Very Risky Business

...This is the scariest and most immediate prospect for most Americans...

...It doubles the stakes: now, instead of betting just on the price of silver, it is also wagering on the value of the yen...

...Assume further that the company's analysts believe the value of the yen will fall against the dollar...

...So in 1994 it enters into a contract with a mining company to pay the going 1994 rate in 1995...

...Unfortunately, the formula didn't anticipate the Federal Reserve Board's rate hikes this year...

...The new speculative twist is much, much riskier for both Company X and the bank...

...So it calls a derivatives dealer—often a major bank—to find another company, call it B, which is willing to bet that the floating rates will be more favorable than the set rate...

...Why would Greenspan, in light of the mounting evidence, soft-peddle the problem...

...Let me explain by example...

...And because these are federally chartered corporations, the possibility of the federal government getting stuck with clean-up costs is great...

...Say a company that manufactures film—Company X—needs to buy silver every year and wants to guard against rising silver prices...

...But this kind of traditional futures trading takes place on organized exchanges that are well-regulated and well-understood...

...With a $35 trillion derivatives market, a crash would make these precursors look Lilliputian...

...The risk to Company B is that B will end up paying higher rates than the fixed rate it receives from A. If you had trouble following that, then you are starting to get the idea...

...But what banks do with money insured by the taxpayers is another matter entirely...

...in Orange County, California, taxpayers had to meet a $140 million collateral call when some derivatives speculations started going bad...

...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...

...It's entirely possible—in fact, it's all too likely—that you wouldn't know whether your fund had money at risk...

...And here's the real kicker: Because the key players are federally insured banks, every taxpayer in the country is on the line...

...Back in the mid-eighties, when thrifts were beginning to collapse, it seemed as if it were a Texas story one day, a California story the next—never a national story...

...Very Risky Business If we don't watch out, a new kind of Wall Street gambling—exotic derivatives trading—could shake the market and put the taxpayers on the line for another bailout BY SENATOR BYRON 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...

...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...

...Interest rate gambles are common, too, and in this volatile year have led to many of the big losses, including the $700 million that Piper Jaffray, the respected Minneapolis firm, lost on behalf of clients that included small city governments and the local symphony association...

...Suppose X, our film company, had entered into a swap with a New York bank...

...the failure of the Bank of New England cost taxpayers $1.2 billion...

...In typical fashion, the media moved on to other matters, content that where there's no immediate crisis, there can be no fire...

...This is not mere fantasy...

...Senate, which would prohibit banks and other federally insured institutions from playing roulette in the derivatives market...

...and when Drexel Burnham Lambert went under, the government had to underwrite the firm's payments to creditors...

...CS First Boston Inc., $40 million...

...Because its analysts, in consultation with the bankers, used complex mathematical models and probability charts to decide the yen bet was a good gamble...

...And all of this can be done without anyone even knowing, since such transactions can be done "off book"—effectively concealing them from stockholders and employees...

...This does not augur well...

...Of course, what investors do with their own money is their own business...

...The federal government, too, is quietly but rapidly getting into the game...

...And banks, so long as they created pools of betting money outside their federally insured deposits, could gamble to their hearts' content...

...But when financial institutions are setting up what amount to keno pits in their lobbies, it's something that should concern all of us...

...Mound's local taxpayers lost money...

...This is a risk for X if silver prices tumble, because they will be required to pay the higher price...

...about two-thirds of those assets were in short-term bond funds sold to average investors...

...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...

...And the feds have had to clean up non-banking financial messes as well...

...Regrettably, they are outgunned by the derivatives dealers in several ways...

...Part of the reason is that, as with the S&Ls, the disasters so far seem local: Piper Jaffray is a Minnesota story, etc...

...Two-thirds of the assets held by tax-exempt U.S...

...They are especially tailored to X's needs, and are therefore unattractive to other buyers...

...The failure of the Bank of New England, in 1991, cost taxpayers $1.2 billion, and the bank had a $30 billion portfolio of derivatives that had to be painstakingly unwound to avoid, in the words of the GAO, "market disruptions...

...Government takes a hit—either directly or indirectly—through bank losses in derivatives...

...The International Swaps and Derivatives Association, a trade group of the most exotic operators, recently hired one of the top Washington lobbying firms to make their case...

...But not with our money...

...So now a default by X could create a domino effect: X could not pay its bank, and its bank therefore couldn't make the payments on its offsetting contract, and so on until the chain of losses enters the exchange, where the originally esoteric bet can hurt real businesses...

