Derivatives: The Risk That Still Won’t Go Away

But within two weeks of the bankruptcy filing, BofA sued Lehman to recover the $357 million, saying that Lehman in fact owed derivatives payments to BofA. Ultimately BofA placed the amount it was owed at $1.95 billion! In other words, by BofA’s thinking, Lehman didn’t have a plus of $357 million, but rather a minus of $1.95 billion. Trying to capture some of that money, BofA had by that time seized $500 million belonging to Lehman—described by Lehman as an overdraft account—held in a BofA Cayman Islands branch. Leave aside the point that anything about banking in the Caymans raises eyebrows, and behold that rich overdraft account, whose size suggests that Lehman may have been the Imelda Marcos of investment banks.

As of now, there has been no court finding as to the accuracy of BofA’s $1.95 billion or whether the seizure of the $500 million was lawful. Meanwhile, BofA is still trying to recover its $357 million of collateral. But it turns out that before the bankruptcy filing, Lehman had deposited this collateral with its clearing bank, J. P. Morgan, which upon the bankruptcy seized it to cover derivatives debts that Lehman supposedly owes Morgan. So, to sum up, Morgan has captured $357 million of either BofA’s or Lehman’s assets—we don’t know which—to offset what Lehman supposedly owes Morgan on derivatives, though Morgan has never told the court what that amount is.

We may put down some of these absurdities to lawyers pushing their claims. But to avoid the kind of morass this tale describes, a working group co-headed by Jerry Corrigan has recommended that the counterparties in a trade periodically discuss and agree on its value. One intermediary helping that happen is a Swedish company called TriOptima, which offers a service called TriResolve. Raf Pritchard, head of TriOptima’s U.S. operations, says his reconciliation service is booming, embraced by derivatives folk who, for example, truly wish to know what amounts of collateral should be changing hands. It sounds as if some of the Lehman litigants could benefit from the service.

Considering the unending complications of derivatives, wouldn’t we be better off without them? Robert Pickel, CEO of the International Swaps and Derivatives Association, acknowledges that the opposition includes “a camp that would ban them all—like Charlie Munger would” (referring to the vice chairman of Berkshire Hathaway). But the very suggestion of a ban causes most of those with even remote connections to the derivatives business to stiffen; turn from friendly to antagonistic; question the sanity of the fool who asked; and recite the creed of financial derivatives, which is that they beneficially spread risk. Never mind that we have spent several pages casting doubt on the idea that, the wholesale spreading of risk is a virtue. In the mind of all who have dealt with derivatives, and typically made their living off them, it is.

Pickel does not include Munger’s colleague, Warren Buffett, among those who would ban derivatives, because it is a celebrated fact in the financial world that the man who sparked 1,370,000 Google citations for “financial weapons of mass destruction” has bought a good many of them for Berkshire Hathaway. Explaining, Buffett points out that as far back as 1998 he had told shareholders about derivatives Berkshire owned, and that he never said he wouldn’t again exploit a mispricing when he saw one in a derivative. (It is the opinion of this writer, a friend of both Buffett’s and Munger’s, that Buffett is incapable of ignoring mispricings, wherever in the financial markets they may exist.)

Congress, which has never shown talent for putting genies back into bottles—think of earmarks—once again has derivatives on the agenda. The last time Washington considered regulating them, in the late 1990s, things didn’t go too well. The champion of change then was the chairman of the Commodity Futures Trading Commission, Brooksley Born, who was determined to bring these exotic, unregulated instruments under the purview of her agency, which already oversaw futures trading—of puts and calls, for example. Still living in the Washington area today, she recently told the Washington Post that dire premonitions about derivatives back then caused her to wake repeatedly in a “cold sweat.”

It couldn’t have helped that in daylight she faced three men who were implacably opposed to regulation: Fed chairman Alan Greenspan, Secretary of the Treasury Lawrence Summers, and Senator Phil Gramm (R-Texas). Not only did Born lose the battle, but Gramm pushed through legislation that specifically barred federal regulation of OTC derivatives.