CHICAGO - Merton Miller, the Nobel Prize-winning economist at the University of Chicago, says derivatives have been getting a bad rap.
Prof. Miller blames most of the high-profile losses in the past year not on the theoretical models backing these instruments, but on what he calls the "godfather" effect.
"The godfather problem is that you owe the godfather $25,000 that is due tonight, and you have only $10,000," he said. "So you go to the nearest casino and bet the full $10,000 on double zero from one spin of the roulette wheel.
"If you win, you get $35,000. If you lose you're dead. But you're no deader than you would have been without the gamble."
Prof. Miller said the losses in derivatives were simply desperate gambles that didn't pay off. On balance, he argues, derivatives have worked to reduce risk.
Since the late 1950s, Prof. Miller's views on the world of finance have created controversy. His paper on leverage and the cost of capital, which he co-wrote with economist Franco Modigliani - for which Prof. Miller won the Nobel Prize in 1990 - created an uproar among some corporate leaders when it was published in 1958.
Recently his role as a director at the Chicago Mercantile Exchange has kept him in touch with events shaping the industry, and he has been sparring publicly with Mary Schapiro, the chairman of the Commodities Futures Trading Commission, over its actions in the Metallgesellschaft derivatives case.
Although he says he believes human error is to blame for most problems with derivatives, he warns that overreliance on technical models also carries some risk.
In fact, he says, the losses experienced by hedge-fund manager David Askin point to the problems of implicitly accepting the values provided by pricing models.
In that case, inaccuracies in the underlying assumptions of the value of the fund's collateralized mortgage obligations led to huge losses.
"His model told him one thing and the market told him another," Prof. Miller said.
Although the case shows that leveraged derivatives can be risky, Prof. Miller is among those who argue that the usual function of the financial instruments is to reduce risk.
The commercial banking industry, he says, is a case in point.
Disintermediation meant that banks replaced many of their A-rated companies with companies whose credit histories prevented them from tapping the commercial paper markets themselves.
But the development of the derivatives markets changed that, at least for the big dealer banks. The instruments have reduced banks' reliance on riskier borrowers and therefore made the industry safer, Prof. Miller contends.
"I think in some ways you've got better control of the credits in a swap," he said. "The terms of a swap are such that if the company's credit deteriorates, they're out - so it becomes a two-year or three-year instrument, instead of a 10-year commitment."
"And, contrary to all these horror stories, the good banks have quite adequate risk-control programs. Nobody's program is perfect, but they are pretty darn good."
The Barings debacle was an example of how important these risk management procedures are. By putting a trader in Singapore in charge of the front and back offices, the company set itself up for failure, Prof. Miller said.
"It was management failure for not having a procedure that would have prevented him taking those positions without their knowledge," he said. "But there wasn't a problem with any formula."
Nonetheless, he does not think a failure similar to Barings could happen here.
For one thing, regulators as well as exchanges monitor dealers in these markets. Frequent audits help to ensure that member firms do not give dual authority to one person, as Barings did with trader Nicholas Leeson.
And in the over-the-counter market, dealers are contracting only with the best credits, to prevent a serious market meltdown.
Though the list of new products seems to keep regulators on their toes, Prof. Miller thinks the pace of change will slow in coming years.
The reason, he says, is the dearth of breakthrough research of the kind that came from theorists like Fisher Black, Myron Scholes, and Harry Markowitz.
"Right now, you've got the option model, and it's not just that it's a great intellectual achievement, it's kind of like a fundamental building block," he said. "If you give me enough options, I can create anything.
"But as I look over the literature now, I don't see anything comparable to that coming," he said. "What we're going to see is that there are options everywhere.
"Once you're alerted to the idea of options, you find them everywhere. I think you will see various kinds of transactions that we don't think of as options."