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The risk that won't go away

Like alligators in a swamp, derivatives lurk in the global economy. Even the CEOs of companies that use them don't understand them.

By Carol J. Loomis

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(Fortune magazine) -- This story originally ran on March 7, 1994.

(FORTUNE Magazine) - TO ALL generally well-informed business people, a few words of semicomfort about financial derivatives: First, if you don't really understand what these are, don't fret. Most of your colleagues, top brass included, are equally baffled. Second, if ten years from now - despite periodic booster shots from articles like this one - you still can't keep these things in focus, then cheer! That will mean derivatives have not been forcibly brought to your attention by bad, bad news, in which they make headlines as a villain, or even the villain, in some financial crisis that sweeps the world.

That possibility must be entertained because derivatives have grown with stunning speed into an enormous, pervasive, and controversial financial force. Derivatives are contracts whose value is derived - the key word - from the value of some underlying asset, such as currencies, equities, or commodities; from an indicator like interest rates; or from a stock-market or other index. The derivative instruments that result - variously called swaps, forwards, futures, puts, calls, swaptions, caps, floors, collars, captions, floortions, spreadtions, look-backs, and other neverland names - keep bursting into the news, as they did recently when the Federal Reserve raised interest rates and share prices sank, costing some traders of derivatives huge amounts that in some cases surely ran into many millions.

Derivative contracts also produce amazing statistics: growth rates, for example, of 40% a year. ''These things,'' says one Wall Streeter, ''are metastasizing.'' They demand superlatives, are measured in trillions of dollars, are quintessentially global, and are positioned on what wags call ''the bleeding edge of technology.''

Derivatives are fixtures by now in thousands of corporations, but you need a playbill to figure out the cast. The lead actors, small in number, are derivatives dealers: the big commercial banks, the major securities firms, plus an occasional outlander from insurance. For these players, derivatives have become an imposing source of profits, earned largely on the fastest-growing, most controversial instruments of all: customized, over-the- counter contracts written between a dealer and another party. A Citicorp executive goes so far as to call derivatives ''the basic banking business of the 1990s.'' The remaining roles in derivatives are played by the end users, who include the dealers themselves and just about anybody else capable of taking the other side of those contracts -- smaller banks, industrial companies, insurers and other financial services firms, pension funds, governmental units such as municipalities. These ''counterparties'' to the contracts customarily use them to hedge some business risk they don't want to bear, such as a jump in interest rates or a fall in the value of a currency.

But transferring such a risk doesn't wipe it away. The risk simply gets passed by the initial contract to a dealer, who in turn may hedge it by a separate contract with still another dealer, who for his part may haul in yet another dealer or maybe a speculator who wants the risk. In the words of Rodgers and Hammerstein's King of Siam: ''et cetera, et cetera, et cetera.'' What results is a tightly wound market of many, many interconnections - global interconnections - that is altogether quite different from anything that has ever existed before.

Most chillingly, derivatives hold the possibility of systemic risk - the danger that these contracts might directly or indirectly cause some localized or particularized trouble in the financial markets to spread uncontrollably. An imaginable scenario is some deep crisis at a major dealer that would cause it to default on its contracts and be the instigator of a chain reaction bringing down other institutions and sending paroxysms of fear through a financial market that lives on the expectation of prompt payments. Inevitably, that would put deposit-insurance funds, and the taxpayers behind them, at risk.

This threat, even if judged remote, is part of the conundrum that derivatives pose for regulators. Every regulatory speech on derivatives takes a bow to their hedging ''benefits.'' Less publicly, regulators pay their respects to derivative profits, a blessed relief from the banks' troubled loans to less-developed countries, highly leveraged companies, and real estate swingers. For U.S. regulators, an added satisfaction is knowing that American commercial banks are the worldwide leaders in this business.

Yet these things are regulatory nightmares. They are ''off balance-sheet'' instruments whose mere existence, leaving aside their complexities, obscures what's going on at the store. They make leverage all too easy to come by. Concocted in unstoppable variation by rocket scientists who rattle on about delta, gamma, rho, theta, and vega, they make total hash out of existing accounting rules and even laws. Tellingly, the laws of many countries have considered some derivative contracts to be gambling bets, in the sense that the outcome of the transaction is not under the control of either party to it. Drivatives have the aspect of a big, rawboned teenager of tremendous strength who has grown up in a household that had neither the time nor the skill to formulate rules for his behavior and that now senses he just might be capable of gross misconduct. You can't exactly manhandle a kid like that. For one thing, he might pick up his marbles and set up shop in some well-furnished telephone booth overseas.

