Very risky business - derivatives - Cover Story

Washington Monthly, Oct, 1994 by Byron L. Dorgan

Perhaps it seems that none of this concerns you directly, but in this spooky new financial world, there are basically three ways you could lose.

* You have money in a money market fund or a mutual fund. This is the scariest and most immediate prospect for most Americans. It's entirely possible--in fact, it's all too likely--that you wouldn't know whether your fund had money at risk. Two-thirds of the assets held by tax-exempt U.S. money market funds, which were created to give the small investor access to high rates of return, are now covered by derivatives. BankAmerica recently had to pump $67.9 million into its Pacific Horizon money market funds to make up for derivatives losses. As for mutual fund losses, ask Mound, Minnesota. When the public officials of the Minneapolis suburb wanted to tuck $2.5 million away to pay for new water meters and sewers, it chose an eminently respectable, reputedly conservative Piper Jaffray mutual fund that invests in U.S. government securities. But as The Wall Street Journal reported this summer, Mound lost $500,000 because Piper Jaffray was playing a derivatives game with the town's money, betting that interest rates would fall. Leaders of Moorhead, Minnesota, can tell you a similar story.

* A private investment goes bad. If you are a stockholder in a company that's trading in derivatives, and the bets turn out badly, the stock is going to take a hit. In one of the biggest cases so far, the German firm Metallgesellschaft, a mining, metals, and industrial company, took what may be a $2 billion loss on derivatives. One of the company's U.S. subsidiaries, MG Corp., which owns an oil refinery, bet on oil prices and lost badly. Several divisions of the company have had to be sold, and 7,500 out of 46,000 employees were laid off.

* Government takes a hit--either directly or indirectly--through bank losses in derivatives. Mound's local taxpayers lost money; in Orange County, California, taxpayers had to meet a $140 million collateral call when some derivatives speculations started going bad. This is not the best use of the taxpayers' money. The federal government, too, is quietly but rapidly getting into the game. The Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation use exotic derivatives, as does Sallie Mae. And because these are federally chartered corporations, the possibility of the federal government getting stuck with clean-up costs is great.

Bank shots

In the peculiar market of recent years, successful exotic derivatives have been a miracle drug for bank balance sheets, not to mention the dealers who are shovelling in millions. It's not surprising, then, that these banks and dealers are resisting reform. What is surprising is that the Office of the Comptroller of the Currency (OCC) and the Federal Reserve agree, too, that legislative reform is unnecessary. "As far as the Federal Reserve Board is concerned," Chairman Alan Greenspan testified in May, "we believe that we are ahead of the curve on this issue as best one can get." Why would Greenspan, in light of the mounting evidence, soft-peddle the problem? Partly, it's the old story. Because the Federal Reserve, like other banking regulators, tends to think more like the people it is supposed to be watchdogging--in this case, the banks and the larger financial community--than they think like the rest of us. And in fact, in the case of the Federal Reserve, it is the industry it is supposed to oversee: The members of the Federal Reserve are bankers.