Derivatives, in the news because of the spectacular $1.5 billion loss sustained by the Orange County treasurer, appear once again likely to become the scapegoat.
Anytime anyone loses a substantial amount of money these days, derivatives are the obvious, although often innocent, suspects.
In Orange County, as appears to have been the case with the losses incurred by Procter & Gamble Co. and others this year, derivatives played a peripheral role. It seems the loss again was a terrible interest rate bet. Leverage did the most damage.
In fact, more damage is done by bad interest rate bets than anything else. Derivatives merely help people make those bets more efficiently, just as they help them make good bets more efficiently.
The question is: Should someone like the Orange County treasurer be making those bets? Obviously not.
But because of the Orange County loss and others, derivatives may soon become so discredited that many genuinely able to use them with skill and prudence will stay away. That could prove costly in the market to taxpayers, pension beneficiaries and shareholders as stewards of finance and investment capital use less efficient means to accomplish the same ends they could have done more economically with derivatives.
That would be unfortunate.
In addition, the stunning loss probably will reinforce calls for regulation of derivatives. Indeed, the loss should speed efforts to improve disclosure, accounting and controls in general of the use of derivatives in investing and financing. But inappropriate and burdensome regulation risks doing more harm in the long run, if it seeks to somehow micromanage the decision to use derivatives and retard financial innovation.
Government regulation can often harm the very thing it is trying to protect. It didn't protect savings and loan investors or taxpayers. In terms of public pension funds, it has cost taxpayers and beneficiaries in opportunity costs in states, such as West Virginia, Indiana and South Carolina, that ban investments in equities.
The sellers and users of derivative instruments bear much of the blame for the poor image of the vehicles because of their failure to discuss their use in an open and detailed manner. Their reticence has created the impression that derivatives are something mysterious, a bit shady or shaky as investments.
But the real problem in Orange County is in the management, not the investment instrument. Robert L. Citron, who was treasurer of Orange County, managed an investment pool of $8 billion from the county and other government entities, including the Orange County Employees' Retirement System. He leveraged the pool by another $12 billion, giving him $20 billion in all to invest.
How well was it appreciated the portfolio was so leveraged? Where were the officials and investors, like the Orange County pension fund, who were supposed to oversee Mr. Citron's activities? Who, in fact, was supposed to oversee his activities?
With any significant amount of money under management, let alone billions of dollars, the key question is: What oversight and controls, investment policies and disclosure are in place to ensure the risks taken are appropriate?
Blaming the disaster on Mr. Citron's apparently minimal use of derivative securities when the real causes are elsewhere will only increase the chances of a similar problem occurring in the future.