So regulators have circled derivatives uneasily, not sure of what to do about them, except to worry. The new worriers include Congressman James A. Leach, 51, of Iowa, who calls derivatives the ''wild card'' in international finance. The ranking Republican on the House Banking Committee, Leach has just introduced a bill that proposes a new Federal Derivatives Commission, whose authority over these products would be extensive. The old worriers include Gerald Corrigan, 52, who was until recently president of the Federal Reserve Bank of New York and who has just become a top-level international executive at Goldman Sachs, itself a large derivatives dealer.

Two years ago the formidable Corrigan - given to mumbling, but not on this occasion - set off an industry commotion by sternly asking a ballroom of bankers whether derivatives might not be introducing new elements of risk and distortion into the financial system. To bank managements, he said, ''I hope this sounds like a warning, because it is.'' This January, talking to FORTUNE, Corrigan praised the steps that major financial institutions have since taken internally to tighten their risk-management systems - the controls of this business. He commended the work of the Washington think tank called the Group of 30, which last year asked dealers and end users to strengthen their controls further. And he made the customary salaam to the ''benefits'' of derivatives, presenting a case that the vast array of hedges set up in the world has reduced the possibility of financial crises.

Nonetheless, Corrigan said he probably would do no more today than slightly tone down his warning of two years ago. There's that growth to worry about, he said, and a string of risks. Included in his recital of these was the thought that some shock - as extraneous even as a coup in Russia or a natural disaster - might indeed cause what he calls ''payment gridlock'' in the market. Regulators can handle almost any problem, Corrigan said, if they can wall off a troubled financial institution from the rest of the world. Derivatives, because of all their interconnections, have made that job tougher. Moreover, the interconnections frequently lead to securities firms and other nonbanks, to which government safety nets might have to be extended if the banking establishment is to be protected. Without precisely conceding that point, Corrigan says that ''for these purposes, the distinction between banks and nonbanks is hardly relevant. If something bad happens, everybody's just got to do the right thing.''

The big dealers seem inconsistent on the subject of deep trouble. When they have talked to regulators who have subsequently reported their comments in official studies, some dealers have expressed concern about systemic risk. They have focused, in particular, on the buildup of linkages in the business and the speed with which reports of trouble whip through the market and affect prices. Publicly, most dealers claim the talk of a meltdown to be greatly overblown, partly because they believe each institution in this business to be diligently doing the right thing by intensely monitoring its own risks. Says Mark Brickell, one of J.P. Morgan's derivatives experts: ''It's in our own self- interest to make sure that no big problems develop.'' That is certainly true: A derivatives disaster would not only crumple the dealers' bottom lines but assuredly bring on new regulation the industry would detest. Consequently, as Corrigan indicates, many dealers have worked incessantly to perfect their risk-management systems, have sprung for the high-tech equipment that makes the systems possible, and have worked for laws that will distinguish derivatives from Lotto.

Unfortunately, the very need for these efforts impresses on an outsider just how much risk there is to be contained and how difficult the job is. And history is not entirely reassuring. In the 1987 stock market crash, according to the conclusions of the official Brady report, colossal sales of stock index futures by so-called portfolio insurers - whose investment strategies depended entirely on these derivatives - greatly exacerbated the 500-point market decline. On the other hand, when two derivatives dealers, Bank of New England and Drexel Burnham, later failed, the damage was successfully walled off. But in ''notional value,'' which means principal and is the flawed but standard way by which a derivatives business is measured, these companies were also-rans. Each had only about $30 billion of contracts outstanding when the guillotine fell.

The derivatives industry has not been tested by a giant failure, as it would have been, for example, if the serious liquidity problems affecting Salomon Brothers at the time of its Treasury bond scandal in 1991 had pushed that firm over the edge. Salomon had more than $600 billion in derivative contracts on its books. Even so, it is itself an also-ran in derivatives. Chemical Bank, the world's titular leader, is up to about $2.5 trillion. Fact is, nobody knows how this powerful, interlocked business - this genie out of a bottle, as everybody calls it - would come through a really severe crisis.

