financial weapons of mass destruction."

But Buffett, his neighbors in Omaha, Neb., and all of us are already beneficiaries of the democratization of derivatives. Airlines constantly hedge the price of jet fuel, which allows them to commit to 30-day-advance fare purchases. Developers are frequently required by lenders to hedge interest-rate risk, the better to preserve their ability to pay off loans. Coca-Cola uses derivatives to control the cost of the vast quantities of sugar it needs to make syrup. The comparatively low and steady prices we pay for staples like bread, vegetable oil, and coffee have everything to do with derivatives. Derivatives allow home-buyers to lock in mortgage rates 30 days in advance, and they permit people whose portfolios are concentrated in the stock of the company where they work to hedge against a meltdown.

Which is not to say that Shiller's admittedly utopian scenario doesn't have its flaws. First, buying and selling derivatives is essentially gambling. And as William Bennett knows, when people gamble, the house always wins in the long run. In this case, the house is Wall Street, which creates derivatives and profits by facilitating trading. Second, we know Shiller to be a connoisseur of irrational market behavior. But for this derivative-based regime he foresees to work, all members of society would have to exhibit an exceedingly high degree of economic rationality.

Partnoy thinks derivatives are crack cocaine—a cheap, potent drug with the potential to deliver a more powerful high and cause greater damage. Shiller sees them as Tylenol—a cheap, off-the-shelf analgesic that can alleviate the pain caused by chronic conditions. In reality, they're more like prescription drugs such as Viagra and Valium—legal drugs that improve the quality of life for many. But when used recklessly or to excess, derivatives—like Viagra—can have some nasty side effects.

Daniel Gross is a longtime Slate contributor. His most recent book is Better, Stronger, Faster. Follow him on Twitter.