China Blames Investment Banks For Derivatives Losses

Caveat emptor. Caveat emptor.

Chinese official are blaming US banks for selling some of the country’s state-owned companies complex derivatives on which they lost money. The FT and other media report that “A senior Chinese official who oversees the country’s largest state-owned enterprises has publicly slammed western investment banks for `maliciously’ peddling complicated derivative products that caused huge losses for Chinese companies over the last year.”

The Chinese government claims that as many as 68 of more than 130 state-owned entities were hurt by derivatives losses.

The Chinese can join the legions of financially sophisticated banks, corporations, and brokerage that bought the same paper and lost hundreds of billions of dollars are a result of their purchases. Governments from the US to most of those in the EU have complained that they were forced to salvage many of their banks at great cost to taxpayers because these same derivatives caused massive losses throughout the financial industry. The critical difference between many Western firms and those in China is that Western banks both created the instruments and in many cases lost money on them as well. The Chinese argument is based to some degree on the “not invented here” excuse. Perhaps if banks on the mainland had invented derivatives that would not have been so “maliciously peddled.”

Creating a financial instrument should be separated from its eventual value and whether customers make or lose money on it, unless that product was illegal or created by illegal means. A complex derivative may be hard for financial novices to understand, but it is ultimately no more subject to gains or losses than a simple share of stock. The buyers take a risk and often makes money. Loses are a normal by-product of that risk.

The primary criticism of derivatives, especially mortgage-backed securities, is that they carried “too much” risk when they were first created and sold. They were also immensely complex in their design, making them difficult to understand even by sophisticated investors.

There was always a way to avoid the risk of derivative losses which was to avoid buying the instruments in the first place.

Douglas A. McIntyre