"[D]erivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
—Warren Buffett, Berkshire Hathaway 2002 Annual Report

"When used properly, derivatives are a valuable risk management tool…"
—Kathryn E. Dick, OCC Deputy Comptroller for Risk Evaluation

Ever since the collapse of Long-Term Capital Management threatened the safety and soundness of the financial system, regulators and investors have demonstrated a hair- trigger susceptibility to define all derivatives as "bad" or worse. Even the Sage of Omaha has thrown his two-cents’ worth of hyperbole into the discussion. This is not to say that the concerns are unfounded. Even though we have learned the hard way that derivatives can indeed wreak havoc in the hands of the wrong practitioner, their usage is soaring and new troubles seem to surface every day. "The derivatives genie is now well out of the bottle," Mr. Buffett wrote in his Chairman’s letter this year, "and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear."

The bad and ugly of derivatives is the belief that the derivatives skyscraper that is now reaching the moon has been built on a sand foundation of a relatively smaller and poorly-accounted capital base. The relationship among global financial institutions and securities markets has become ever more complex and interdependent because of the use of derivatives, and the fear is that a hiccup in one corner of the world causes a collapse in the rest of the system: The sand shifts and the skyscraper comes tumbling down.

Freddie Mac is just a suspect, but there is a long line of institutions that have been felled by the misapplication of derivatives, beginning with Orange County, California, and followed by Barings Bank, LTCM, Beacon Hill, and more. We emphasize suspect, because unlike the others, Freddie Mac’s issue is apparently over a technical accounting restatement which has yet to be concluded, but the sheer size of Fannie Mae and Freddie Mac and their primacy in the financial markets is causing unease. The same goes for derivatives. If you’re looking for weed-like growth in today’s economy, look no further than the activity in derivatives. According to the International Swaps Dealers Association, the global trade association representing leading participants in the over-the- counter derivatives industry, the notional amount of plain-vanilla currency and interest rate derivatives contracts outstanding at year-end 2002 was approximately $100 trillion, an increase of 44% from 2001 and more than triple the amount outstanding just five years before. The U.S. Office of the Comptroller of the Currency, the regulator of the nation’s banks, reported in its most recent Bank Derivatives Report that the notional amounts of interest rate and currency derivatives contracts at American banks totaled about $60 trillion at the end of the first quarter of 2003, a 34% jump from a year ago. Moreover, approximately 97% of all activity is being conducted by the top 7 banks—call it the 97/7 rule.

Derivatives, explained Kathryn E. Dick, the OCC’s deputy controller for risk evaluation, "help bank institutional customers manage a broad array of different risks arising from common business activities such as securing long-term funding or protecting the value of importing or exporting commercial goods." Bob Pickel, the CEO of ISDA, was equally bland but reassuring when discussing the merits of derivatives. "The continued pace of growth in the OTC derivatives markets during times of economic and political uncertainty demonstrates their importance as a mechanism for mitigation and dispersion of risks our members encounter in the course of their business."

It seems to us as if Mr. Buffett on the one hand and OCC and ISDA on the other are both right, but they are talking about nominally different things. Mr. Buffett is decrying the lack of understanding on the part of the policymakers and regulators of how derivatives work systemically. Certainly the OCC knows how a swap works, but derivatives have gotten more and more complicated, and the risks that are supposedly being hedged are being socialized over a financial system that is perhaps ill-prepared. Whatever risk is being hedged by a derivatives user is being borne by someone or some group of institutions. When Fannie Mae is engaged in the quite necessary practice of hedging its interest rate risk in order to avoid having the cost of its funds exceed the yield on its assets, it is passing along that risk to its counterparties, who in turn pass that risk along to their counterparties. Here is where it gets difficult to quantify the risks in the system. Moreover, the complexity of some derivatives transactions move way beyond the textbook interest rate swap to the extent that their users aren’t fully aware of how they operate in extreme market conditions. In short, Mr. Buffett is talking about organization failure, system failure and complexity risk.

But Ms. Dick and Mr. Pickel are talking about something else: They are talking about the intrinsic usage of derivatives, and these can be beneficial. A derivative, as its name implies, is an instrument whose value is derived from the value of something else, sometimes called the "underlying". In a call or a put option on an individual stock—in which the owner of the option has the right to purchase or sell a stock at a specific price by a certain date—the underlying is the stock. In a future or forwards contract, the buyer is essentially agreeing to buy the underlying—a physical commodity like gold or wheat or a financial commodity like a currency or Treasury bill— at a specific price at a specific point in time. The value of the option, future or forward changes as the price of the underlying changes.

These types of derivatives could be used for hedging purposes, in which the hedge is put in place as protection against an unwanted, loss-inducing outcome. For example, if one owns a sizable position in a stock and wants to hedge against the possibility of the value of that stock falling, he or she could buy a put option (which rises in value as the underlying stock price goes down). At the same time, the exact same derivative contract could be used for speculative purposes, in which the investor wants to make an outright bet on the direction of the underlying. For example, it is a speculation if one buys a put option simply due to the belief that a stock price would go down. When a derivative is used for speculation, the investor’s capital is potentially at far greater risk than when that capital is used for hedging.

