It’s an interesting term – risk management. It sounds so organized and reassuring. A risk that is managed is tamed, brought within well understood parameters and reduced to a level that shareholders can tolerate. Investment bankers and their tame economists constantly tell us that the derivatives market has reduced risk in the financial system and made corporate earnings stabler and more predictable, so it must be true, right?

So why has Ford had to restate its last 5 years’ earnings? Why has Fannie Mae still to produce a 10-K annual SEC filing for 2004, in the process of doing which it will wipe $11 billion off the earnings already reported for the years 2001-2004? What precisely is “managed” about an $11 billion write-off that takes 2 years to compute?

Derivatives trading totaled $370 trillion in the first half of 2006 and is still rising rapidly. That’s almost 10 times Gross World Product, so even though derivatives volume is hugely overstated (because the value of a derivative – an option or a swap—is a small fraction of its nominal amount) and trading volume includes large amounts of Mickey Mouse round-tripping among the dealer community, it has clearly become a very large business indeed.

The derivatives business, in its modern large scale form, originated in the 1970s from two pretty well separate sources: stock options and currency options trading on the Chicago exchange and the parallel loan/swaps market in London. The separation between the two markets’ origins is reflected in the different rationales available for derivatives’ use. Options trading in Chicago was always primarily a speculative activity, whereas currency and interest rate swaps were initially used primarily for hedging. Thus derivatives today are often sold as hedging vehicles, but may in reality reflect buyers’ wish to speculate on their own superior intuition.

The derivatives market depended heavily on the PC revolution, since valuation methods such as the Black-Scholes options valuation formula were impossibly cumbersome to use with only a calculator. The “mark to market” position valuation methodology, which used interest rates derived from broadly traded instruments such as Treasury bonds to calculate valuations for much more exotic instruments, was also only possible on a daily basis using computer technology. It was devised because management wanted to calculate whether the activity was making a profit and traders wanted to pull income forward so they could declare the maximum possible profit for bonus purposes.

Traditionally, derivatives losses resulted from trading mistakes. In a classic 90s example, the German company Metallgesellschaft lost $1.5bn in 1993 in the oil markets. It contracted to sell 160 million barrels of oil forward over the next 10 years, but with an option allowing counterparties to terminate the contract early if the New York Mercantile Exchange future oil price was higher than the price at which Metallgesellschaft had contracted to sell. To hedge, it purchased short dated oil futures on the NYMEX. Metallgesellschaft then discovered that its trading represented a substantial portion of total NYMEX trading volume and that it didn’t have the cash to meet margin calls. Thus it was forced to crystallize the loss when oil prices dropped suddenly.

This was a typical trader-driven loss, as were similar disasters at Barings (bankruptcy, from Japanese stock futures) and Orange County ($1.6bn loss in Treasury bond futures) in 1994-95. These losses all had in common trading in excessively large amounts by improperly controlled traders motivated by the lure of short term personal profit.

The Long Term Capital Management hedge fund collapse of 1998 spotlighted a different problem. Again, excessive trading volume was partly at fault. However nobody could blame LTCM’s risk management systems; they were state of the art, with two Nobel Prize winners on the Board of Directors to confirm that LTCM was managing its risks in line with the finest tenets of modern finance theory. It appears that the LTCM people were so convinced they were the cream of the intellectual crop that they failed to allow for the possibility that their models were rubbish. This should have caused an episode of deep risk-aversion in the derivatives markets, but 1998 being 1998, it didn’t.

Then there was Enron. The swingeing sentences handed out to Enron’s top management made it appear that its collapse was due to thieving but in fact the thieving was minimal in the context of Enron’s overall size. The collapse resulted from sheer incompetence. Enron was running a huge energy trading operation from a company whose debt rating never exceeded BBB. Consequently, when the market turned against it, Enron’s counterparties quickly required additional collateral to be posted and the house of cards collapsed. Enron’s energy trading operation was perfectly viable, as has been demonstrated by its subsequent success within UBS, but was far too big for anyone but a major international bank.

