More Derivative Blowups? Why Yes, We Worry …
This article is from the archive of The New York Sun before the launch of its new website in 2022. The Sun has neither altered nor updated such articles but will seek to correct any errors, mis-categorizations or other problems introduced during transfer.

It was one of the stock market’s more memorable disasters in recent years — the 1998 blowup of the hedge fund Long Term Capital Management due to big derivative losses.
As a result of the LTCM fiasco, the market got clobbered and the shares of banks, a big player in derivatives, got slaughtered. For example, the shares of JPMorganChase alone plunged from $50 in late July of 1998 to less than $25 at the depths of the crisis in October. In other words, a 50% haircut in just a few months.
So why write about it now? Because the dangers inherent in these highly risky leveraged derivative contracts — which primarily bet on the direction of interest rates, commodities, currencies, and even stocks — have reached alarming proportions and represent a real threat to the stability of the market, an analyst with Money&Markets.com, Michael Larson, tells me.
He warns, for example, that any sharp, unexpected move could easily trigger a new derivative crisis arising from:
–A surprise swing in interest rates,
–A big run-up in stock prices (especially risky given all the bets against it).
–A housing collapse (which looms large because of all the high-risk mortgages out there)
–Another big drop in oil prices.
–Rising problems on the credit front, especially those related to the explosion in “credit default swaps” (derivative contracts designed to guard against credit quality going sour).
Describing the derivative danger as a “global Vesuvius, ” he notes that derivatives currently stand at a mind-boggling $285 trillion in very high-risk debts and bets. To put that in perspective, this amount, he points out, is equivalent to more than six times the 2005 output of the entire world economy ($44.4 trillion), 22 times the total value of entire Standard & Poor’s 500 Index ($12.7 trillion) and 25 times America’s federal and agency debt ($11.3 trillion).
Mr. Larson asserts that derivative risks have never been greater because “derivative growth is out of control.” He observes, for example, that derivative volume shot up 13.5% in the past year, 45% in the past two years, and a stunning 224% since the turn of the century.
Even more disturbing, he says, is the huge derivative exposure of American banks and the extent of the credit risk they add up to per dollar of capital. (See the accompanying chart of the 10 banks with the most derivative exposure, according to the Office of the Comptroller of the Currency).
Also worrisome, Mr. Larson says, is the huge participation in derivatives by the nation’s hedge funds, which, unlike the banks, lack the financial muscle to weather storms and seem to be trading contracts in largely an unregulated environment. Many of these funds, he contends, don’t have a clue where the risks lie until it’s too late.
A couple of examples of recent disasters: Energy hedge fund Amaranth Advisors vaporized more than $6 billion with high-risk natural gas bets that went awry and hedge fund Vega Select Opportunities got crushed with $400 million in redemptions when it made the bad bet that bond prices would decline.
Adding to the risks, he goes on, large speculators have recently made more bets on rising Treasury note prices than at any time in recorded history — almost twice the previous record.
Derivatives had been largely used in the past to ensure bonds against default in case the economy went into a recession, but now they have greatly expanded for use in other derivative instruments. “The risks are rising every day,” Mr. Larson says. “No one knows when these bets might turn sour, and things could get ugly very fast.”
So how should investors protect themselves? Our derivative worrywart strongly recommends a sizable amount of a portfolio be confined to short-term Treasuries. Likewise, he says, avoid putting 100% of your money into stocks, don’t over-leverage yourself and avoid the stocks of the big banking players in the derivative market.
“I know it’s hard to tell people to play it safe when the market keeps going up,” Mr. Larson concedes, “but the global Versuvias — the amount of interwoven bets and debt in derivatives — is so huge and so scary that it could erupt at any given moment and instantly throw the world’s financial markets into turmoil.”
The bottom line: More derivative blowups seem inevitable. So like the boy scout: Be prepared!