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

Then there is the question of how to clean up after a derivatives meltdown. When, after some gamble has gone horribly wrong, the government intervenes to soften the blow to investors, it creates a moral hazard. Once people expect that someone else will pick up some of the cost of their speculative failures, they are more likely to undertake risky actions than they would if they had to bear the cost themselves. The amateur mountaineers who venture into places they would never go if there were no park rescue services are a case in point--the existence of a free rescue service prompts people to take risks they wouldn't otherwise, necessitating even more rescues.

Government bailouts of failing investments create a similar moral hazard. The stronger the expectation of a government safety net, the less investors will concern themselves with the risks inherent in the investment. When the average private corporation makes a mistake with derivatives, it suffers a loss. After a few mistakes, it either goes out of business or learns its lesson and changes its practices. But large private hedge funds and money-center banks know that they are "too big to fail," at least in the government's eyes. In the event of a financial catastrophe, they expect to be bailed out by government deposit insurance and the Fed. Such bailouts came to be commonplace under Federal Reserve Chairman Alan Greenspan, especially when he was teamed with Treasury Secretary Robert Rubin.

After the October 1987 market crash, after the savings and loan collapse of the early '90s, and during the crises in Mexico, Russia, and East Asia, the U.S. government rode to the rescue of investors. In September 1998, when the large Long-Term Capital Management (LTCM) hedge fund faced a severe financial crunch, the government stepped in again. The Fed cut rates three times, and the New York Federal Reserve brokered a controversial de-leveraging of LTCM'S derivative trades, which had gone south when the Asian and Russian financial crises unfolded. Large money-center bank were on the other side of many of these trades. "If Long-Term defaulted ... the banks ... would be left holding one side of a contract for which the other side no longer existed," Roger Lowenstein explained in his book, When Genius Failed: The Rise and Fall of Long-Term Capital Management (2000). "In other words, they would be exposed to tremendous ... risks."

The Fed's actions sent a clear signal to markets--and the European central banks that had invested in LTCM--that large, politically connected banks with exposure to losing derivatives trades would be protected. There is some evidence that this action contributed to the Enron debacle. For instance, a U.S. district judge in New York ruled that some Enron derivative trades were actually "disguised loans" from a bank previously involved in the LTCM affair.

"In the short run the intervention helped the shareholders and managers of LTCM to get a better deal for themselves than they would otherwise have obtained," economist Kevin Dowd has commented. "It implies a return to the discredited doctrine that the Fed should prevent the failure of large financial firms, which encourages irresponsible risk taking."