Breathe deep. just as the media-and some media hounds in Congress-hyped the threat of a large-scale banking crisis in 1992, they’ve now identified derivatives as the source of the financial system’s next big shock. But if you’re waiting for the world to collapse, wait on. Yes, derivatives can be used for speculation. And yes, they carry risks, as Procter & Gamble discovered when it reported a $102 million derivatives loss last week. But far more than most people realize, derivatives have become standard tools for the day-in, day-out management of corporate finances. “It’s not as foreign as it might seem,” says Federal Reserve Gov. Susan Phillips.
The details can be incredibly arcane, but the basic concept is easy to grasp. Consider this problem: how much should you pay for a ticket to watch the Knicks in game 7 of the NBA championships? Unless you adhere to the “money isn’t everything” school of economics, it’s not a simple question. What are the odds that the Knicks will even make the finals? That the finals will end in six games, rendering the ticket worthless? If the Knicks hit a losing streak, could your $75 seat lose half its value? Or might you buy now and resell for a big profit in May? Plank down $75 and you risk losing it all. But for just $20, your scalper might sell you an option to buy that ticket on June I for $75. If the Knicks tank, you’ll walk away only $20 poorer; if they surge, your seat won’t cost more than a total of $95. Your derivative can be resold at whatever the market will bear. Is $20 too dear? just $12.50 might get you that $75 option, valid only if the Knicks end the season ahead of the Atlanta Hawks.
Businesses face the same sort of problem every day. Any transaction, from lending money to buying oil, carries the risk that interest rates and exchange rates will change. Derivatives offer a way to eliminate much of that volatility or, for the right price, to take it on. The idea is age-old. But new math and powerful computers allow Wall Street’s wizards to calculate volatility to four decimal places, slice it into pieces and peddle it far and wide. As stock underwriting slows, the profits from such deals are keeping the Street fat and happy. Last year Merrill Lynch took in more from trading derivatives than from trading stocks.
This isn’t just for high rollers. Conservative companies are among the biggest users. Take the Student Loan Marketing Association, which finances one third of the nation’s student loans. Sallie Mae raises money most cheaply by selling fixed-rate bonds, but the payments it gets from borrowers float up and down with rates on Treasury bills. Its solution is to sell fixed-rate bonds and then swap bond payments with a company that has issued floating-rate bonds. That lets Sallie Mae’s payments rise and fall along with its income-and makes student loans a tad cheaper than they would be other-wise. Such “plain vanilla” swaps are already old hat on Wall Street. At Tradition, a Manhattan swaps brokerage, Emil Assentato deals them as easily as he might peddle bonds.
But plain vanilla isn’t what’s paying Wall Street’s bills. The action is in “exotics,” such as options linked to other options. At Salomon Brothers, Eric Sorensen, 46, a former fighter pilot and finance professor, oversees a staff of quantitative analysts-“quants,” in street jargon-whose hush-hush mathematical work lies behind those new products. Academic research “is usually five or 10 years behind what’s going on here,” Sorensen says. More to the point, these researchers have days, not years, to flesh out their theories-and the markets will test them immediately. Says statistician Joe Mezrich, “A lot of the people who were designing ballistic missiles 10 years ago are now doing this. It’s very exciting.”
The job is building mathematical models, systems of equations that predict which strategy best hedges a particular risk, how much it should cost and how it would perform as the economy changes. This is the guts of the derivatives business, incomprehensible to all but those on the mathematical leading edge. It requires not just massive crunching of historical data on prices and interest rates, but a search for correlations that others may not have spotted-say, that the French franc is most volatile against the U.S. dollar when cocoa prices are between $950 and $1,000 per ton. The ability for quants to engage in large-scale data mining from their desks, impossibly costly just a couple of years ago, is what has transformed derivatives into a big-time business. If the models are right, Salomon prospers and its customers are happy. If the models are wrong, hedges won’t perform as promised, leaving customers in the lurch, while Salomon could lose big from having taken on the wrong risks at the wrong price.