Here's how derivatives derive their value - and their risk. Say you don't buy General Electric stock, but instead buy a call on GE, an option entitling you to buy GE for a specified time at a specified price. From then on the value of your call - your derivative - is going to be determined by what happens to the price of GE stock, which in trading lingo is known as ''the underlying.'' The cost of the call, or the premium, will be relatively small and give you great leverage if the stock does well. But if the stock loafs or falls, the call could be worthless.

OPTIONS, such as that call, are one of the two basic kinds of derivatives. The other is forwards, which can be illustrated in terms of a U.S. company planning to build a French plant, for which it expects to need $20 million in French francs six months from now. Wanting to nail down its cost today - wanting, in other words, to hedge against a rise in the price of francs - the company promptly contracts with a bank to buy $20 million in francs six months forward at a price negotiated now. That contract will turn out to have been good value for the company if the franc thereafter jumps in price, but will be a loser if the franc's price falls. Whatever the company makes on the contract, the bank will lose - and vice versa. The mathematics work out that way because derivatives are a zero- sum game. On the other hand, you can argue that the certainty of knowing what its francs will cost provides the company with a gain not mathematically measurable.

The meat and potatoes of the derivatives business is a kind of forward contract called a swap, which we will explain by momentarily benching the dealer community. Instead, imagine two homeowners, each holding a mortgage not entirely to his satisfaction. Joe's mortgage, whose principal value is $100,000, has a fixed 8% rate. Chuck's mortgage, also $100,000, has a floating rate, tied to Treasury bills and currently costing him 8% as well. But Chuck worries that interest rates are going to go up. Joe thinks they could go down. So they ''swap'' their interest positions (that is, swap floating for fixed), agreeing to settle up between themselves every quarter, depending on what interest rates have done in the meantime. In effect, the deal sets up a series of forward contracts, each covering a quarter. Chuck must pay money to Joe if interest rates go down, and Joe must pay off if they go up. Even if Chuck emerges the loser, he has eased his mind by putting a cap of 8% on the interest rate he will have to pay.

***

Of course, Joe and Chuck have each acquired a new concern: For the duration of this deal, which could be years, will the guy on the other side of the contract be good for whatever he turns out to owe, if anything? This is credit risk, and it is a central issue for the dealers and end users who enter into contracts. The character of securities firms, normally short-term transactors, is actually being transformed by derivatives, which put them for the first time into the business of extending long-term credit. That means they are beginning to look more like commercial banks, which, of course, assume credit risk every time they make a loan. But loans are for a finite amount. What's owed on a derivative expands and contracts as market prices move. In the Joe/ Chuck example, volatility in interest rates could cause one side to end up owing the other a bundle.

In that deal also, the $100,000 - that's the notional value - serves only as the reference amount against which the interest rates are figured. But notionals are just about the only way to measure the size of the derivatives business. So notional values go into the adding machine and out comes trillions. Counting everything, including both derivatives traded on the futures and options exchanges and over-the-counter (OTC) derivatives, the notional value of derivative contracts outstanding is today an estimated $16 trillion. That leaves the GDP of the U.S., at around $6.4 trillion, in the dust.

Multinational companies have been entering into currency contracts for many decades, and futures and options trading on exchanges has been hot stuff for more than ten years. But what have really been burning up the track are OTC derivatives, the tailor-made contracts whose dazzling growth began in the mid- 1980s and which are now up to an estimated $10 trillion in notional value. These are the derivatives that are making the business so complex and difficult for regulators to get their arms around.

The derivatives portfolio of a given OTC dealer - its book - still includes many plain-vanilla swaps, in which the bank and an end user will have exchanged floating for fixed and be dealing entirely in U.S. dollars. But these players are way beyond that point in many contracts and, like the spacecraft Galileo, are still heading for Jupiter.

Asked recently to give an example of a complicated swap, Peter Hancock, head of derivatives at J.P. Morgan, edged into the language of trading: ''It would be something,'' he said, ''in which you get beyond binary risk and into a combination of risks, such as interest rates and currencies. Or take an oil company, which has risks of oil prices dropping and interest rates rising. To hedge, it could buy an oil price floor and an interest rate cap.'' But maybe, said Hancock, the company would like something a little cheaper: ''In that case, we could do a contract that would pay out only if oil prices are low and interest rates are high at the same time.''

