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May 15, 2013
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What's so dangerous about derivatives?" Institutional Investor asked back in September 1992. Quite a bit, as European Bureau Chief Kevin Muehring and Senior Writer Saul Hansell showed over the course of this cover story.
It's a classic Institutional Investor story, breaking down a complex and opaque topic and delivering it to the reader in a digestible format. But few II stories — few stories by any media outlets — have quite the prescience of this one. (See the section on nightmare scenarios, for example.)
Hansell and Muehring had been covering the topic for several years and wanted to highlight the dangers and the need for sensible regulation. Indeed, Muehring was so keen to pick the brains of then New York Federal Reserve Bank president E. Gerald Corrigan, the loudest voice on derivatives at the time, that he refused to be turned off by repeatedly declined interview requests and chased Corrigan around the world, eventually catching up with him in Basel and again in London.
This is the most recent in our ongoing series, From the Archive, which highlights the best of Institutional Investor's financial journalism over the course of the last four decades. See also International Editor Tom Buerkle's 2002 story, What's Wrong with the ECB?
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"I wasn't born yesterday," New York Federal Reserve Bank president E. Gerald Corrigan is fond of saying. His formative experience as a central banker was the Herstatt Bank crisis of 1974, when the collapse of an obscure German bank sent shock waves through the Euromarket. Since then Corrigan has dealt with the debris of the LDC crisis, the collapse of Continental Illinois Corp. and the depredations of Drexel Burnham Lambert. "I have seen them all," says the burly regulator in his gravelly voice.
So it was with a jaundiced eye that Corrigan began to probe the banks under his supervision about their headlong rush into the financial phenomenon of the decade: over-the-counter derivatives. Do you know the risks you are taking and how to control them? he asked. And as chairman of the Bank for International Settlements' banking supervisory committee, Corrigan was also seeking answers to the question looming ever larger in the minds of his fellow regulators in Basel: Could these new markets somehow destabilize the financial system?
The market for the highly technical, tailor-made instruments created through stand-alone or embedded interest rate and currency swaps, options and the complex combinations thereof, and known loosely as derivatives, has mushroomed eightfold in just five years. Its notional value is a whopping $4 trillion, according to the BIS, which works out to an estimated $250 billion in actual credit risk. For Corrigan, numbers like this in what has been a spottily regulated market -- one, moreover, that crisscrosses equity, fixed-income, foreign exchange and commodities markets -- are hard to ignore. Especially difficult to overlook is the fact that a mere dozen U.S. banks hold accumulated positions of $150 billion.
The responses he heard back from the bankers were not comforting. They admitted that they didn't really understand derivatives or how much money they could lose if something went haywire. To be helpful, they offered to introduce Corrigan to their head derivatives traders. Big blunder. The million-dollar-a-year swaps experts proceeded to brush off Corrigan's concerns as if he were some Luddite in a pin-striped suit: "Jerry, Jerry baby, you don't understand the business. We know what we're doing. Now don't go and spoil the party." Thus does one top banker, who was hastily deployed to placate Corrigan, characterize the swappers' condescending attitude.
It was no surprise when Corrigan decided to flex some regulatory muscle where derivatives were concerned. In a much-remarked speech before the New York State Bankers Association on January 30, Corrigan told his audience bluntly that they had better "take a very, very hard look at off-balance-sheet activities." In case anyone missed the point, he added, "I hope this sounds like a warning, because it is."
Nightmares
Corrigan's speech hit the bankers like a billy club, putting a whole new spin on discussions of derivatives. Soon, in press reports, in political speeches, even in cocktail party chatter, derivatives were being talked about in worried tones as the possible cause of a financial melt-down. Derivatives are "a time bomb that could explode just like the LDC crisis did, threatening the world financial system," warned Royal Bank of Canada chairman Allan Taylor at the International Monetary Conference in May. And Lazard Freres & Co. senior partner Felix Rohatyn was quoted in this magazine's 25th Anniversary issue in July as worrying that "26-year-olds with computers are creating financial hydrogen bombs."