Are Derivatives the Real Problem?
This piece was published in FT.com earlier today…
Regulators, Congress, and
the media generally focus on the crisis at hand. The Enron scandal gave us
Sarbox. The market crash has created a PR flurry against “sponsored access” and
proprietary trading. AIG generated a firestorm surrounding the use of credit
derivatives. The common thread is that policy-makers are reactive and missing
the big picture, leading to short-termism and a host of poorly constructed
rules and policies. And invariably the word “derivatives” is used as a
lightening rod for why new regulations should be promulgated. The problem,
however, isn’t exclusive to derivatives; it’s the underlying “business purpose”
of transactions. Hedging has a legitimate business purpose. Making markets,
speculation, and financing projects have solid business foundations as well.
But entering into transactions that serve to hide or obfuscate economic reality
work against this principle. And this lack of business purpose is not confined
to the derivatives markets, but frequently takes place in the cash markets as
well.
Consider leasing, a transaction
that has been popular for over 50 years. As the industry has evolved,
transactions such as sale/leasebacks and “asset defeasance” have been used to
synthetically borrow money without the obligation being reflected as debt on
the balance sheet. The form of the transaction: a lease. The substance of the
transaction: a borrowing. The
multi-trillion dollar securitization industry has the same motivation: moving assets
(and liabilities) off the balance sheet, while economic recourse still exists
should asset values and/or debt ratings drop. This is what the market
discovered when Citigroup’s multi-billion structured investment vehicles (SIVs)
began to fail and the assets and liabilities came back onto its financial
statements. What is the proper characterization of a contractually obligated
stream of payments? Debt. How should a portfolio of assets and associated
liabilities be treated if the risks and rewards of ownership haven’t been
completely transferred? As never having left the balance sheet. Yet the
accounting profession, with the SEC’s support, has enabled this charade to
continue.
Derivatives have also been
used to achieve similar ends. Structured transactions have been designed to
generate upfront cash without a corresponding obligation being recorded on the
financial statements. The recent discovery of Greece’s use of these instruments
has shined a light on the dangers of hidden borrowings. Municipalities have
mortgaged their futures by selling strips of participations in cash flow
generating assets (roads, bridges, airports, etc.) in order to generate
liquidity today (at a steep cost to financial solvency tomorrow). The virtually
unbounded rise of the credit derivatives industry is partly due to the mismatch
between the notional value of derivatives being written and the actual value of
underlying instruments. This mismatch can be 5x or more of the bonds being
“hedged,” leading to market failures when physical delivery is demanded from
counterparties lacking actual ownership (or the ability to borrow the
position). Neither of these examples embody true business purpose.
Both cash-market and
derivative instruments should be put to the “business purpose” test. Accounting
rule-makers, with support of the SEC, should move towards a “principles-based”
system where common sense, and not black-and-white rules around which myriad
loopholes can be found, should become the new paradigm. But let’s be clear. The
issue isn’t derivatives; it’s all financial transactions whose objective is to
deceive or to weaken financial transparency.
