Who Cares If Derivatives Merely Spread Risk Around?

With the financial system in meltdown mode, you see a lot of finger-pointing at derivatives, and shouts that all this hedging and trading did nothing to dissipate risk, but instead they just spread the risk around. Is that actually a serious critique?

Well what if we said that about garden-variety retail insurance?

Car insurance, we could say, doesn’t reduce the risk of getting into an accident or the amount that someone needs to pay out in the event of an accident, so it doesn’t serve any purpose, right? Or health insurance. It doesn’t make anyone healthier, and it doesn’t reduce total health expenditures. So everyone should be willing to just junk it, right?

Well, no, these statements don’t make much sense. Sure, total potential liabilities don’t decrease via these types of insurance, but they do provide a mechanism of distributing the risk in such a way so that the various parties (the car owner and the insurer) are better off. The mere spreading of risk, through a market mechanism. The key is that the health insurer’s risk is uncorrelated — it can afford to pay out claims for its customers, so long as they don’t all get sick on the same day.

Finance is no different. In a must-read post over at RGE Monitor, Peter J. Wallison defends the much-vilified credit default swaps, and how they legitimately transfer risk around in a manner that benefits everyone. The post, titled “Everything You Wanted to Know about Credit Default Swaps–but Were Never Told”, covers many topics, including the myth that CDS are what felled several of the big firms, and the idea that the notional values of CDS (trillions and trillions of dollars!) is particularly worrisome. But here’s the part on how swaps spread risk optimally:

In light of the consistent failure of traditional regulation, a sophisticated and intelligent regulatory process should now foster risk-management innovations that have been developed by the private sector, especially the derivative instruments that have greater potential to control risk than government oversight. CDSs are one of these instruments, but not the only one. A simple example of effective risk-shifting is the interest rate swap, which–like the CDS–was developed by financial intermediaries looking for ways to manage risk. The documentation for interest rate swaps, as well as for CDSs, was developed by the International Swaps and Derivatives Association (ISDA). Interest rate swaps have been an important and useful risk-management device in the financial markets for at least 20-five years. The value of an interest rate swap is that it allows financial intermediaries to match their assets and their liabilities and thus to reduce their interest rate risks. Say that a bank has deposits on which it must pay a market or “floating” rate of interest, but it also holds mortgages on which it receives only a fixed monthly interest payment. This is a typical position for a bank–but a risky one. If interest rates rise, it may be forced to pay more interest to its depositors than it is receiving from the mortgages it holds, and thus would suffer losses. Ideally, it would want to trade the fixed rate it receives on its mortgage portfolio for a floating rate that will more closely match what it has to pay its depositors. That way, it is protected against increases in market rates. An interest swap, in which the bank pays a fixed rate to a counterparty and receives a floating rate in return, is the answer; it matches the bank’s interest rate receipts to its payment obligations.

But what kind of entity would want to do such a swap? Consider an insurance company that has fixed obligations to pay out a certain sum monthly on the fixed annuities it has written. Insurance companies try to match this obligation with bonds and notes that are the ultimate source of the funds for meeting its fixed obligations, but these do not necessarily yield a fixed return for periods long enough to fully fund its annuity commitments. Instead, they mature well before its annuity obligations expire, and may–if interest rates decline–yield less than it is required to pay out to annuitants. The insurance company, then, would be able to avoid risk with a swap that is the exact mirror image of what the bank needs. Into this picture steps a swap dealer, which arranges a fixed-for-floating interest rate swap between the bank and insurance company. The notional amount can be set at any number–its purpose in an interest rate swap is simply to provide the principal amount on which the interest will be paid–so the parties agree on $100 million. The bank agrees to pay the insurance company a fixed amount–say, 5 per cent–on the notional amount of $100 million, and the insurance company agrees to pay the bank a floating rate of interest on the same notional amount. If interest rates rise to 6 per cent, the bank is “in the money” and the insurance company pays the bank the 1 per cent difference, and, if they fall to 4 per cent, the bank pays the insurance company 1 per cent.

The important thing to notice about this transaction is that both the bank and the insurance company are better off–both have reduced their risks. Read the whole thing >

As he goes on to explain, CDSs work similarly, allowing multiple parties to trade risk in a way that improves all of their health.

This, of course, doesn’t mean banks aren’t screwed. The economy is going into the tank, and now the entire industry is paying the price for loose lending standards, and the creation of too many bad loans. No doubt more entities will go totally belly up. But blaming derivatives, rather than the obvious cuplrits, doesn’t cut it.

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