...share is estimated at $16 trillion, which is four times the nation's economic output...

...Partly, it's the old story...

...Unlike a traditional future, moreover, these exotic derivatives are almost impossible to sell if one of the two bets goes south...

...This is not the best use of the taxpayers' money...

...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...

...Worse, exotic derivatives—the stuff the big boys are doing—just don't fit within the existing scheme of federal finance regulation...

...And of course, dealers must be required to tell their customers when derivatives are involved...

...They have begun, in some cases, to look like a financial casino where the decisions are wagering decisions, not business ones...

...Why the yen...

...Of course, what individual investors knowingly do with their own money is their own business...

...This is called an "over-the-counter," or OTC, transaction, since it does not take place on an organized exchange...

...There has been a steady flow of such losses in past months...

...Say Company A has borrowed money at a floating interest rate but is worried that rates might rise...

...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...

...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...

...But if prices rise, X wins because it will be able to buy the silver for less than the 1995 market price...

...According to the Brady Report on the causes of 1987's Black Monday 508-point fall, the problem was worsened by automatic computer programs that kept ordering traders to sell stock index futures—which are, in essence, derivatives...

...Felix Rohatyn, the investment banker...

...One or two people at the top of the agencies are really knowledgeable, but I don't know how deep the talent goes...

...It wants to lock in the rates at the lower level...

...BankAmerica recently had to pump $67.9 million into its Pacific Horizon money market funds to make up for derivatives losses...

...It's a little like asking traffic cops to stop the nation's computer crime...

...The top seven domestic bank OTC dealers accounted for more than 90 percent of total bank derivatives action, and the top five U.S...

...Think a federal bailout can't happen again...

...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...

...If an institution has deposits insured by the federal government, it should not be involved in trading risky derivatives...

...So what's the big deal...

...Derivatives are no doubt widespread: An Investment Company Institute survey found that 475 mutual funds with net assets of $350 billion recently held derivatives...

...Maybe this was a . . . derivatives collapse...

...In fact, there was stockbrokers-looking-for-upper-floor-windows kind of fright...

...There are the S&Ls...

...and Henry Kaufman, the bond guru, among others—to warn that derivatives are out of control...

...A chorus of operators, experts, and federal regulators assured the public and Congress that nothing was substantially amiss...

...And at the big banks, you're going to have talent all the way down...

...Fortune called them an "enormous, pervasive, and controversial financial force...

...That bank in turn might then enter an offsetting contract with another bank which in turn might continue to pass along that risk on and on and on, perhaps using exchange-traded futures...

...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...

...Say Company X is under an obligation to sell film in Japan next year...

...That task falls to small teams of about 10 to 15 examiners who go into major banks like Citicorp and are expected to track deals that the banks need up to 100 different analysts and traders to put together...

...That's where the press comes in—or should...

...Derivatives have become much more than managing risk...

...But if they were wrong about the yen, and wrong about the silver, too, the result would be like having two lead weights slide to one end of a see-saw...

...It's a case where the government is outgunned and outmanned," says a senior GAO official...

...in the Piper Jaffray debacle, customers did not understand what was happening...

...The classic purpose of deposit insurance, one of the enduring legacies of the New Deal, is to encourage saving and create a pool of capital to build homes and businesses and jobs...

...You have money in a money market fund or a mutual fund...

...The S&Ls are the most notorious example, of course, but there are others...

...More trouble comes from exotic new derivatives called "swaps...

...In 1990, when Drexel Burnham Lambert failed, the government had to insure payments that flowed between Drexel's sundry creditors and debtors to avoid a chain reaction...

...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...

...A rumor went around the Street: Maybe something truly sinister was brewing...

...The headline on the Fortune cover was "The Risk That Just Won't Go Away," shown over a pool of alligators...

...9 A private investment goes bad...

...The Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation use exotic derivatives, as does Sallie Mae...

...One of the company's U.S...

...They take the basic futures idea a quantum leap further into a netherworld of high finance...

...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...

...And that's a simple example...

...The reports of recent derivatives disasters could be the first trickles of water through a rickety dam: Askin Capital Management, in New York, lost $600 million...

...Currency fluctuations are just the beginning...

...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...

...The U.S...

...This combination of global involvement, concentration, and linkages," warns Charles Bowsher, the head of the GAO, "means that the sudden failure or abrupt withdrawal from trading of any of these large U.S...

