("Quid coniuratio est?")
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 "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 bad."
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 profits."
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 say.
I encourage distribution of "Conspiracy Nation."