Unlike earlier derivatives catastrophes, Ford’s and Fannie Mae’s losses don’t relate to poor trading, but from the difficulty in valuing a large portfolio of derivatives in financial statements. Financial Accounting Standard 133, which deals with derivatives valuation, allows companies to divide derivatives positions between trading, in which positions are marked to market and profits and losses taken and hedging, in which they are held for the long term against the asset being hedged. Naturally, you’re supposed to decide immediately you buy the derivative which category it will go into. In the case of Fannie Mae, management had been holding new derivatives positions for several weeks to see which way the market went, and then recording them so as to book the profits and leave the losses as hedges, to accrue over the life of the instruments concerned.

Needless to say, when this trick was discovered much later, after Fannie Mae management had collected several years of record bonuses, it was more or less impossible to determine what the correct position should have been – thus the accounting uncertainty and the two years of cleanup work.

Derivatives are sold by investment banks to corporations seeking to hedge risks in interest rates, currencies, equities or commodities. To the banks selling them, who make trading profits through their knowledge of the deal flow, they’re a wonderful business. To corporate management, which can use them to create artificial profits in a quarter in which earnings are falling short of forecasts, they may also be attractive – any accounting restatements occur several years later, and pass almost unnoticed by the market. For example Sears, now owned by ex-trader Ed Lampert, announced Thursday that it made more money — $101 million – from trading in credit derivatives in the third quarter of 2006 than it did from its core retailing business –$95 million.

I’m sure Lampert feels very proud of himself, and will be given some suitably munificent reward. However Sears shareholders – and customers, and employees – will wonder what the hell is going on. Trading credit derivatives is a huge distraction from management’s primary purpose of running a retailing operation. Indeed, the market reflected this view, with Sears’ share price dropping 5.5% on the day.

To corporate shareholders derivatives are all risk and no reward. In addition to the risk of a rogue trader, the risk of a hedging system that proves flawed and the risk of overtrading, shareholders also suffer the risk of corporate management dressing up earnings. Further, whereas before the derivatives era shareholders in a company selling products in Germany knew they would have an exposure to the deutschemark/euro, and could judge the investment merits of that position, these days a company doing business in Germany may turned out to have exchanged that cash flow for floating rate Thai baht. At the end of the year, shareholders who read annual report footnotes carefully will discover their new baht exposure, but not before. Options make the position even more opaque. Given the agency problems between shareholders and management, and between management and traders, allowing companies to play the derivatives markets is a mug’s game for shareholders.

There are a number of partial solutions which shareholders can adopt to this problem. One is to reverse the organizational change, adopted in many companies in the 1980s, which made the finance function a profit centre. In most companies, this caused it to expand vastly while seeking to pay for itself through “hedging” – more properly speculation—in the derivatives markets. Naturally, if their speculations were successful senior finance people were awarded huge bonuses and options grants. It’s much cheaper and safer for shareholders to insist on the finance function being headed by a Controller, make it responsible only for raising money, preparing budgets and controlling expenses, and return it to being a cost centre. This will reduce enormously both risk and cost. If this doesn’t work, shareholders need to change the company’s Articles of Incorporation, to prevent it entering into derivatives contracts at all.

By eliminating the ability to create short term profits from “hedging” the company’s financial statements will become more transparent and its finance function much cheaper.

If companies adopt these approaches, Wall Street’s revenues from trading derivatives will be slashed – the investment banks will be reduced to gambling with each other in a perpetual zero sum roulette, which no doubt will produce for most traders a satisfactory flow of bonuses, at the cost of an occasional bankruptcy by the game’s losers. Eventually even the downtrodden investment bank shareholders will get tired of this activity – but at least Wall Street will no longer be able to feed itself from the misguided “hedging” of the corporate sector.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)