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 
"notional" value.

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 
derivatives work.

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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