Hancock then moved closer to Jupiter. He postulated the case of a German bank whose loans have been made almost entirely to German companies and a Texas bank whose loans are almost totally Texan. ''What you'd like to do,'' he said, ''is figure out a way they can diversify by swapping exposures, with the German bank taking over some of the Texas risk and vice versa.'' And what's preventing this kind of deal from happening? Says Hancock: ''Well, what you lack are good underlyings, which would be an index of credit losses in Texas and another for Germany. Those kinds of indices are in their infancy.''

Eugene H. Rotberg, a Washington lawyer who has held high-level jobs at the World Bank, the Securities and Exchange Commission, and Merrill Lynch, illustrates how convoluted the business has become for dealers by quoting a descriptive passage from Risk, a British magazine: '' 'On the risk-management side the bank runs five separate books: a spread book, a volatility book, a basis book, a yield-curve book, and a directional book. The spread book trades swap spreads using Treasuries to hedge medium- to long-dated swaps and a combination of futures and Treasuries for the short term. The volatility book makes markets in caps, floors, and swaptions as well as captions, floortions, and spreadtions. The basis book deals with the spread between different floating-rate indices, such as prime and commercial paper vs. LIBOR. The last two books are structured to arbitrage changes in the steepness of the curve as well as overall movements in interest rates.' ''I doubt,'' adds Rotberg, ''that the CEO of that bank was equipped to supervise that operation.''

YET REGULATORS are adamantly insisting these days that CEOs, and their boards, do understand what is going on in the derivatives operations beneath them. The Office of the Comptroller of the Currency issued 26 pages of guidelines last October as to how national banks should manage the risks of their derivatives business and specifically mentioned more than a dozen times how responsibilities for these fall on the banks' boards.

This warning is no more than a reprise of past efforts by regulators to make directors understand they're on the line for the deeds of their banks. But comprehending derivatives may be the ultimate burden for a director. Says Michael M. Wiseman, a banking partner at New York law firm Sullivan & Cromwell: ''It's just one more reason why no one in his right mind wants to be on a bank board.''

As for CEOs, they obviously vary in coping ability. At one end of the range would be Charles Sanford, of Bankers Trust, and Dennis Weatherstone, of J.P. Morgan, both experts because they came up through trading. Close to the other end would be the CEO of a large U.S. regional bank, both a dealer and end user of derivatives, who recently begged off answering a fairly rudimentary question about his bank's derivatives portfolio. Said he: ''I am rapidly sinking over my head.''

It is certain that this floundering CEO could not have learned much about his bank's derivatives portfolio by consulting his own annual report. Disclosure is abysmal in U.S. annual reports and virtually nonexistent in countries like Japan and Germany. The conventional holding pen for derivatives in the U.S. is a footnote to the financial statements called ''off-balance- sheet financial instruments.'' It is usually densely packed but uncommunicative. Although companies could clearly do better, the difficulty of explaining a derivatives operation is profound.

THE POINT has been driven home recently by the painful and peculiar odyssey of Banc One, eighth-largest U.S. banking company, avaricious acquirer, and - normally - stock market star. Banc One, strictly an end user of derivatives to hedge business risk, not a dealer, spent last year trying to explain to the world what it was doing with swaps, and just why these things were contributing so much to profits. Out of $1.2 billion in pretax profits in 1992, swaps contributed an extraordinary $318 million. But only an experienced bank analyst could have understood what Banc One had to say about this phenomenon, and some of them disliked this high-tech faucet spewing out profits.

In April, Banc One's stock began to drift down, which is woe for this company that constantly uses its shares to acquire other banks. Still later, the SEC began to put pressure on Banc One to improve its disclosure about derivatives. So in its third-quarter 10-Q report filed with . the commission, the company had an elaborate new page of explanation. Peter Lincoln, an investment vice president of United States Steel and Carnegie Pension Fund, which owns about $50 million of Banc One stock, has had 33 years of Wall Street experience. But he says he gained very little from the 10-Q explanation.

By that time, though, Banc One was dispatching its cavalry. In early December a large delegation, headed by CEO John B. McCoy, held meetings in New York and Boston for analysts and the press to discuss this one subject. Lincoln, among the 260 or so who packed the New York gathering, said it did the job. ''Of course,'' he added, ''it took from 9 o'clock to 3 o'clock.'' The brief explanation is this: Traditionally, banks have met a slump in loan demand by moving their spare cash into investments. Since these provide lower profit margins than loans, banks have also often leveraged themselves up during such periods, borrowing so that they could build the size of their investment portfolios and thus keep earnings up during the slow spell for loans.

