Fukushima and Derivatives Meltdowns

CAMBRIDGE – Financial commentators have likened Japan’s earthquake, tsunami, and nuclear catastrophe to derivatives’ role in the 2008 financial meltdown. The resemblance is clear enough: each activity yields big benefits and carries a tiny but explosive risk. But the similarity between the two types of crisis ends where preventing their recurrence begins.

For the Fukushima nuclear-power plant, a 1,000-year flood and ordinarily innocuous design defects combined to deprive the reactors of circulating water coolant and cause serious radiation leaks. In financial markets, an unexpected collapse in real-estate securities and design defects in the derivatives and repo markets combined to damage core financial institutions’ ability make good on their payment obligations.

While the basic risks originated outside the systems – a tsunami for Fukushima, over-investment in real-estate mortgages for financial institutions – design defects and bad luck meant that the system couldn’t contain the damage. In the United States, AIG, Bear Stearns, and Lehman Brothers – all with large derivatives and/or repo investments – failed, freezing up credit markets for a scary few weeks.

We now understand the Fukushima risks and design defects well. Not so for the derivatives risks that jeopardized the global economy. For Fukushima, crews are valiantly trying to stop the radiation leakage. But for derivatives, the analogous efforts are misdirected and won’t save us from the financial fire next time. We are rebuilding derivatives and related financial structures atop the same, still-active faults.

Financial players use derivatives to transfer risk: one player assumes the risk of, say, euro fluctuation, but doesn’t want yen risk, while for another, it’s the opposite. So the former promises to deliver euros next June 1, while the latter promises to deliver yen. If one currency declines relative to the other, the loser pays the difference.

Repos are financing transactions. Financial firms sell assets, like Treasury bonds or real-estate securities, for cash, and promise to buy those assets back (i.e., to repurchase them or, for short, to do a repo), typically the following day. But, with the cash coming from short-term repos making up much of core financial firms’ balance sheets, tremors in financial markets could hit them hard, drying up repo financing for a few, as occurred in 2008. Some, like Bear Stearns, then failed.

Individual derivatives and repo transactions are hardly nefarious. Each alone legitimately transfers risk to those better able to bear it, or backs financial holdings. But, when over-used by systemically vital firms, they can blow up the financial system, owing to its design defects. Even today, about 70% of the core US financial firms’ liabilities are very short-term loans, like overnight repos.

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