11/19/2009

Economist.com

Derivatives

Over the counter, out of sight
Nov 12th 2009 From The Econom ist print e dition

Derivatives are extraordinarily useful—as well as complex, dangerous if misused and implicitly subsidised. No wonder regulators are taking a close look
Illustration by Otto Dettmer

IN 1958 American onion farmers, blaming spec ulators for the volatility of their crops’ prices, lobbied a congressman from Michigan named Gerald Ford to ban trading in onion futures. Supported by the president-to-be, they got their way. Onion futures have been prohibited ever since. Futures are agreements to trade something at a set price at a given date. They are perhaps the simplest example of a derivative, a contract whose value is “derived” from the price of a c ommodity or another asset. Derivatives c ontinue to be vilified, usually when someone loses a lot of money. Orange County and Procter & Gamble lost fortunes on them in the 1990s. They were at the core of Enron’s failure. And in September 2008 they brought American International Group (AIG), a mighty insurer, to its knees. Its fetish for credit default swaps (CDSs), a type of derivative that insures lenders against borrowers’ going bust, led it to guarantee at least $400 billion-worth of other c ompanies’ loans—inc luding those of Lehman Brothers. The Americ an government forked out $180 billion to save AIG from collapse. Every catastrophe brings c alls for restrictions on derivatives. This year Joseph Stiglitz, a Nobel economic s laureate, has said that their use by the world’s largest banks should be outlawed. But derivatives have defenders too. Used carefully, they are an excellent—some would say indispensable—tool of risk-management. Myron Scholes, another Nobel prize-winner, says a ban would be a “Luddite response that takes financ ial markets back decades.” Because of the mayhem of the past