Banc One's strategy in the past few years has instead been mainly to do swaps in which the bank receives fixed interest rates and pays floating rates. The notional amounts of the swaps are very large: $23 billion as of last September, onto which Banc One had then piled $15 billion worth of various other derivatives, for a total of $38 billion. The bank chose to ''receive fixed and pay floating'' because it expected rates to go down. This ''bet'' -- a word used by Banc One at the meeting -- worked, which means the company was the winner in its zero-sum swaps with the dealers.

Along the way, Banc One leveraged itself up without its showing. A swap contract obviously has risks. But when a contract is born, absolutely nothing goes on the balance sheet of either counterparty. Only thereafter, as the swap creates receivables and payables, does anything move onto the balance sheet.

In contrast, had Banc One borrowed and bought securities, as banks traditionally have done, the balance sheet immediately would have expanded. The bank's ''leverage ratio'' - the relationship of its equity capital to its assets - would consequently have fallen, a result regulators don't care for. In effect, Banc One has created a synthetic bank that does swaps and that helps the real bank through slow periods.

Investors could see that as the latest example of the adept management for which Banc One is renowned. Or they could see it as financial engineering that doesn't have much to do with banking. Why couldn't, say, Toys ''R'' Us do the same thing in a slump? Or Merck, now that times are tough? These questions suggest why some bank analysts are still not happy with the quality of Banc One's earnings. The stock was recently down about 25% from its high last April.

The trick for an end user of derivatives is plainly to be on the right side of the bet. ''This is an art,'' says Richard D. Lodge, the Banc One executive who runs the synthetic bank. Another master on this canvas: speculator and hedge fund operator George Soros, who in the fall of 1992, when many European currencies crumbled in value, made a reported $1 billion by using currency derivatives and other tools to short the market. Alas, the government of Malaysia went long about the same time, and lost nearly four times that much - that's right, almost $4 billion.

Currently the cause celebre in the wrongheaded department is Metallgesellschaft, a metals, mining, and industrial company whose $15 billion in sales make it Germany's 14th-largest industrial corporation. For its 1993 fiscal year, ended last September, the company reported a preliminary loss of about $200 million. But that was before calamitous news spurted from one of Metallgesellschaft's 251 subsidiaries, MG Corp., a U.S. marketing organization and part owner of a U.S. oil refiner. The subsidiary had been playing in derivatives, where it has so far reported nearly $500 million in losses and may lose perhaps another $800 million.

MG took a couple of years to dig its hole. In Part 1 of this affair, it entered into long-term, fixed-price contracts (which are not derivatives) to supply oil products to gasoline stations and other users. In Part 2, it negotiated other long-term contracts to buy oil, so that it would have product to deliver against Part 1's contracts. But for whatever reason, it did not line up 100% of its requirements. So it was left bare on some of its supply agreements, a situation exposing it to fluctuations in the price of oil. In Part 3, therefore, it put on a pseudo-hedge, employing tons of leverage, buying quantities of oil derivative contracts on the futures exchanges and from OTC dealers. The idea was that rising oil prices, if these came, would boost the value of the derivatives, creating profits to offset losses MG would then realize from having to buy high-priced oil to satisfy its long-term contracts.

The fatal defect in this plan was that the derivative contracts were short term and not a true hedge against the long-term supply contracts. In trading terms, MG had a hedging ''mismatch,'' in which it was vulnerable to a widening of the spread between the long- and short-term prices of oil. The mismatch turned this supposed end user into a speculator on the oil spread. Whereupon the spread did widen, by means of a collapse in the short-term price last fall. MG's derivatives turned into dreadful losers.

In December, as the truth began to emerge, Metallgesellschaft's flamboyant CEO, Heinz Schimmelbusch, 49, was fired. He is now under criminal investigation for fraud and breach of trust. (Schimmelbusch's only comment: ''I always informed the supervisory board to the best of my knowledge, based on the information available to me at the time.'') Two banks that are both owners and creditors of the company, Deutsche Bank and Dresdner Bank, then muscled the other creditors into what is being called the ''biggest rescue operation since Dunkirk.'' Altogether, Metallgesellschaft's creditors, most of whom were shocked to find they'd been lending to an energy derivatives speculator, are putting in a colossal $2 billion. In addition, divisions of the company will be sold and about 7,500 out of 46,000 employees will lose their jobs.

