Derivatives: Alive, But Oh So Boring

Yesterday’s shooting stars are today’s low-margin mules

The last decade has not been kind to American commercial banks’ product lines, which have come under fierce attack by competitors. As a response, during the late 1980s, a few of the most venturesome banks perfected a shiny new product with a wondrous profit margin: the derivative. Soon, many investors and corporations were using them for hedging risks and betting on interest rates and currencies. Dozens of other banks rushed in, and the number of derivatives dealers mushroomed between 1988 and the end of 1993.

Now, though, the once wondrous margins are shrinking fast. A slew of multi-million dollar hits taken by American corporations and institutional investors has caused many users to run for cover. Demand for the most exotic derivatives contracts – those that are most lucrative for dealers but often carry the most risks – has plummeted. Many users now limit themselves to the safest derivatives, those least profitable for dealers. “The only thing people are buying these days is Chevys,” says Bruce.L.Campbell, associate director of corporate derivatives marketing at Fuji Bank &Trust Co. ”They don’t even want to see a Maserati in the showroom window.”

Still Handy. Derivatives will not go away. Too many corporations and investors view them as useful, indeed critical, risk-management tools, and experts expect derivatives activity to continue to expand at a healthy pace. But they agree that the days of outrageous profitability for dealers are over. With corporations and investors still licking their wounds, traffic in the most complex derivatives will likely stay slow for some time. “The structured-note market will continue to exist,” says John K. Darr, finance director of the US Federal Home Loan Bank system, referring to the intricately structured instruments that are a big part of the complex derivatives market. “But it may be somewhat smaller than it was.”

Moreover, with the proliferation of the derivatives dealers, it will be difficult if not impossible for the preeminent ones to retain a lock on the market, especially for complex, exotic derivatives. Inevitably, as profit margins shrink, making money in derivatives will depend more on volume than spreads – just as in dozens of other bank businesses.

In the halcyon days of the market derivatives were a dealer’s best friend. Citibank and, later, Banker’s Trust and J.P. Morgan were the dominant U.S. banks in the business and produced huge returns. As more complex derivatives were developed, banks with the product know-how could book a return on equity in excess of 100% on some of the more exotic derivatives.

The slump is literally scaring some dealers away. “The whole idea of leverage (and exotic derivatives) for many investors is out,” says Heinz Binggeli, managing director of Emcor Risk Management Consulting. “We’re getting back to prudent hedging rather than yield enhancement.”

By Kelley Holland in New York

Notes

1. Chevy (от Chevrolet) - очень популярный вид сокращения слов в американском английском языке: Boggy (Humphrey Bogart), Gorby (Gorbachev). Ссылка на предпочтение, которое американцы отдают надежной и известной марке автомобиля собственного производства перед дорогостоящей иностранной моделью. Сравнивается ситуация с производными ценными бумагами.

2. structured note – структурированная краткосрочная ценная бумага

3. to retain a lock on the market– сохранить контроль над рынком

4. US Home Loan Bank system (FHLB) – федеральная система банков жилищного кредита (США)

5. a one-trick pony – цирковое животное, которое выступает только с одним номером. Эта метафора означает, что в основном деятельность Bankers Trust строилась вокруг деривативов.

6. to change one’s stripes – to change one’s policy cardinally

7. leverage – средства повышения доходности или стоимости инвестиций без увеличения суммы инвестиций (например, покупка опционов)

8. spread– «спред» :1) разница между курсами, ценами, ставками

2)одновременная покупка фьючерсного контракта на одинаковый финансовый инструмент с поставкой в разные сроки или на разных рынках

Vocabulary

banks’ product lines – различные финансовые продукты (инструменты), которые выпускает банк

profit margin – размер прибыли

to hedge risks – хеджировать риски (защищаться от рисков)

lucrative– прибыльный, доходный, выгодный

risk-management tool – инструмент (средство) управления рисками

structured note – структурированная краткосрочная ценная бумага

prudent– осмотрительный, осторожный; prudence – осторожность, обдуманность, отказ от рискованных действий – основной принцип в работе банков

Exercises

1. Find in the text the synonyms to the following:

rival, exchange, twelve, to contract, a great number of, profitable, to drop down (plunge), very important, speed, ten years, to spread (increase at a fast rate), controlling (commanding), a profit from investment, wise (cautious).

2. Make up derivatives from the following and translate them into Russian:

produce, compete, profit, invest, to deal, institute, manage, expand

Dangerous Traders

Nicholas Leeson, a 27-year-old trader, bets that Japanese stocks will rise and bankrupts a 227-year-old British investment bank, Barings, in a few weeks of unauthorized trading. Joseph Jett, a 36-old-trader for Kidder Peabody, fools accountants into believing that his trades of government bonds were fabulously profitable; in fact, they were fictitious. Treasurer Robert Citron single-handedly drives Orange County, California, into bankruptcy by betting taxpayers’ money believing that interest rates would drop. They rose, and now the county is forced to cut educational, medical, and other services.

What allowed individual rogues to destroy, harm or humiliate venerable institutions nearly overnight? What allowed sophisticated managers to sleep while underlings brought organizations to or over the brink of extinction? Astonishing greed, arrogance and incompetence are part of the answer. But so, too, are derivatives – financial instruments whose value goes up and down with the value of underlying stocks, bonds, currencies or other assets. The three rogues bought and sold derivatives with borrowed money to make large, reckless bets.

Until this week, it was easy to dismiss fear-mongering calls for regulating derivatives out of existence. Most companies and governments use them to reduce risk – for example, insulating investment funds from the impact of interest rate changes. Moreover, derivatives are only one way to make risky bets. Savings and loan institutions during the 1980s, for example, managed to go bankrupt investing in real estate without any help of derivatives. Now, with the Barings fiasco, these propositions deserve second, third and fourth looks.

How could a world-class bank fail to see what outside analysts had observed – an underling betting the company’s wealth on the unpredictable movements of Japanese stocks? How could Kidder Peabody’s management fail to note that Mr. Jett’s profitable trades had yet to put a dollar in the company’s bank account?

The three calamities deliver a ringing call for vigilance. In the United States, state governments will want to rein in county governments. Corporate executives must toughen oversight procedures. So far, the fiascoes at Bearings and Kidder have hurt only shareholders. But federal regulators will want to reconsider whether banking laws – spruced up in 1990 to require banks to hold large reserves and require regulators to intervene when those reserves drop to dangerous levels – are tight enough to prevent a repetition of the savings and loan fiascoes.

Derivatives serve important corporate purposes, so intervention ought to be carefully crafted. But regulatory authorities need to ask what type of managerial oversight, monitoring and reporting are needed to prevent a future Nicholas Leeson from hiding trades that should never have taken place or a future Joseph Jett from enriching himself from trades that never took place.

The New York Times