NOT UNDERSTANDING $$ DEALS DOESN'T STOP DEALERS
By Martin Mann
From *The Spotlight*, June 27, 1994
"Derivatives" has been a term often seen -- but never fully
explained -- in recent financial news. Yet no matter how remote
and intricate, these financial instruments require a closer look,
if only because they have been costing American taxpayers
billions -- over $50 billion in the past 12 months, according to
one estimate -- and now threaten the entire U.S. economy.
Total derivative contracts outstanding at the beginning of June
-- including contracts traded on the futures and options
exchanges and over-the-counter derivatives -- has been estimated
by *Fortune* magazine at $16 trillion (the gross domestic product
of the U.S. is a comparatively piddling $6.4 trillion). But this
figure is based on the "underlie," i.e., the money involved in
the contracts. Even *Fortune* admits that the figures are
somewhat arbitrary, since the dollar value of the contracts is
only one way to measure the market. The contracts themselves
control vast chunks of cash, much larger than their so-called
But it is all "off the books," with no way for anyone -- the
government or the traders themselves -- to confirm any figure.
Meanwhile, George Soros, known as the "derivatives king," says he
lost several hundred million in trades last year, while some
published sources are saying he won $1.1 billion. "There's simply
no way to know," said a Wall Street source. "There are no
figures; no paper trail; no way to check anyone's claims good or
Derivatives are financial instruments so convoluted and
manipulative that even the sharpest speculator, such as George
Soros, who has used them to gamble -- and win -- billions on
global currency trades claims he does not understand just how
Yet the basics of derivatives are simple: "Take two businessmen,
Luke and Lance, and assume that each has borrowed $100,000 to
invest in a real estate deal," explained veteran Wall Street bond
trader Hugh Diericks. "The terms of their loans are different,
though. Luke pays fixed interest on what he owes, while Lance's
I.O.U. draws interest at what is called a 'variable' rate --
let's say it follows the fluctuations of the prime rate."
Both men are concerned about the inherent risk of interest rate
shifts, but in opposite ways. "Luke hopes that over time,
interest rates will go up, or at least stay even, because
otherwise he risks paying too much on his fixed rate obligation,"
related Diericks. "Lance, on the other hand, is afraid that if
interest rates are inflated, his variable-rate debt will balloon
into a losing proposition."
To "hedge" their investment against such a risk, Luke and Lance
may enter into a contract stipulating that if interest rates
drop, "Luke will be compensated for his loss by Lance," noted
Diericks. "But if interest rates rise and Lance gets clipped, it
is Luke who pays to make good Lance's loss."
Because the payout between the two businessmen depends on --
"derives from" -- the way interest rates fluctuate, it is called
a "derivative" in the financial markets.
Major corporations often turn to such derivative contracts to
hedge the risk to their export revenues raised by sudden swings
in the international currency markets. Insurance companies have
used them as "reinsurance" against unpredictable upsets.
"Derivatives are simply contracts whose value is derived -- the
key word -- from the value of some underlying asset such as
currencies or commodities, or from indicators such as interest
rates," says Carol Loomis, the award-winning business writer and
longtime editor of *Fortune Magazine*. "In many countries they
are legally considered mere gambling debts."
-+- Big Casino -+-
That was precisely the sort of financial instrument speculators,
wheeler dealers, corporate raiders and get-rich-quick fund
managers were looking for in the greed-driven, smash-and-grab
1980s, Wall Street sources say.
As Michael Milken and his circle of predatory junk-bond
manipulators in the Reagan era converted the U.S. into what
analysts now call a "casino economy," other profiteers began to
use complex derivatives to play vast international shell games.
"Most deals involving big stakes leave a paper trail, even if
moved offshore," says financial reporter Gil Mercer. "But
derivatives don't. They are the dream of every money manager who
wants to cover his tracks."
By the same token, derivatives are also "regulatory nightmares,"
warns the knowledgable Ms. Loomis, "They are off-balance-sheet
instruments that obscure what's going on, rather than revealing
it. Concocted in unstoppable variations... they make total hash
out of existing accounting rules and even laws."
With speculation in derivatives becoming the rage on Wall Street,
major firms hired mathematicians and rocket scientists to devise
ever more elaborate computerized variations of such contracts.
The financial markets were swamped with tangled transactions
worth literally trillions of dollars that not even the money
managers understood any longer.
"Let me show you an example," explained Diericks. "At Kidder,
Peabody & Co., one of Wall Street's largest brokerages, now a
subsidiary of General Electric, they recently fired a bond
manager called James Jett. It came as a shock: Jett, head of the
firm's government bond division, was known as a wizard
derivatives trader, who received more than $10 million in pay and
compensation last year for making Kidder some very big paper
But auditors sent in by G.E. found the lucrative deals reported
by Jett simply didn't exist. "Kidder had to admit that instead of
booking big profits, it had lost $350 million last year on Jett's
derivatives contracts, which were never properly supervised or
audited because no one else at Kidder -- not even the top
managers -- quite understood them," Diericks revealed.
A *Spotlight* survey has found that a number of major Wall Street
investment banks and brokerages, even staid industrial
corporations such as Procter & Gamble, have been hit by similar
heavy losses caused by arcane derivatives deals last year.
"Although he may not find it appetizing... the American taxpayer
ends up eating a large share of these deficits," warned Diericks.
"Take the scandal at Kidder: with the total shortfall in
derivatives trading put at $350 million, the giant brokerage took
an immediate tax credit of $140 million. That estimated revenue
must now be squeezed by the government from other taxpayers, most
likely from you and me."
Can a speculative craze be reined in by regulators, if no one
really understands what makes it run? Rep. James Leach (R-Ohio)
has proposed new legislation, and the establishment of a federal
Derivatives Control Commission toward that end. His initiative is
worth serious -- and urgent -- consideration, financial experts
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