Very risky business - derivatives - Cover Story

Washington Monthly, Oct, 1994 by Byron L. Dorgan

Last spring, when the stock market took its hair-raising ride, in one corner of Wall Street there was more than the usual anxiety. In fact, there was stockbrokers-looking-for-upper-floor-windows kind of fright. In April, clients of the giant Bankers Trust New York Inc.--including Procter & Gamble--took multimillion dollar losses on a kind of trading most Americans had never even heard of, called "derivatives." A rumor went around the Street: Maybe something truly sinister was brewing. Maybe this was a ... derivatives collapse.

The spring market panic hit just as the March issue of Fortune--hardly a carping business critic--cast a dark pall over derivatives, which are complicated futures contracts based on mathematical formulas. Fortune called them an "enormous, pervasive, and controversial financial force." The magazine added: "Most chillingly, derivatives hold the possibility of systemic risk--the danger that these contracts might directly or indirectly cause some localized or particularized trouble in the financial markets to spread uncontrollably."

The headline on the Fortune cover was "The Risk That Just Won't Go Away," shown over a pool of alligators. With that staring back at brokers and investors from their coffee tables, the sudden dip in the Dow and the story of Bankers Trust made people think, Hey, we really need to get a grip on this. But the dip turned out to be a blip, and the crisis passed out of the news. In typical fashion, the media moved on to other matters, content that where there's no immediate crisis, there can be no fire.

Yet, this "false alarm" could turn out to be a harbinger of a real financial conflagration--one that would make us nostalgic for the days of the $500 billion savings-and-loan collapse. In August, The Wall Street Journal declared that derivatives were now a $35 trillion--that's right, trillion--worldwide market. The U.S. share is estimated at $16 trillion, which is four times the nation's economic output. And the Journal estimates that since 1993 there have been $6.4 billion lost in the derivatives game--$6.4 billion that could have opened businesses and created jobs. Derivatives are no doubt widespread: An Investment Company Institute survey found that 475 mutual funds with net assets of $350 billion recently held derivatives; about two-thirds of those assets were in short-term bond funds sold to average investors. And here's the real kicker: Because the key players are federally insured banks, every taxpayer in the country is on the line.

So what is this thing called a derivative? Bankers and speculators maintain it's just hedging, a perfectly normal practice to manage risk. Farmers hedge, so do banks and businesses. So what's the big deal? Derivatives have become much more than managing risk. They have begun, in some cases, to look like a financial casino where the decisions are wagering decisions, not business ones. Derivatives may well be the most complicated financial device ever--contracts based on mathematical formulas, involving multiple and interwoven bets on currency and interest rates in an ever-expanding galaxy of permutation. Of course, what individual investors knowingly do with their own money is their own business. But when financial institutions are setting up what amount to keno pits in their lobbies, it's something that should concern all of us.

Let me explain by example. One form of derivative--the most simple--is a futures contract, which is the traditional device for a company to lock in a price for materials at a future time. Say a company that manufactures film--Company X--needs to buy silver every year and wants to guard against rising silver prices. So in 1994 it enters into a contract with a mining company to pay the going 1994 rate in 1995. This is a risk for X if silver prices tumble, because they will be required to pay the higher price. But if prices rise, X wins because it will be able to buy the silver for less than the 1995 market price. Of course, speculators can buy and sell such commodities contracts with no intention of actually obtaining the commodity, hence gambling on the fluctuation of prices. But this kind of traditional futures trading takes place on organized exchanges that are well-regulated and well-understood.

The troubling derivative deals are much different. They take the basic futures idea a quantum leap further into a netherworld of high finance. Let's take a simple example. Say Company X is under an obligation to sell film in Japan next year. Assume further that the company's analysts believe the value of the yen will fall against the dollar. The analysts would like to protect against the risk that silver and yen prices may fluctuate over the course of the year, thus hedging their original hedge. The company can't go to an exchange in Chicago and get that precise deal, so it gets on the telephone to its bankers and suggests that the bank write a customized contract that is based on the delivery price of silver in yen, not in dollars. This is called an "over-the-counter," or OTC, transaction, since it does not take place on an organized exchange.