Lessons from the Subprime Financial Crisis:
When Are Financial Derivatives Likely to Be a Worldwide Time Bomb? Although financial derivatives can be useful in hedging risk, the AIG blowup discussed in Chapter 8 illustrates that they can pose a real danger to the financial system. Indeed, Warren Buffet warned about the dangers of financial derivatives by characterizing them as “financial weapons of mass destruction.” Particularly scary are the notional amounts of derivatives contracts—more than $500 trillion worldwide. What does the recent subprime financial crisis tell us about when financial derivatives are likely to be a time bomb that could bring down the world financial system? There are two major concerns about financial derivatives. The first is that financial derivatives allow financial institutions to increase their leverage; that is, these institutions can in effect hold an amount of the underlying asset that is many times greater than the amount of money they have had to put up. Increasing their leverage enables them to take huge bets, which if they are wrong can bring down the institution. This is exactly what AIG did, to its great regret, when it plunged into the credit default swap market. Even more of a problem was that AIG’s speculation in the credit default swap (CDS) market had the potential to bring down the whole financial system. An important lesson from the subprime financial crisis is that having one player take huge positions in a derivatives market is highly dangerous. A second concern is that banks have holdings of huge notional amounts of financial derivatives, particularly interest rate and currency swaps, that greatly exceed the amount of bank capital, and so these derivatives expose the banks to serious risk of failure. Banks are indeed major players in the financial derivatives markets, particularly in the interest rate and currency swaps market, where our earlier analysis has shown that they are the natural market makers because they can act as intermediaries between two counterparties who would not make the swap without their involvement. However, looking at the notional amount of interest rate and currency swaps at banks gives a very misleading picture of their risk exposure. Because banks act as intermediaries in the swap markets, they are typically exposed only to credit risk—a default by one of their counterparties. Furthermore, these swaps, unlike loans, do not involve payments of the notional amount but rather the much smaller payments that are based on the notional amounts. For example, in the case of a 7% interest rate, the payment is only $70,000 for a $1 million swap. Estimates of the credit exposure from swap contracts indicate that they are on the order of only 1% of the notional value of the contracts and that credit exposure at banks from derivatives is generally less than a quarter of their total credit exposure from loans. Banks’ credit exposures from their derivative positions are thus not out of line with other credit exposures they face. Furthermore, an analysis by the GAO indicated that actual credit losses incurred by banks in their derivatives contracts have been very small, on the order of 0.2% of their gross credit exposure. Indeed, during the recent subprime financial crisis, in which the financial system was put under great stress, derivatives exposure at banks has not been a serious problem. The conclusion is that recent events indicate that financial derivatives pose serious dangers to the financial system, but some of these dangers have been overplayed. The biggest danger occurs in trading activities of financial institutions, and this is particularly true for credit derivatives, as was illustrated by AIG’s activities in the CDS market. As discussed in Chapter 18, regulators have been paying increased attention to this danger and are continuing to develop new disclosure requirements and regulatory guidelines for how derivatives trading should be done. Of particular concern is the need for financial institutions to disclose their exposure in derivatives contracts, so that regulators can make sure that a large institution is not playing too large a role in these markets and does not have too large an exposure to derivatives relative to its capital, as was the case for AIG. Another concern is that derivatives, particularly credit derivatives, need to have a better clearing mechanism so that the failure of one institution does not bring down many others whose net derivatives positions are small, even though they have many offsetting positions. Better clearing could be achieved either by having these derivatives traded in an organized exchange like a futures market, or by having one clearing organization net out trades. Regulators such as the Federal Reserve Bank of New York have been active in making proposals along these lines. The credit risk exposure posed by interest rate derivatives, by contrast, seems to be manageable with standard methods of dealing with credit risk, both by managers of financial institutions and the institutions’ regulators. New regulations for derivatives markets are sure to come in the wake of the subprime financial crisis. The industry has also had a wake up call as to where the dangers in derivatives products might lie. There is now the hope that the time bomb arising from derivatives can be defused with the appropriate effort on the part of the markets and regulators.