Not so long ago, the financial world seemed fairly simple. Investors put their money into stocks, bonds and futures contracts for commodities like corn and copper. Then, about 20 years ago, a new species crept onto the investment shore. Commodity exchanges introduced "financial" futures and forward contracts on Treasury bonds and Eurodollars. Stock indexes like the Standard & Poor's 500 began trading like pork bellies. Options on indexes arrived. Options on index futures. And "swaps" for exchanging fixed and floating-rate debt.
The inevitable step up -- some might say down -- the evolutionary ladder came in the mid-1980s, when banks and investment firms began to assemble packages of these instruments. Today, such packages protect insurance companies against hurricane losses and exporters from currency devaluations, among other things.
If most of this strikes you as a financial twilight zone, you're hardly alone. What's worrisome, in fact, is whether anyone truly understands it. Derivatives -- the generic term for this panoply of artificial instruments, because they are derived from more-basic securities -- "can be as complex as three-dimensional chess," notes Ezra Zask, head of a Connecticut-based firm that trades in the products. And if the agencies that regulate the banks and the securities firms that increasingly depend on income from the creation and trading of derivatives aren't up to speed, what they don't know could hurt you.
The case against derivatives has been stated most bluntly by Rep. James Leach of Iowa, the ranking Republican on the House Banking Committee, who voiced an early warning in the savings and loan debacle and will soon introduce legislation to more closely regulate derivatives. He views the $7 trillion market, which has been inflating by a third each year, as a house of cards. "This market is a disaster waiting to happen," he says.
Warning from Europe. Some cards have already started to tumble. Last week, a consortium of international banks scrambled to bail out Metallgesellschaft AG, a huge German conglomerate that lost nearly $1 billion from trading energy-related derivatives. The hastily arranged rescue alleviated concerns that the company's problems would cascade into New York's petroleum futures market, now the key price-setting mechanism for world oil prices.
That kind of chain reaction is what Leach and other critics fear most. The concern is that these leveraged instruments may help produce, or at least aggravate, another financial cataclysm, as "portfolio insurance" did in the October 1987 worldwide stock- market crash. That purported hedge was supposed to let financial institutions like pension funds protect their stock holdings against a market drop. But it failed to work when most needed -- and attempts to use it actually worsened the fall, according to a number of post-mortems.
While regulators here and abroad are keenly aware of potential problems, they have been loath to squelch a market they also see as beneficial. "In our efforts to contain risk taking," it is important to "not unduly stifle innovation," Federal Reserve Chairman Alan Greenspan told the American Bankers Association last November. Greenspan, however, is known to be worried that derivatives have grown up in a largely benign environment of falling rates and rising stock prices and have yet to be tested under adverse conditions.
The central bank has assembled an "A team," centered at the New York Fed, to brainstorm the problem. And in case of a sudden financial flare-up due to derivatives, the Treasury Department has resuscitated an interagency crisis-management team that was put together in the wake of the 1987 crash. So far, regulators "have mainly decided to stress increased disclosure, which has become a cure-all for the world's anxieties about derivatives," notes Joe Kolman, editor of the newsletter Derivatives Strategy.
A study due out soon from the government's General Accounting Office could make Wall Street wince with calls for far stronger safeguards. One recommendation under consideration: Establish risk-management committees at corporations and financial institutions to monitor their use of derivatives.
The credit-rating agencies are also playing an active role. Recently, Standard & Poor's started rating bond mutual funds based partly on their use of derivatives. Some funds managed to enhance their yields when interest rates were falling by adding derivatives to their fixed-income portfolios, but the recent rise in rates has caused this strategy to backfire. The Securities and Exchange Commission is worried that investors, attracted by the high yields, have been indirectly investing in derivatives without really knowing what's involved. And it's hard for the average investor to find that out.
When it comes to derivatives, the more worries, reports and disclosures the better. Rarely do accidents occur when everyone is prepared for one to happen.
