The dangers of derivatives as the “Goldilocks era” ends

In 2002, Warren Buffett warned that derivatives were “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”.

Nobody paid much attention at the time. Investment banks were busy constructing and selling an alphabet soup of derivatives: mortgages were sliced and diced into mortgage-backed securities (MBS); car, credit-card and corporate loans were bunched into collateralised debt obligations (CDOs).

The dangers of derivatives

The idea was that if “banks repackaged their loans, mixed them up and sold them to different people, it would diversify their exposure to risk”, as Gillian Tett of the Financial Times explained. “So instead of having a concentrated exposure to one type of risk, they’d be sharing that risk between them, making them stronger.” (They were also collecting fat fees from the repackaging process.)

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She likened the system to butchers making sausages with meat from different cows.

The problem was that once it became clear that chunks of the new securities had gone bad – when the housing market turned, and the value of subprime mortgages slumped – it paralysed the entire system, just as a batch of poisoned meat that had been spread far and wide from a factory would cause people to stop buying sausages.

Financial institutions stopped trading with each other to avoid contagion; the world economy froze. A system designed to reduce overall risk had actually increased it.

The past few days have provided another example of this phenomenon. Defined-benefit pension funds have been using a strategy known as liability-driven investment (LDI) to match their assets to their liabilities. This has involved using derivatives and leverage, rather than simply buying bonds.

That backfired spectacularly last week as yields soared, prompting the Bank of England to intervene to temper a vicious cycle of selling and pre-empt systemic risk.

Goodbye to the Goldilocks era

A striking feature of both these blow-ups is that the people involved seem to have assumed that the benign conditions underpinning the investment techniques would last forever.

In the mid-2000s everyone thought house prices would go on rising. More recently, it was assumed that interest rates and bond yields would stay low forever or rise only slowly.

James Coney in The Sunday Times recalls an “awkward silence” when someone on the board of a final-salary pension fund he used to sit on asked, after a speech on the merits of LDI, what would happen if rates began to rise.

The entire financial world is now learning what happens when rates change quickly. Bonds are going down, ending a bull market that had lasted since the early 1980s.

Mortgage rates are going up; house prices are likely to go down as the supply of credit is squeezed.

Stocks have also become too accustomed to low rates. Dearer money reduces the present value of future earnings, which is especially awkward for companies where rapid-growth assumptions are priced in.

That explains why technology stocks are slumping – the Nasdaq Composite index has fallen by almost 30% this year.

However, with inflation far from vanquished, risk aversion rising and further rate rises on the cards, markets skewed towards value rather than growth stocks and offering a tempting dividend yield may prove resilient – markets like Britain, for example.