So it goes with the benefits of derivatives. If end users sometimes get boiled in oil or other trading hot tubs, the big dealers seem to paddle along extremely well. True, some of the evidence is circumstantial. Many dealers are mum about the dollars coming in from derivatives. They bury these instead in trading and foreign exchange revenues, which are profits before compensation, operating expenses, and taxes. These businesses have boomed. Figures compiled by the Wall Street firm of Keefe Bruyette & Woods show that trading revenues (including foreign exchange) of the seven biggest U.S. banks grew more than five times as fast over the past five years as all other revenues.

And derivatives are plainly a big reason. Disclosures from a couple of major banks have provided proof. Reporting 1992's figures, for example, J.P. Morgan separated out several kinds of derivatives, including swaps and forward currency contracts, and said these contributed $512 million, or about 53%, of total trading revenues, which were $959 million. Then, late last year, Chemical Bank went all the way, stating its derivatives revenues straight out. For the first nine months of 1993, ! these were $236 million, a huge 53% jump from the $154 million gleaned in 1992, and about 30% of Chemical's total trading revenues.

It could be bad for the banks to offer greater detail about derivatives. Analysts consider trading revenues to be uncertain income, and the growth of these has on its own definitely depressed price/earnings multiples. Though it is the top bank in FORTUNE's list of most admired companies, Morgan was recently selling for only eight times 1993 earnings. Bankers Trust, which has made itself a virtual derivatives department store, had a basement-level multiple of only six times earnings.

Investors are just not comfortable with the risks they perceive in derivatives. One is deadbeats - otherwise known as credit risk. Yes, every dealer worth the name carefully polices the credit quality of its counterparties and sets limits on how much business it will do with each. But within the span of a five- or ten-year derivative contract, a counterparty's creditworthiness can deteriorate substantially. When Olympia & York, the Canadian real estate giant, tumbled into deep distress, the detritus included a good many derivative contracts - some since settled in bankruptcy proceedings for 15 cents on the dollar.

Perhaps the most problematic credit risks around today are hedge funds, the big pools of investment capital like George Soros's Quantum Fund. Many have moved aggressively into derivatives, making themselves such important customers that no dealer wants to turn them away. But their creditworthiness is suspect because the funds' investors typically have the right to withdraw their money every three months. So a fund could suddenly shrink into counterparty nothingness. A dealer can partially protect itself by trying to get collateral for what a fund owes it, as Salomon told a group of analysts recently that it tries to do. But can a dealer get a line on how deeply extended that fund may be with other dealers? ''No,'' said Salomon's treasurer, John G. Macfarlane. ''That is quite difficult to do.''

ANOTHER HAZARD that dealers face is market risk, which is the prospect that prices will take off in a direction that leaves them losers on unhedged positions (a la Metallgesellschaft). Some of these positions will have been accumulated deliberately in the name of ''proprietary trading,'' in which dealers use their brainpower, technology, and feel for the market to make money for their own firm. In other cases, hedges may be difficult to put on, or a dealer may think it has a hedge and finds it doesn't. Says Gene Rotberg, the Washington lawyer: ''The only perfect hedge is in a Japanese garden.''

For various complex reasons, options are the most difficult derivatives to hedge. They are also the fastest-growing segment of the business, partly because institutional investors have been looking for ways to insure themselves against a drop in the stock market. So they have been buying puts from the dealers, which allow investors to unload stock on the dealers at agreed-upon prices if the market begins to collapse. Dealers - the writers of these puts - are potentially in the same hot seat that many speculators and other unfortunates occupied when the stock market ''gapped'' - that is, dropped chaotically - in October 1987. A goodly number of these folk, forced to buy the stock put to them, foundered as the market kept falling.

Says the risk manager at one dealer: ''You have to do some of this stuff in options because of customer demand. Nobody wants to write a lot of these things because the risk profile is horrible. You end up making a tiny bit of money, or you lose a gigantic amount.'' Can't he hedge his positions? ''Yes, to an extent. But you are always vulnerable to a gap move. You just can't hedge it.'' What you can do as a dealer is constantly run ''stress simulations'' that test the ability of your establishment to withstand shocks that are, say, 6.6 on the Richter scale or higher. These simulations are a staple of the dealer community, and it is only to be hoped they work better than the ones that tested the strength of the Los Angeles freeways.