Fixed income investors can also use derivatives for hedging against an unwanted outcome. The most commonly used hedge for a fixed income investor is one that reduces an investor’s exposure to interest rate risk, which is a risk of loss to future earnings or long-term value that may result from changes in interest rates. The most commonly used form of interest rate derivative is a swap in which two counterparties exchange fixed-rate and variable-rate interest payments. Swaps are custom-tailored to meet the needs of the counterparty, by choosing the dollar amount to be swapped and the exact maturity of the swap. In a plain vanilla swap, one counterparty will have an initial position in a fixed rate debt instrument while the other has an initial position in a floating rate instrument. The positions themselves are not swapped—these are the notional amounts—just the cash flows derived from them. By swapping interest rate flows in this way, fixed income investors can minimize or negate any interest rate risk.

The best way to illustrate this is with an example. Let’s say a savings and loan has extended a 15-year fixed-rate mortgage of 4.0%, which it has funded with cash from its depositors. The S&L pays a rate of LIBOR plus 1% on its deposits, and let’s say LIBOR is 1.5%. In the event rates rose and the S&L had to pay more on its deposits, its spread will be compressed, or even rise above the yield it is earning on the mortgage it extended. To protect against this outcome, the treasurer at the S&L could enter in a swap with a counterparty in which he is essentially turning his fixed rate mortgage into a floating rate instrument. Another way to express it is that the S&L treasurer is turning his floating rate liability (the rate he pays on his deposits) into a fixed rate liability. In this swap, the treasurer agrees to pay the swap counterparty 4% and receive LIBOR plus 2%. Because the 4% he receives from the mortgage is passed on to the swap counterparty, the S&L treasurer has locked in a spread of 1%, i.e., the difference between the LIBOR +2% he is receiving from the swap counterparty and the LIBOR +1% he is paying to his depositors.

FAS 133, issued by the Financial Accounting Standards Board in 1998, offers direction on accounting for derivative instruments and hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in its financial statements. Depending on the transaction, a derivative is classified as (i) a fair value hedge, in which the derivative is used to hedge against the change in fair value of an asset or liability of a company, (ii) a cash flow hedge, in which the derivative is used to hedge against exposure to variable cash flows, or (iii) a foreign currency hedge, in which the derivative is used to hedge against foreign currency exposure. The example illustrated above is a cash flow hedge. In a cash flow hedge, the changing value of the swap is reflected in the shareholders’ equity portion of the S&L’s financial statement, typically in a section called Other Comprehensive Income. Just as the value of a stock option rises and falls with the rise and fall in the price of the underlying, so does the value of the swap in this example vary as rates rise or fall.

The benefits of the swap in this example are clear, but even a plain vanilla swap that is utilized for hedging purposes contains risks. For example, the value of the swap might not offset the change in value of the underlying, or the swap counterparty could be downgraded or fail to live up to its obligation. As with any investment decision, the prudent portfolio manager has to weigh these risks against the supposed benefits of the derivative and monitor the derivative closely.

Academics and journalists, regulators and businesspeople have written countless books and articles on the business of derivatives. Different derivatives carry varying degrees of risk, and the same derivative can have a changing risk profile depending on current market conditions. If these risks are misunderstood, or if the users are over-reliant on "black boxes" for decision-making, the results can be devastating. Furthermore, as market observers have seen from the difficulties at Freddie Mac, misapplication of accounting rules for derivatives can also pose a risk, even if the underlying economics of the transactions are effective. (Needless to say, misapplication of accounting rules can—and does—happen in virtually every aspect of a company’s financial statements; derivatives are no different in that regard.) However, on a company-specific level, the benefits of a derivatives portfolio are obvious, and the sheer growth in the market is a testament to those benefits. The current market environment, in which interest rates across the yield curve are at multi-decade lows, poses particular risks to managers of interest-rate sensitive businesses, and the prudent application of derivatives as hedges, i.e., interest rate swaps and related contracts, will continue to be used.

While market participants need to heed Warren Buffett’s words of caution, they must also understand the benefits of derivatives. Risk is just another way of expressing the probability of a range of outcomes in a given discipline. Managing that risk—minimizing negative outcomes, maximizing positive ones—is the job of the manager, whether it is an S&L treasurer, a portfolio manager or a baseball coach. For the portfolio manager, derivatives have a place if using them is the best way to minimize a negative outcome.

August 6, 2003
By Jeremy Diamond, Executive Vice President
Annaly Capital Management

This commentary is neither an offer to sell, nor a solicitation of an offer to buy, any securities of Annaly Capital Management, Inc. (“Annaly”), FIDAC or any other company.

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