As promised, here's Jesse Eisinger's response to my earlier blog entry on derivatives. It's a good one, too, so I'll let him have the last word.

My first blog entry on Portfolio! So exciting.

First of all, I think we agree on much here. Derivatives are mostly used as a form of insurance. (As an aside, the derivatives industry doesn’t like the comparison to insurance, because insurers typically are heavily regulated and required to hold minimum amounts of capital against their policies. Derivatives traders are not. Hmm.) The industry types prefer the words “hedging” or “protection.”

These instruments are, I agree, used mainly to smooth cash flows, make markets more predictable and spread risk from those who are vulnerable (say, farmers) to those who want it or can handle it better (commodity speculators).

And I will concede a bit of First-Issue-of-Big-Glossy-Magazine fear-mongering in referring to nominal figures when talking about the size of the markets. The headline of my column uses the $300 trillion amount for the whole derivatives market. In the column, I refer to the $26 trillion amount for the notional amount outstanding in the credit default swaps market. They are the real nominal figures but they are a bit hyperbolic. I disagree they are meaningless. They show how much the derivatives markets have grown, for one. Answer: a lot. These are the fastest growing markets in the world.

But there are some inherent concerns about derivatives. One is that they are a form of leverage. Anyone can write a credit default swap on Felix Salmon Fisheries Corp., take a fee, and be on the hook for some big sum in the event that Felix goes belly up. (Groan.)

Maybe the writer can handle the risk and maybe not. You think that “most derivatives” are not “speculative” investments. Oh really? How do you know? What’s the breakdown of prudent hedging compared with speculative? You don’t know. I don’t. No one knows how much leverage there is and how much speculation there is.

What we do know is that the derivatives markets are large, liquid, for sophisticated investors, and are largely off the radar screen. That is pretty much the platonic ideal of a natural environment for speculation. Now speculation has a bad connotation, but it’s not inherently bad. Some of the speculation transfers risk properly. If the speculators are taking risks that they can handle, that is. Amaranth couldn’t handle the risks, but the fallout was minimal. Long-Term Capital Management couldn’t either – but the
fallout was hardly minimal and the fund needed a massive bailout.

The question becomes whether the users are accounting properly for how much exposure they have and whether they are doing proper due diligence on their counterparties. Warren Buffett writes that the accounting can be screwy and that both sides of derivatives trades can immediately book paper profits. I’ll trust him on that.

Are derivatives being valued properly? Gen Re wasn’t the most cutting edge derivatives player but they were a financially savvy group of guys. They didn’t value some of their instruments correctly. Maybe they are the exception, but I doubt it.

The sophisticated institutions supposedly have good risk controls that should prevent similar problems, but do they? Amaranth and LTCM were widely viewed as having top-class risk controls. That doesn’t give me much faith in risk controls, especially in a crisis.

Does that mean we are going to have a crash? I don’t know. I agree that it’s a zero sum game in theory and that they cannot wipe out wealth of non-participants per se. But their prices are derived from securities. If the securities markets sneeze, you say the derivatives markets are the tissues; I say they might be the virus. That's where the worry about systemic risk comes in; if the gains are concentrated in a very small number of players but the losses hit a big bank, look out.

And the concept of a crash doesn’t simply mean wealth-destruction. These markets can crash in a very real way: They can go away. There are relatively few major derivatives dealers; in a panic, they won’t pick up their phones. It’s conceivable that one day investors will wake up and the CDS market or some part of the collateralized debt obligation market or something else won’t be open for business – as the subprime mortgage originators essentially found a few weeks ago. (Obviously, this is a matter of price. Things settled down in subprime and now the subprime window is open. But mortgages are being packaged and sold at a discount, rather than a premium.)

So what do we have? We have relatively new markets that are wildly popular with risk-hungry investors, growing like weeds, haven’t been tested in a crisis, and have the potential to increase leverage dramatically. Furthermore, mostly derivative transactions aren’t transparent to other market participants or the regulators.

And Felix says, What, Me Worry?