IN ADDITION to credit and market risks, dealers must contend with valuation risk, which addresses the possibility that the profits of a transaction may be misstated. The good thing about a dealer's derivatives portfolio is that it is marked to market. The bad thing is that judgments about what the ''market'' is can vary widely. That is true even on short-term derivatives, which are readily priced because they trade in a liquid market. Calculating their results, derivatives traders, who are typically paid based on how much they make for their employer, will want to ''up-front'' all the profits they can. Employers, conversely, will think it prudent to delay the recognition of part of the profits by setting up reserves for credit risk, maintenance costs, and potential losses should they need to bail out of a position in a rough market. The ingredients are present for a tug of war.

The valuation difficulties are just that much tougher if the derivative in question is long term and exotic. The heart of the problem is that many derivatives are originally priced, and subsequently valued, by mathematical models that must include an estimate of what the volatility of the underlying will be over the term of the contract. Volatility, known to the trade as vega, can be measured in different ways. A model builder would probably consult history for guidance, looking perhaps at the annual percentage difference between a stock's high and low. But how much history do you examine? The past six years of the Standard & Poor's 500-stock index would give you one picture of volatility. Add in 1987, with its crash, and volatility would go into overdrive.

However you look at volatility, your assumptions can change during the term of a contract, with effects on profits that are powerful. A drop in volatility raises profits - and here is your trader, your expert, telling you that, happily, volatility has indeed gone down.

The system shrieks for checks and balances, which all good dealers have. Internally, they will probably have ''independents'' who check the assumptions of the traders. Outside accountants, who are climbing the learning curve in this business, will also keep an eye on the traders' valuations. Robert Herz, a partner of Coopers & Lybrand, says that his firm often asks academics or consultants to value certain of a client's derivatives, to make sure the client's figures are defensible.

What can happen when a trader has the whip hand over valuations is suggested by some fresh details about the big, widely publicized fight last year between American International Group, the big insurer, and its former derivatives boss, Howard Sosin, 43. Sosin moved to AIG from Drexel Burnham in 1987 and became the 20% owner of a new joint venture, AIG Financial Products (called FP), which specialized in long-term derivative contracts that many of its competitors wouldn't touch. Sosin supplied the expertise; AIG, an AAA-rated company, provided the creditworthiness demanded by customers entering into FP's stretched-out deals.

Though FP never grew to more than 135 employees, it became a huge provider of profits both to Sosin and to AIG. Sosin, however, was a control freak who wanted no interference from AIG. The company's tough, commanding CEO, Maurice ''Hank'' Greenberg, 68, could take that only so long. AIG's 1992 annual report disclosed that Sosin would be leaving, and at the company's annual meeting in April, Greenberg put the blame on ''a difference of opinion.'' He thought stronger risk management and credit controls were needed, he said, and Sosin didn't agree.

Taking 25 FP employees with him, Sosin went off to look for a new AAA backer. Figures that he circulated to prospects showed that FP had a ''distributable profit'' in 1992 of $340 million. That was eye-catching because AIG had reported its share of FP's 1992 profits at $171 million. Assuming that AIG had 80% of the profits as it did 80% of the ownership, total profits should have been about $210 million. The difference between that figure and $340 million of ''distributable profit'' is large.

Offering an explanation to FORTUNE, Edward E. Matthews, AIG's vice chairman for finance, says that it is not right to jump at the conclusion that AIG got 80% of the profits. But beyond that, Sosin and AIG were calculating profits in very different ways. Sosin's contract allowed him to up-front profits in an aggressive way and to be compensated accordingly. AIG, on the contrary, was both accruing profits over the life of the contracts and setting up reserves - very large ones, it would appear. When Sosin talks about his distributable profits, says Matthews, he is ''not reporting on the conservative side of the ledger.''

