Financial Times: Wall Street Plays Dangerous Derivatives Games

By John Morgan

The same kinds of complex, confusing derivatives that almost brought down the global financial system in 2008 are back in spades, according to the Financial Times. As one trader put it: “We’ve reformed nothing.”

The U.K. newspaper suggested investors may be fooled by a false sense of security, and are therefore “chasing levered returns via certain types of US credit derivatives that Wall Street is willingly providing in the current climate of low interest rates and moribund volatility.”

The developments suggest that the financial industry learned little from the 2008 meltdown and that reforms put in place since then are ineffective.

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“While standardized derivatives such as interest rate swaps are now transacted in exchange-
type venues and centrally cleared, the flourishing area of opaque products are not, and moreover there are few records of activity that regulators can monitor,” the Times said.

The newspaper warned that strong growth in the use of complex derivatives may exaggerate the impact of the next major market reversal. The deja vu boom in credit derivatives is being fueled by yield-hungry investors and Wall Street’s quest for new revenues.

“We’ve reformed nothing,” said Janet Tavakoli, president of Tavakoli Structured Finance. “We have more leverage and more derivatives risk than we’ve ever had.”

Two popular new derivatives are total return swaps (TRS) and options on indices comprised of credit default swaps, according to the Times.

TRS products enable investors to leverage their exposure to the performance of credit without owning an actual asset. “The downside is that any sharp deterioration in the value of credit means an investor would need to compensate the other party in this transaction, usually a bank that arranged the deal,” the Times said.

Options tied to CDS indices, known in slang terms as “swaptions”, have grown exponentially, in part because they are not required to be centrally cleared, according to the Times. Swaptions let investors defend their portfolios from large movements in markets, known as “tail risk”.

Citigroup analysts estimated more than $60 billion of CDS index options currently trade each week – up from only $2 billion monthly in 2005.

Bloomberg reported that JP Morgan and Goldman Sachs are among those crafting fresh derivatives for a “new generation.”

“Wall Street is starting to return to the financial innovation that helped extend the debt rally seven years ago before exacerbating the worst financial crisis since the Great Depression,” Bloomberg reported. “The instruments are springing back to life as investors seek new ways to boost returns that are being suppressed by central bank stimulus.”

Lawrence McDonald, chief strategist at Newedge USA and author of the book “A Colossal Failure of Common Sense,” told Bloomberg, “The true sign of a top is when you have these new structures piling up.”