TIME: Almanac 1995

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<text id=94TT0369> <link 94TO0156> <title> Apr. 11, 1994: How The Big Game Began </title> <history> TIME--The Weekly Newsmagazine--1994 Apr. 11, 1994 Risky Business on Wall Street </history> <article> <source>Time Magazine</source> <hdr> COVER STORIES, Page 32 How The Big Game Began </hdr> <body> By John Rothchild This business of derivatives can be traced back to Chicago, the old hog butcher for the world and stacker of wheat. Chicago learned it could make an easier living by selling pretend wheat and pretend hogs in the pits of the commodities exchanges. These imaginary creatures are called "futures." The point was you could buy a hog future and turn a nice profit before the real hog ever showed up. Or, if you were Hillary Rodham Clinton, you could make 100 times your money on cattle futures without ever having to put up with a cow. Having taken the bother out of farming and changed it into high finance, Chicago then turned its attention to high finance itself, introducing futures and options so that investors could buy and sell pretend baskets of stocks. These baskets were a big hit among professional fund managers, who used the pretend stocks to hedge their positions whenever they were afraid they owned too many real stocks. The whole shebang spread to New York City, where banks and brokerage firms hired roomfuls of geniuses and paid them handsome salaries to develop new lines of imaginary products. The geniuses stared up at the ceilings and came down with derivatives, some of which they called ELKS (equity-linked securities), YEELDS (yield-enhanced equity-linked securities) and CHIPS (common-linked higher-income participation securities), as well as LYONS, TIGRS and CMOs. A decade ago, if you wanted to work on Wall Street, you went to business school; but now you can study genetics and end up at Merrill Lynch, where instead of splitting genes to clone an elk, you can graft a share of Snapple (which doesn't pay a dividend) onto a dividend, thus creating the Snapple ELK--a dividend-paying fictitious concoction that rises and falls in value along with Snapple itself. The makers of derivatives like to say their products are used mostly by people who are trying to reduce risk in the market, but they also provide exciting betting opportunities for billion-dollar gamblers who are too big for Vegas. The potential payoffs are so huge that if the word gets out to the crowd at the track and the casinos, they'll give up horses and blackjack for oil straddles and currency swaps. If you have a home mortgage, you can be involved in derivatives already without even knowing it. These days there's a good chance yours won't be kept in one piece by the banks that lent you the money. Instead, many mortgages are shipped off and bundled into packages called mortgage-backed securities, which in turn can become raw material for other derivatives such as REMICs (real estate mortgage-investment conduits). It's possible that your mortgage has been chopped in half--with the principal portion sold off and bundled up into a P/O, which stands for "principal only," and the I/O, "interest only," going another way. Bond funds use I/O derivatives to add yield to their portfolios and make aggressive bets on the direction of interest rates. Two trillion dollars in mortgages is now bound up in mortgage-backed securities, up from zero two decades ago. All told, there's a huge speculative overlay on stocks, bonds, mortgages, corn, hogs, etc., owned by regular people in the real world, which the derivative people refer to as "the underlying." These abstract concoctions are floating over the real world of stocks, bonds, corn and hogs in the same way that the island of Laputa, that fanciful domain of theorizers and stargazers, floated over real towns and villages in Gulliver's Travels. It's not the first time in American history that so much is riding on so little. In the 1920s there were investment pools and trusts. In the investment trusts, a series of shell companies was piled on top of a real company, most often a dividend-paying utility. Each shell company offered a dividend that was dependent on its receiving the dividend from below. The price of each shell company's stock reached such lofty heights that the value of the original company below was lost sight of, and eventually the investment trusts came crashing down. Two of the most celebrated operators were Samuel Insull and Ivar Krueger, a.k.a. the Swedish "Match King," both of whose faces appeared on the cover of this very magazine. Insull erected a Rube Goldberg-like structure of 65 companies that operated utilities in 32 states, and by 1932 it had completely collapsed in a $750 million loss for investors. Krueger's ventures came to a similar end, and the Match King snuffed himself out. How can the average investor in stocks and bonds down here in the underlying protect himself or herself if more of these shenanigans lead to a general calamity? One way is to avoid owning shares in companies that are the biggest players in derivatives. This would include several large banks, such as Chemical, Bankers Trust, Citicorp, J.P. Morgan and Chase Manhattan. Lately the banks have reported excellent earnings, helped along by a recent winning streak. But what happens if the banks get on a losing streak? If and when another correction rattles the stock market, possibly aggravated by speculations from above, we inhabitants of the underlying have to remind ourselves that we own real shares in real companies with real earnings and real value, which will survive and prosper as long as our financial system survives. All the side bets Wall Street wants to make won't determine the ultimate outcome of the game. </body> </article> </text>