The ability to create an infinite supply of stock option puts, credit default swaps and other derivatives — and thus infinite leverage compared to the underlying asset — carries significant blame for the credit market debacle and drain in corporate valuations.
Buy enough put options, and the stock will have a propensity to dive. The same logic applies to credit default swaps. When a large volume of protection is sought for a company, the CDS spread widens and the debt value declines.
This situation worsens dramatically because there is no limit to the amount of stock option puts and default swaps that can be created. At multiples of the underlying value of the assets, derivative shorts can exert an inordinate strain on company values, well beyond that achievable through credible shorts or sales by the actual security owners.
The problem reaches beyond corporate valuations. Financial institutions can create unlimited derivatives of any kind — currencies, commodities, real estate, equities, debt — without the consent or knowledge of the underlying asset holders. While that ability already creates anxiety because of the potential corporate value destruction, the extension of derivatives influence to nearly every asset class should serve as a real wake-up call.
Another issue with endless derivatives creation is the degree of influence that any active financial company can subsequently wield. Given the unrestrained ability to create, sell and buy in the derivatives market, any party could conceivably make itself structurally important through extensive participation. The collapse of a large derivatives organization could evolve into a nightmare scenario for credit markets, as it has with the fall of Lehman Brothers Holdings Inc.
With all of these factors in mind (the ability to influence any asset, the ability to create this influence), one might expect that the only participants allowed to engage in such activities would be a select group of prudent, highly capitalized actors who hold the stability of our financial system in the highest regard. Perhaps these parties would serve as trustees for the functioning of the financial markets.
Reality is closer to the opposite. Nearly anyone can participate, without consideration for the long-term viability of the financial system. Most incentives are short-term, and while asset-level capital requirements exist, thousands of players do not have firm-level leverage constraints.
Taken together, the allowance of players who could create a countless supply of derivatives, which could then push and pull values far from the underlying asset without regard for the sustainability of the U.S. financial framework while using leverage for the purpose of maximizing short-term gains, does not seem prudent. In the end, because regulators have allowed this activity and the financial system is now at risk, the taxpayer must bail everyone out.
While a few suggested solutions point in the right direction, the current set of proposals is piecemeal and incomplete. The best recommendation to date has been the CDS clearinghouse, which would effectively remove systemic counterparty risk, create guidelines that limit exposures, add transparency for oversight and provide regulators with the means to enforce rules. But unless all over-the-counter derivatives are cleared in this fashion, significant risks remain. Yet central clearing for all derivatives is suboptimal because customized contracts are important in solving real problems and standardization severely reduces incentives for innovators.
A more complete remedy would be for credit-rating agencies, financial companies and regulators to agree on the degree of acceptable leverage for each asset class and market participant. Limits on the amount of derivatives outstanding relative to underlying assets are warranted because company-specific leverage constraints and capital requirements alone are not enough to ring-fence potential damage, as seen with American International Group Inc. Still, largely unregulated institutions such as hedge funds should be subject to risk-protection measures such as capital ratios. At the asset level, leverage multipliers could be assigned based on market value, liquidity, volatility, true economic hedging need, importance in price discovery, correlation with other assets and relative significance within the context of the global market.
The salutary effects from these recommendations are considerable. Leverage restrictions on puts and credit default swaps impose a more realistic boundary on the extraordinary valuation pressures faced by companies. Potential for value destruction in other areas is reduced. Financial institutions become less risky. And financial stability improves because derivatives outstanding would grow in some proportion to both underlying assets and the balance sheet of financial institutions.
In all this, we must delicately balance the objectives of providing enough market liquidity and latitude for innovation, without jeopardizing the entire system.
At this juncture, Washington has moved to stem the tide of financial disaster, but has not yet addressed an important cause. Until the leverage problem is rectified, companies, creditors, shareholders and the financial system will be at risk. The government will have no choice but to intervene each time. Worst of all, the nightmare could recur, draining taxpayer resources until corrective action is finally taken. Let's fix this now.
Philip J. Lee is a New York-based senior global fixed-income strategist at Barclays Capital Inc., the investment banking division of Barclays Bank PLC. The views expressed in his commentary article are his own and not necessarily the views of his employer.