...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...

...But the dip turned out to be a blip, and the crisis passed out of the news...

...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...

...Kidder Peabody, $350 million...

...Nobody would care if these were just a few Donald Trumps taking a hit at a respectable financial casino...

...Procter & Gamble bought a floating rate deal like this from Bankers Trust, losing a reported $157 million in the process...

...subsidiaries, MG Corp., which owns an oil refinery, bet on oil prices and lost badly...

...It's not surprising, then, that these banks and dealers are resisting reform...

...securities firms accounted for 87 percent of all such activity in securities in the country...

...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...

...I think I have a better, cleaner idea...

...Certainly the industry understands the parallel—enough, at least, to try to convince Congress that the parallel doesn't exist...

...Leaders of Moorhead, Minnesota, can tell you a similar story...

...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...

...Banks will argue that derivatives are good since they hedge risks they take by loaning money to real people...

...money market funds, which were created to give the small investor access to high rates of return, are now covered by derivatives...

...Another reason is that much of this story lies in the pedestrian precincts of the regulatory culture...

...Deposit insurance is not supposed to underwrite airy speculation on Wall Street, and my bill will stop that...

...Several divisions of the company have had to be sold, and 7,500 out of 46,000 employees were laid off...

...And the Journal estimates that since 1993 there have been $6.4 billion lost in Byron Dorgan is a Democratic senator from North Dakota...

...Why would X do this...

...dealers—including federally insured banks—that are extensively linked to one another and to exchange-traded markets...

...Instead of inquisitive reporting, we get reports of assurances from Greenspan and others...

...At the Fed and the OCC, there are about 3,000 examiners but hardly any of them monitor derivatives...

...The troubling derivative deals are much different...

...These men are not given to impetuous overstatement where finance is concerned...

...For one, there are fewer examiners than dealers, and many examiners are young and inexperienced...

...Such debacles have led some leading Wall Street sages—Gerald Corrigan, the former president of the New York Federal Reserve...

...Dollars and sense House Banking Chairman Henry Gonzalez wants to strengthen reporting requirements for derivatives trading—a sound step, but alone this keeps federal taxpayers in the line of fire...

...Bankers and speculators maintain it's just hedging, a perfectly normal practice to manage risk...

...So what is this thing called a derivative...

...But except for a few pieces, the national press has been cowed by the complexity of the subject...

...Let's take a simple example...

...I have introduced S. 2123 in the U.S...

...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...

...The General Accounting Office found this year that much of the big OTC derivatives dealing is concentrated among 15 major U.S...

...Farmers hedge, so do banks and businesses...

...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...

...Making matters still worse is the concentration of big derivatives dealers...

...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...

...Piper Jaffray had decided on the basis of obscure mathematical formulas that interest rates would not rise...

...This kind has has happened before, albeit on a smaller scale...

...With the huge exception of The Wall Street Journal (and even it is more specialized a publication than, say, The New York Times or The Washington Post), a story like the S&Ls or derivatives only makes it off the business pages after disaster strikes and it's too late to rally public attention to reform...

...If this seems a remote possibility, don't forget that financial implosions nearly always seem that way—before they happen...

...And although some members of Congress are awake to the derivatives problem, it takes more than that to reach a critical mass...

...All that stands between the public and a financial disaster of this sort is the guardians of the banking system in Washington...

...But my proposal would not affect traditional, conservative forms of hedging...

...As for mutual fund losses, ask Mound, Minnesota...

...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...

...If the analysts were right about the yen, of course, it all works out...

...dealers could cause liquidity problems in the markets and could also pose risks to the others, including federally insured banks and the financial system as a whole...

...In August, The Wall Street Journal declared that derivatives were now a $35 trillion—that's right, trillion—worldwide market...

...A swap results: Company A will pay a fixed rate of interest to Company B, which will pay a floating market rate to Company A. The risk to Company A is that rates will fall but A will be obligated to pay the higher, fixed rate...

...Because doubling the bet may hedge their risk in both the silver and yen markets...

...Add in the always-more-volatile foreign markets (tied to about $4 trillion of the U.S.'s $16 trillion) and we're talking real money...

...Just a few years ago, the S&L crisis began with a trickle of bad news, a few seemingly unrelated belly-flops...

...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...

...They happen all the time...

...the derivatives game—$6.4 billion that could have opened businesses and created jobs...

...government securities...

...But the truly scary thing is how losses like these could spread through the entire banking system...