As a result of the 2008 government bailout, we taxpayers now own a significant share of some very large companies. In order to return some of those invested dollars to the treasury, the government is pushing two of them, GM and AIG, to sell shares into the stock market. I am regularly frustrated at the level of business sense most politicians display and can only hope a forced offering (which would probably yield much lower returns) can be avoided. A better idea would be for this to be allowed to happen sometime in the future when company prospects have improved and a higher return is more likely.

It’s pretty easy to understand how General Motors got into trouble. For various reasons, it was wedded to a strategy of building large vehicles primarily in domestic plants. As oil prices continued to shock our economic system, GM’s offerings became less competitive and GMAC financing became a critical component of purchase decisions. When the bond market crash closed that door, sales simply dried up. GM has apparently become leaner under government tutelage, so perhaps it will have a chance of eventually surviving in the open market.

American International Group’s story is a little more difficult to understand but headlines advised us that derivatives were somehow involved. Since not everyone knows just what a derivative is, I thought I’d take a few minutes to explain a little about how they work and what went wrong at AIG.

At its most basic level, a derivative is a contract whose value is determined by something else. Although derivatives have gotten a lot of negative press over the past couple of years, they serve their original agricultural purpose admirably. As a practical matter, all farmers in a region plant, fertilize and harvest on approximately the same schedule, leaving them at the mercy of the weather for several months. With no way of being certain what their crop will be worth at harvest, many of them choose to sell at least part of it in advance. On the other side of the transaction are companies like Kellogg’s and Hormel which buy farm products by the train load. They need to ensure that they have at least part of their supply available a known price. These buyers and sellers get together through the sale/purchase of derivative securities known as futures contracts. The term “hedging your bets” comes from this decision to take a position in one market (commodity futures) to offset exposure in another (the open market at harvest time) is known as hedging.

As the world has become more complex, so have derivatives. Contracts can now be purchased to cover currencies, interest rates or practically any commodity you can imagine. How are these used in everyday business? Let’s take the largest local company, Cummins, as an example. Although headquartered in Columbus, Cummins does business all over the world, buying and selling products in a basketful of currencies. Because the relative value of these currencies fluctuates constantly, Cummins, like other multinationals, uses derivative contracts to lock in the value of at least some of its transactions, i.e. they hedge their currency exposure.

Now we can take a look at AIG’ problems. Insurance can be a great or terrible business, as the comparison between Warren Buffett’s Berkshire Hathaway and AIG reveals. Success is largely a result of accurate underwriting, i.e., the company must have a clear understanding of the risks against which it is insuring. Calculating risks properly allows a company to be competitive at the time of sale while not later being forced to endure unaffordable losses as claims are made. AIG’s role in the 2008 crisis was one of having provided investment banks with protection against falling bond values. An AIG unit based in London used what it confidently assumed to be accurate models to predict the future values of the extraordinarily complex bonds dreamed-up by the large brokerage firms. Last year, ABC News shared a tape it had obtained in which the department’s manager, Joseph Cassano, told investors “It is hard for us, and without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions”. That hubris was part of the serious mispricing which later led to AIG’s inability to make enormous payouts. Not meeting those obligations would have brought about an even greater surge of failures to its counterparties, the investment banks. Rather than allow that, our government stepped in with enough cash to cover the insured losses.

As with medicines and other modern inventions, potentially valuable things can be ill-used, bringing on unexpected problems. In our wealth management practice, Warren Ward Associates hedges almost all of our clients’ positions in one way or another. We would never place a huge bet on any one outcome as a dedicated hedge fund might but we do believe that appropriate use of hedging strategies is in our clients’ best interests. Various methods of offsetting potential risks have become an integral part of our asset management strategy.