Roger Ehrenberg, a veteran of Wall Street (and derivatives), contends that the focus on the ‘evils’ of the derivatives market is misplaced.
Regulators, Congress, and the media generally focus on the crisis at hand. The Enron scandal gave us Sarbox. The market crash has created a PR flurry against “sponsored access” and proprietary trading. AIG generated a firestorm surrounding the use of credit derivatives. The common thread is that policy-makers are reactive and missing the big picture, leading to short-termism and a host of poorly constructed rules and policies. And invariably the word “derivatives” is used as a lightning rod for why new regulations should be promulgated.
The problem, however, isn’t exclusive to derivatives; it’s the underlying “business purpose” of transactions. Hedging has a legitimate business purpose. Making markets, speculation, and financing projects have solid business foundations as well. But entering into transactions that serve to hide or obfuscate economic reality work against this principle. And this lack of business purpose is not confined to the derivatives markets, but frequently takes place in the cash markets as well.
Consider leasing, a transaction that has been popular for over 50 years. As the industry has evolved, transactions such as sale/leasebacks and “asset defeasance” have been used to synthetically borrow money without the obligation being reflected as debt on the balance sheet. The form of the transaction: a lease. The substance of the transaction: a borrowing.
The multi-trillion dollar securitization industry has the same motivation: moving assets (and liabilities) off the balance sheet, while economic recourse still exists should asset values and/or debt ratings drop.
This is what the market discovered when Citigroup’s multi-billion structured investment vehicles (SIVs) began to fail and the assets and liabilities came back onto its financial statements. What is the proper characterization of a contractually obligated stream of payments? Debt. How should a portfolio of assets and associated liabilities be treated if the risks and rewards of ownership haven’t been completely transferred? As never having left the balance sheet.
Yet the accounting profession, with the SEC’s support, has enabled this charade to continue.
Derivatives have also been used to achieve similar ends. Structured transactions have been designed to generate upfront cash without a corresponding obligation being recorded on the financial statements. The recent discovery of Greece’s use of these instruments has shined a light on the dangers of hidden borrowings. Municipalities have mortgaged their futures by selling strips of participation in cash flow generating assets (roads, bridges, airports, etc) in order to generate liquidity today (at a steep cost to financial solvency tomorrow).
The virtually unbounded rise of the credit derivatives industry is partly due to the mismatch between the notional value of derivatives being written and the actual value of underlying instruments. This mismatch can be 5x or more of the bonds being “hedged,” leading to market failures when physical delivery is demanded from counterparties lacking actual ownership (or the ability to borrow the position). Neither of these examples embody true business purpose.
Both cash-market and derivative instruments should be put to the “business purpose” test. Accounting rule-makers, with support of the SEC, should move towards a “principles-based” system where common sense, and not black-and-white rules around which myriad loopholes can be found, should become the new paradigm. But let’s be clear. The issue isn’t derivatives; it’s all financial transactions whose objective is to deceive or to weaken financial transparency.
Roger Ehrenberg is currently managing partner at IA Ventures Strategies, focusing on big data tools and technologies. He is a serial venture investor and former President and CEO of DB Advisors and pens the blog Information Arbitrage.