A further indication of that comes from the aftershocks of Sosin's leaving. In the middle of last year, AIG set up reserves of $215 million to recognize an ''impairment'' in the value of certain FP investments. The recognition of these losses, plus the spread between Sosin's view of profits and AIG's, suggests why the two parties fought bitterly last year over what walk-away money Sosin deserved. On the eve of arbitration proceedings, they finally reached a settlement, for an undisclosed amount. One report says Sosin received $150 million. In a recent interview with FORTUNE, Greenberg indicated repeatedly that he thought an aggressive approach to recognizing profits on derivatives was just plain wrong.

It's ''fair enough,'' he said, to talk about marking to market. But the uncertainties of this business, he thinks, require that companies have ''some degree of flexibility'' to delay the recognition of profits on a contract until it's certain they exist. Accounting rules don't make it clear that Greenberg can have as much flexibility as he would like. But don't expect much up-fronting of profits at AIG.

Sosin is still minus a backer. Logic says he might well have tried General Electric, an AAA company whose GE Capital is important in just about every segment of the financial services business except derivatives. Sosin never talks to the press, and GE's chairman, John F. ''Jack'' Welch, won't say whether Sosin came calling. But if he did, his reception was not warm. Derivatives, said Welch recently, are a business ''we have chosen to miss.'' He sees these instruments as producing trading surprises he doesn't care for, and his experience in financial businesses - for example, lending on commercial real estate - has made him aware of the excesses these businesses can spur. Says Welch: ''Things tend to grow to the sky, get a momentum. 'Let's make it a little higher, a little higher.' I think we've learned a lot about that.''

Over the near term, the learning process about derivatives is likely to be nudged along by more attempts on the part of corporations to explain the value of these products to their operations. The SEC has put out a call for such explanations, and the Financial Accounting Standards Board has also launched a hurry-up effort to determine just what new information might make sense. On their own, the big dealer banks that are members of the New York Clearing House are inching toward more disclosure. Certainly, a brighter, clearer light on derivatives in annual reports would be welcome news for investors.

On the regulatory front, there are stirrings aplenty, but mostly slow-motion prospects. In a world fighting bureaucracy, Leach's bill, barring some derivatives disaster, seems a poor bet to get passed. From the so-called Basle Committee on Banking Supervision, which Gerald Corrigan headed until recently, have come proposals for new rules that would stiffen capital requirements for derivatives, which at the moment do not put much strain on capital.

Corrigan obviously visualizes these rules as a brake on the growth of derivatives. Indeed, tougher capital policies could be thought of as the equivalent of margin requirements in the stock market, a concept widely accepted as beneficial. But banks are resisting the Basle proposals, and they are a long way from becoming rules. In Kansas City, the National Association of Insurance Commissioners is hovering over new proposals that would give insurers some increased freedom to use derivatives but would at the same time impose a responsibility on their management and boards to exercise great prudence in employing them. The Department of Labor in Washington is brooding over requests from many derivatives dealers that they be allowed to enter into OTC contracts with pension funds. Says the director of exemptions for Pension and Welfare Benefits, Ivan Strasfeld: ''There are a lot of problems about these things. For example, if your counterparty goes belly-up, you may have real trouble collecting what you're owed. So we're going slow on these requests.''

Adding to the difficulty of regulating derivatives is that bank supervisors are struggling to teach $80,000 bank examiners how to supervise a world in which a top-notch derivatives trader can make $1 million a year easily and maybe much more than that. What, the bank regulators keep asking themselves, should we add to our arsenal of rules? Says the risk manager of a certain dealer: ''I'll tell you, if I woke up one day and, God forbid, I was a regulator, I don't think I'd know what to do. Here in this place, I'm the guy the CEO looks at and says, 'What are our exposures? What do we not want to have happen? What could be the costliest thing that could wrong?' And for me to get the information I need to answer him is a real challenge. And yet I have unlimited access to any information I want. Anybody will take my phone call and answer any question. I tend to know the sort of questions that should be asked. Even given that, it's a full-time job to try to understand all that's going on and to try to make sure that all the pieces are fitting together in a way that gives this organization the kind of risk profile that the shareholders can be comfortable with. And I say to myself, 'If I'm in this position, what is a regulator going to do?' '' Wouldn't he, as a risk manager, have many of these problems even if derivatives didn't exist? ''Yes,'' he answers. ''But with derivatives there's leverage and sometimes illiquidity, and there's complexity. Three words.'' They are a mouthful for a big, strapping teenager who just might have the capacity for getting out of control.

REPORTER ASSOCIATE Erick Schonfeld To top of page


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