The major derivatives dealers perhaps 15 New York banks and brokerage houses and an equal number of foreign institutions-team derivatives specialists with loan officers to customize products for clients, such as an Asian airline that borrows from Chase Manhattan Bank. The carrier worries that higher fuel prices combined with higher interest rates could cripple it if it takes on new loans. In answer, Chase exec Fred Chapey offers what’s called a correlated option: for a $1 million fee, Chase will ensure that the rate on $100 million of the airline’s debt won’t exceed 5 percent at any time jet fuel costs more than 60 cents a gallon.
Chapey, 35, isn’t exactly a salesman. Derivative deals may take weeks to plot; no one buys an interest-rate cap on a whim. His job is to figure out how to work derivatives into customers’ financial planning. Although the convivial Georgetown University alum eschews his private office in favor of a cluttered desk on Chase’s trading floor-“You’ve got to be on the floor to recognize all the opportunities, " he says he spends much of his day removing his jacket and putting it back on as he darts in and out of meetings with loan officers, investment bankers and their clients. If his business doesn’t sound much like banking, well, it isn’t. Chase is renting protection, not money. Its profit comes from taking on risks its customers wish to shed.
Those risks that now grace Chase’s books are one of the reasons derivatives are suddenly causing such an uproar. What will happen to the bank-and the financial system-if things go bad? In the two years since Gerald Corrigan, then president of the Federal Reserve Bank of New York, put that question squarely on the table in a speech that sent shock waves down Wall Street, dealers have been scrambling for an answer.
Undoubtedly, many derivatives will go bad. All of the fancy math that tells Chapey how much to charge for his products is based on one crucial assumption: that the underlying prices and rates change gradually. There’s simply no way to model what a derivative might be worth if price changes are large-or, even worse, if a run in a market means that there is temporarily no bidder at any price. “Now we’ve got exotic options where a jump can hurt you a lot,” says University of California finance professor Mark Rubinstein. “People do not have a good answer to that.”
That problem can’t be eliminated. Neither can the fact that some users, including the fund managers whose dumping of bonds to cover derivatives losses have been blamed for the bond market’s recent bloodbath, want to increase their risks, not limit them. Your scalper, for instance. If the Knicks lose, he’ll be richer by $20 for every option he’s sold. But if the Knicks go on a tear, playoff tickets will soar in value-and if he hasn’t hedged by acquiring either tickets or options to buy tickets, he’ll likely head for Brazil. A subsidiary of German industrial giant Metallgesellschaft placed that same sort of bet, using derivatives not to protect against price changes but to profit from a price rise; when oil fell in December, its losses topped $1 billion. P&G’s derivative losses stemmed from types of swaps that violated corporate policy, the company said. In both cases, more careful management could have avoided the problem.
If a derivative backfires or a user goes broke, that doesn’t mean the whole financial system will collapse. The risks are far smaller than the numbers suggest: Merrill Lynch held derivatives with a face value of $891 billion at the end of 1993, but it would have lost less than $7 billion had every one of its trading partners gone out of business. And dealers, under heavy pressure from regulators, customers and stockholders, have gone to extraordinary lengths to control risk. “To date, these banks have proven to be impressively agile,” says Rep. Jim Leach. “The only question is whether past is prologue.” There are limits on transactions with individual partners and, increasingly, demands that customers post Treasury bills as collateral. There are constant “stress tests” that calculate what will happen to the value of a particular derivative or an entire portfolio if the bottom drops out of the Spanish peseta or if oil prices rise 20 percent. And, most of all, there’s an intense focus on the financial strength of trading partners. That’s why the major New York banks have built their capital to extraordinary levels, while brokerage houses deal in derivatives through subsidiaries that have won Standard & Poor’s highest rating-and must receive S&P’s approval before trading a new type of product.
That doesn’t make the much-feared meltdown impossible, any more than it’s impossible for a major bank to go out of business. The financial system has known life-threatening problems-real-estate loans, loans to developing countries-since long before derivatives came on the scene. If anything, derivatives are less threatening than old-fashioned lending because regulators have forced Wall Street’s top executives to take a personal role in understanding the risks, reviewing the models and disclosing their companies’ positions. “The way for us to address systemic risk is to ensure that they have the proper procedures and controls,” says Doug Harris, who handles derivative issues for the comptroller of the currency. Congress has every reason to be curious. But curiosity is one thing, hysteria entirely another.
