Many regulators and people in the industry itself argue that the decidedly lopsided concentration of derivatives is not as bad as it looks. The largest commercial banking groups typically have the most sophisticated risk management systems and access to resources and counterparties that might not be available to smaller peers. Soothsayers also contend that the gross notional exposure exaggerates the risks, because a significant volume of transactions are interest rate swaps, for example.
So-called “netting” agreements minimize the dangers even further. Under this arrangement, when banks have multiple contracts outstanding with the same counterparty, they agree to tally the total value of what they owe versus what they are due, calculated in present value terms, to arrive at a net exposure, which is typically far smaller than the gross amount. Even on this basis, the overall derivatives-related net credit risk exceeded $1 trillion in the commercial banking sector at the end of 2005.
But that doesn’t include unforeseen circumstances that might lead to differences of opinion, liquidity issues, or torrents of litigation about the value of individual agreements. Nor does it consider the possibility that if one bank gets into trouble, others will be less than cooperative as they face major problems of their own. And even if the banks come to an arrangement among themselves, it will not necessarily address the potential fallout from their exposure to counterparties such as the GSEs, hedge funds, securities fi rms, and fi nance arms of large multinational corporations. Hedge funds, for example, accounted for 55 percent of credit derivatives trading in the year through March 2006, according to Greenwich Associates.
While these concerns will only become more critical when the economic situation takes a turn for the worse, the real dangers are likely to stem from seriously fl awed assumptions and conflicts of interest. Despite the involvement of Wall Street’s best and brightest— academics, rocket scientists, and programmers—and the sense of mathematical certitude conveyed through the use of complex calculations and high-powered computers, pricing derivatives involves a signifi cant amount of guesswork that is not necessarily unbiased. Often, expectations are drawn from historical patterns that, for many newfangled varieties, are woefully incomplete. Or they are based on how other securities are trading, without taking into account differences that gain importance under stressful market conditions.
--From Chapter 4, "Derivatives," Financial Armageddon
After my book was published in the spring of 2007, I can remember so-called experts and clueless bloggers arguing that fears about derivatives were overblown, and that doom-and-gloomers like me didn't really understand "basic" concepts like notional value and netting arrangements.
Under the circumstances, I admit to thinking "I told you so" when I read the following article, "Derivatives Still Pose Huge Risk, Says BIS," by The Telegraph's Ambrose Evans-Pritchard, in which those-in-the-know acknowledge that gross exposure, among other things, really does matter after all:
The global market for derivatives rebounded to $426 trillion in the second quarter as risk appetite returned, but the system remains unstable and prone to crises, according to the Bank for International Settlements (BIS).
The BIS said in its quarterly report that total turnover of derivatives rose 16pc, mostly due to a surge in futures and options contracts on three-month interest rates.
Stephen Cecchetti, the bank's chief economist, said over-the-counter markets for derivatives are still opaque and pose "major systemic risks" for the financial system. The danger is that regulators will again fail to see that big institutions have taken far more exposure than they can handle in shock conditions, repeating the errors that allowed the giant US insurer AIG to write nearly "half a trillion dollars" of unhedged insurance through credit default swaps.
The misjudgement was to think the banks and insurers were safe because their "net" exposure was modest. That proved to be an illusion.
"The crisis has cast doubt on the apparent safety of firms that have small net exposures associated with large positions," Mr Cecchetti wrote. "As major market-makers suffered severe credit losses, their access to funding declined much faster than nearly anyone expected. When that happened, it was gross exposure that mattered.
"The use of derivatives by hedge funds and the like can create large, hidden exposures," he added, citing the discovery that firms in Brazil, Korea and Mexico held huge foreign exchange contracts in late-2008.
"Experience during the crisis points to the need for fundamental improvements in the management of counterparty risk."
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