In Defense of derivatives: between Enron, WorldCom, and Global Crossing, the controversial financial instruments have gotten a bad rap. Here's the truth

Reason, Feb, 2004 by Gene Callahan, Greg Kaza

ATRS officials clearly did not understand the derivatives they were trading, and ATRS became the only state pension system in the U.S. to lose money in the offshore limited partnerships at the center of the Enron bankruptcy. As of mid-2001, more than 5 percent of ATRS' investments were considered "alternative," a high proportion.

In 1995 the Wisconsin Investment Board, which oversees the state's investment fund, lost more than $95 million through positions in leveraged derivative instruments linked to Mexican interest rates and currency. When the Mexican peso plummeted in value in 1994, the Investment Board incurred $35 million in losses. That same year, Independence Township in Michigan lost $2 million through its misuse of domestic swaps.

Legislatures in two Midwestern states responded to these government failures. Wisconsin has become one of three states (along with Kansas and Missouri) that restrict derivatives holdings by government units, prohibiting the instruments except when used "for the purpose of reducing risk of price changes or of interest rate or currency exchange rate fluctuations with respect to investments held" by the Investment Board. The state of Michigan, meanwhile, passed a law requiring government derivatives to be reported in audits, subject to the Michigan Freedom of Information Act.

But politicians usually have been far more interested in passing laws that regulate corporate use of derivatives than in examining governmental use. Forty states have legal definitions or other acts regulating the percentage of portfolios that insurance companies and other firms may invest in derivatives, while only Michigan has mandated transparency for government units dealing in them.

Ch-ch-ch-ch-changes

In response to the various derivatives disasters, many have suggested that the government should become more active in regulating these new markets. Sen. Dianne Feinstein (D-Calif.), following the Enron bankruptcy, proposed giving the Commodity Futures Trading Commission regulatory oversight over all derivative transactions. (Her proposal was defeated in roll-call votes in 2001 and 2002.) State agencies should certainly pay more attention to their own derivatives trading. But there are a number of pitfalls in increasing the regulation of private derivatives trading.

For one thing, as pointed out above, many of the current uses of derivatives are ways to dodge existing regulations. It seems probable that a new round of regulation will spur the development of new derivatives designed to bypass its restrictions. As the Securities and Exchange Commission's Paul Atkins said at a Cato Institute policy forum in March 2003, "every decade sees some sort of financial crisis, followed by new cries for regulators to 'do something.' Yet the new regulations invariably fail to prevent the next crisis."

Partnoy notes that many of Enron's dubious maneuvers involving derivatives were designed to enhance the company's "accounting reality" at the expense of its true economic condition. But the divergence between accounting and economic reality is itself chiefly a product of the regulatory environment in which publicly traded companies exist. The existence of legal "safeguards" to protect the investing public encourages companies to focus on the safeguards at the expense of the actual financial health of the company. That does not excuse the behavior of executives who violated their responsibility to shareholders, but the motivation to do so would not have existed without regulations that create a divergence between economic reality and accounting reality.