Lessons to be Learned From Mistakes in Past Derivatives Markets

Looking at the on-going expansion of the market in credit related products, including complex credit derivatives, it seems to me that there are some important lessons that should have been learned from past mistakes - and they probably haven't been.

There are a number of disturbing parallels between trends in the market today, and those in the past where serious errors were made, and which led to substantial losses for many investment banks.

For example, if we were to compare and contrast the current market in complex credit derivative with the earlier market in complex equity derivatives, at a similar stage in its development, there are some quite disturbing parallels.

What is particularly troublesome, is that, if we look in detail at where these comparisons break down, this strongly suggests that any problems that might now be encountered with credit related product could be several orders of magnitude worse than those previously experienced for other asset classes, such as equities.

A Lesson From the Complex Equity Derivatives Market

In the 1990s there was a period when some really very complex, and in some cases rather inexplicable, derivatives products started to emerge. These were being priced, traded and sold in the market - for a whole variety of reasons.

Investment banks would price and manage these products using a range of mathematical models, which were often tailor-made for the job - and which incorporated a range of different modelling techniques.

During this period, and shortly thereafter, there was a spate of very significant losses in the derivatives operations of a number of investment banks - as a range of problems subsequently came to light. There were quite a few cases where losses of the order of tens of millions of pounds, and a few rather greater than that.

So, what went wrong, and what are the lessons that should have been learned ?

What Caused These Problems

There were a number of factors which lay behind these problems; these are some of the key ones:

• Pricing of such complex products is not an exact science, and some 'quants' had an over-inflated opinion of their own abilities.
• To maintain competitiveness margins were often squeezed well beyond sensible risk-based limits.
• These products were not properly understood by many key people, but very few admitted it.
• Risk management often played 'second fiddle' to the imperatives of trading and sales.
• In the 'beauty parade' of derivatives pricing, there would often be several players who would significantly mis-price requests. These prices would often be too low, and create a downward pressure that others would follow.
• In some cases these products simply should not have been allowed.

The result of these problems - which were to various degrees apparent in many investment banks at the time, was that there was pressure to 'do deals', there were errors of pricing, and products were sold which later lost the banks concerned a great deal of money.

In the author's opinion these types of failure are not confined, for example, to the complex equity derivatives markets of the 1990s, but are also apparent in some of today's markets.

The Problems In Today's Credit Derivatives Market Might be Much Worse

There are a number of factors, which could make the present situation very much worse than the previous example, and which should be a cause for great concern:

• The size of the 'numbers' involved in the 'credit risk' arena are usually much greater than those for 'market risk'. This means that comparable errors might have a financial impact that is perhaps a thousand times greater than those which occurred previously.
• The basic nature of credit risks is that they are inherently more 'binary', which means that they are likely to be much harder to manage in volatile situations.
• There is good reason to think that 'the market' has systemically mis-priced risk in this area. For example, it is not at all obvious how to reconcile credit risk-levels implied in historical bond prices with those inferred from the appropriate risk grades.
• The failures of pricing and modelling might well be worse than in previous markets, but quite possibly involving some of the same individuals.
• Pricing and risk management problems that occurred in previous markets generally came to light quite quickly - within a year or two, after which time losses were crystallised, and practices changed. The nature of the credit markets is such that it could take more than a decade before 'the pigeons come home to roost' in a similar way, after which time problems of a truly colossal magnitude could have been built up.

Given the above, if the failures of the past do repeat themselves in the present context, then the result will not just be a few investment banks making significant losses, but a disaster which, quite literally, could be about a thousand times worse.

My conclusion would be that somebody really should do something about it.