Janet Bush: Mad, bad and dangerous to know ... or do derivatives just need a bit of loving care?

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The Independent Online

Are we facing a financial crash, triggered by a crisis in the huge and mysterious over-the-counter derivatives market? Finance bloggers certainly think so, as do some of the world's most admired investors. Warren Buffett, known for the spectacular success of his old-fashioned stock picking - and regarded as a bit of an old buffer by the flaming Ferraris of the markets as a result - has described deriv- atives as "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal".

Popular misgivings about the crazy twilight world of derivatives - estimated to have had a notional value in mid-2005 of $270 trillion by the Bank for International Settlements (BIS), but incomprehensible even to many market professionals - have been ratcheting up. That's partly due to headlines about high-level meetings between regulators and the big players, partly to instinct.

After all, derivatives have been at the centre of some spectacular implosions - including that of Long-Term Capital Management (LTCM), which in 1998 had to be bailed out to the tune of $3.6bn (£2bn) and whose failure, said the US Federal Reserve, had posed "unacceptable risks to the American economy". Barings was famously brought low by huge exposures to derivatives contracts that went south, while Enron, which had diversified into fairyland accounting and relied on derivatives trading to inflate its growth, also failed. And partly because of a bad derivatives exposure, Parmalat, the Italian food giant, went bankrupt too.

In 2005, Refco, the fourth- largest futures broker in the US, filed for bankruptcy. In February 2004, it was reported to have had $69bn in off-balance sheet derivative contracts; that figure had risen to $150bn by May 2005. In the same month, the exposure of former blue-chip companies GM and Ford was laid bare when ratings agency Standard & Poor's downgraded $453bn of outstanding debt. The announcement caused panic in both the markets for their bonds and their credit derivatives - instruments that allow a bank to unbundle the risks of a corporate exposure to investors, who then bet on corporate downgrades and bankruptcies. The BIS said that the system had come close to meltdown.

The spectacular numbers involved in derivatives trading are enough to make any observer queasy. In December 2004, the US Comptroller of the Currency reported, for instance, that JPMorgan Chase had $43 trillion of derivatives on its books (some four times US GDP). Another example was provided by Deutsche Bank, which reported at its 2004 year-end that it held derivatives positions of a nominal volume of $21.5 trillion - some 10 times the annual turnover of the German economy.

But are we naive to be scared just because we don't understand these things or the sums of money involved? Are derivatives intrinsically dangerous, or are they instead a useful tool for spreading risk and an attractive investment opportunity for the brave? Have they been given a bum rap because of a few instances of industry mismanagement and individual venality or incompetence?

Derivatives aren't new - arguably they go back to biblical days. Genesis, chapter 29, tells the story of Jacob, who purchased an option costing him seven years of labour in return for the right to marry Laban's daughter, Rachel. It recounts how his prospective father-in-law reneged on the deal, making this perhaps not only the first derivative but the first default on a derivative.

The markets, and many regulators, continue to see more positives than negatives. Alan Green- span, former chairman of the Fed, was a consistent fan while in office, although he has sounded more cautious since he left. Ben Bernanke, his successor, told the Senate Banking Committee that "derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand and use them properly".

That shows a touching faith in the common sense of clever, dynamic people who, it has been proved time and again, suspend judgement in favour of the intoxication of trading big money. In 1997, Professors Robert Merton and Myron Scholes were awarded the Nobel Prize for Economics for their method of valuing derivatives. A year later, they were embarrassed after the collapse of LTCM, where they were investors and advisers.

In the Anglo Saxon culture, and particularly in the US, it is worrying to see how close the relationships often are between the regulated and their regulators, and what can seem a cosy collusion between the two on the basis of an ideological inclination towards deregulated markets.

Perhaps discussions between the market and the watchdogs, which have intensified over the past year, will be enough to return derivatives to health. The focus has been on the management of the market, not its fundamentals, for its infrastructure has been left in the relative dark ages as volumes have doubled year on year. Astonishingly, this market has no modern clearing system, many deals are done by telephone or fax, and, as recently as last September, there was an estimated backlog of nearly 100,000 derivatives trades that had not been settled for 30 days.

Clearly there is a case for fixing the market's pipes, and maybe that will be enough to protect us all. Then again, we seem to be looking at an alien culture. Until recently, when regulators insisted on reform, it was perfectly acceptable to sell on a derivative to a third party, and another, and another, with no obligation to inform the lending counter-party. A lot of the time, bluntly, no one knew who owed what to whom.

Gerry Corrigan - former president of the New York Fed, chairman of Goldman Sachs and leader of the group of 14 banks (known on Wall Street, in a mafia reference, as the "Fourteen Families") involved in the bailout of LTCM - is now in talks to sort out the derivatives market. He says he was "horrified" when he found out how widespread the practice of non-notification was. "What it meant was that if you and I did a trade, and you assigned it without my knowing it, I thought you were my counter- party - but you weren't."

Just as alarming is the thought of the ordinary investor entrusting his or her money to such institutions. All we can do is hope that the banks and the regulators are serious this time, wish them luck, and cross our fingers.

We're relying too much on our houses

Bricks and mortar have once again become a convenient source of credit for the British consumer. Bank of England figures last week showed that mortgage equity withdrawal (MEW) increased in the final quarter of last year to £11.8bn, from £8.9bn in the third quarter. Elsewhere, consumer belts are being tightened - household consumption rose by only 1.5 per cent year-on-year in real terms in the final quarter of 2005 - but our attitude towards property appears to defy normal economic behaviour.

Houses have not only become the default investment choice of the British but are also central to our retirement planning. In a new study by the Association of British Insurers, only 17 per cent of respondents said they trusted the Government to provide for them in retirement. The Pensions Commission, which was set up to find solutions to Britain's long-term savings crisis, noted that "a significant proportion of people say they see equity in their home as an alternative or additional retirement asset".

Following a week in which the Government delayed its response to the commission's report at least until the summer, this trend can only intensify.

Over the 20 years to 1999, money held via pension funds and life insurers overtook net housing wealth; since 1999, this trend has been turned on its head so that housing wealth is now worth 40 per cent more than all pension and life policy assets.

Theoretically, property is an asset like any other and there is no reason why we shouldn't rely on it as our main investment. But there are big risks, not least that house prices go down as well as up and that the first rule of investment is to spread risk through diversification.

The Pensions Commission has said we should not rely on our homes to finance our retirements. For one thing, these assets are unevenly distributed: the better off, who also tend to have taken out private pensions and who stand a better chance of inheriting, have the biggest store of housing wealth. For another, there are claims on these assets in retirement - not least the cost of long-term care.

Gordon Brown has always made much of his desire to see balanced growth, but his failure to tackle pensions is contributing to a chronic dependency on our houses, a dangerously imbalanced economy and very serious financial risks for us all, but particularly the less well off. That is not something a Labour government can be proud of.