Watch Senator Dorgan's remarks 15 years after this article was published, at the October 15, 2009 Washington Monthly/New America event "Risky Business: Why We Must Re-Regulate Finance."
ast spring, when the stock market took its hair-raising ride, in one corner of Wall Street there was more than the usual anxiety. In fact, there was stockbrokers-looking-for-upper-floor-windows kind of fright. In April, clients of the giant Bankers Trust New York Inc.—including Procter & Gamble—took multimillion dollar losses on a kind of trading most Americans had never even heard of, called "derivatives." A rumor went around the Street: Maybe something truly sinister was brewing. Maybe this was a ... derivatives collapse.
The spring market panic hit just as the March issue of Fortune—hardly a carping business critic—cast a dark pall over derivatives, which are complicated futures contracts based on mathematical formulas. Fortune called them an "enormous, pervasive, and controversial financial force." The magazine added: "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."
The headline on the Fortune cover was "The Risk That Just Won't Go Away," shown over a pool of alligators. With that staring back at brokers and investors from their coffee tables, the sudden dip in the Dow and the story of Bankers Trust made people think, Hey, we really need to get a grip on this. But the dip turned out to be a blip, and the crisis passed out of the news. In typical fashion, the media moved on to other matters, content that where there's no immediate crisis, there can be no fire.
Yet, this "false alarm" could turn out to be a harbinger of a real financial conflagration—one that would make us nostalgic for the days of the $500 billion savings-and-loan collapse. In August, The Wall Street Journal declared that derivatives were now a $35 trillion—that's right, trillion— worldwide market. The U.S. share is estimated at $16 trillion, which is four times the nation's economic output. And the Journal estimates that since 1993 there have been $6.4 billion lost in the derivatives game—$6.4 billion that could have opened businesses and created jobs. Derivatives are no doubt widespread: An Investment Company Institute survey found that 475 mutual funds with net assets of $350 billion recently held derivatives; about two-thirds of those assets were in short-term bond funds sold to average investors. And here's the real kicker: Because the key players are federally insured banks, every taxpayer in the country is on the line.
So what is this thing called a derivative? Bankers and speculators maintain it's just hedging, a perfectly normal practice to manage risk. Farmers hedge, so do banks and businesses. So what's the big deal? Derivatives have become much more than managing risk. They have begun, in some cases, to look like a financial casino where the decisions are wagering decisions, not business ones. Derivatives may well be the most complicated financial device ever—contracts based on mathematical formulas, involving multiple and interwoven bets on currency and interest rates in an ever-expanding galaxy of permutation. Of course, what individual investors knowingly do with their own money is their own business. But when financial institutions are setting up what amount to keno pits in their lobbies, it's something that should concern all of us.
Let me explain by example. One form of derivative—the most simple—is a futures contract, which is the traditional device for a company to lock in a price for materials at a future time. Say a company that manufactures film—Company X—needs to buy silver every year and wants to guard against rising silver prices. So in 1994 it enters into a contract with a mining company to pay the going 1994 rate in 1995. This is a risk for X if silver prices tumble, because they will be required to pay the higher price. But if prices rise, X wins because it will be able to buy the silver for less than the 1995 market price. Of course, speculators can buy and sell such commodities contracts with no intention of actually obtaining the commodity, hence gambling on the fluctuation of prices. But this kind of traditional futures trading takes place on organized exchanges that are well-regulated and well-understood.
The troubling derivative deals are much different. They take the basic futures idea a quantum leap further into a netherworld of high finance. Let's take a simple example. Say Company X is under an obligation to sell film in Japan next year. Assume further that the company's analysts believe the value of the yen will fall against the dollar. The analysts would like to protect against the risk that silver and yen prices may fluctuate over the course of the year, thus hedging their original hedge. The company can't go to an exchange in Chicago and get that precise deal, so it gets on the telephone to its bankers and suggests that the bank write a customized contract that is based on the delivery price of silver in yen, not in dollars. This is called an "over-the-counter," or OTC, transaction, since it does not take place on an organized exchange.
The new speculative twist is much, much riskier for both Company X and the bank. It doubles the stakes: now, instead of betting just on the price of silver, it is also wagering on the value of the yen. Why would X do this? Because doubling the bet may hedge their risk in both the silver and yen markets. Why the yen? Because its analysts, in consultation with the bankers, used complex mathematical models and probability charts to decide the yen bet was a good gamble.
If the analysts were right about the yen, of course, it all works out. But if they were wrong about the yen, and wrong about the silver, too, the result would be like having two lead weights slide to one end of a see-saw.
Unlike a traditional future, moreover, these exotic derivatives are almost impossible to sell if one of the two bets goes south. They are especially tailored to X's needs, and are therefore unattractive to other buyers.
And that's a simple example. Currency fluctuations are just the beginning. Interest rate gambles are common, too, and in this volatile year have led to many of the big losses, including the $700 million that Piper Jaffray, the respected Minneapolis firm, lost on behalf of clients that included small city governments and the local symphony association. Piper Jaffray had decided on the basis of obscure mathematical formulas that interest rates would not rise. Unfortunately, the formula didn't anticipate the Federal Reserve Board's rate hikes this year.
More trouble comes from exotic new derivatives called "swaps." Say Company A has borrowed money at a floating interest rate but is worried that rates might rise. It wants to lock in the rates at the lower level. So it calls a derivatives dealer—often a major bank—to find another company, call it B, which is willing to bet that the floating rates will be more favorable than the set rate. A swap results: Company A will pay a fixed rate of interest to Company B, which will pay a floating market rate to Company A. The risk to Company A is that rates will fall but A will be obligated to pay the higher, fixed rate. The risk to Company B is that B will end up paying higher rates than the fixed rate it receives from A. If you had trouble following that, then you are starting to get the idea. And all of this can be done without anyone even knowing, since such transactions can be done "off book"—effectively concealing them from stockholders and employees. Procter & Gamble bought a floating rate deal like this from Bankers Trust, losing a reported $157 million in the process.
There has been a steady flow of such losses in past months. The reports of recent derivatives disasters could be the first trickles of water through a rickety dam: Askin Capital Management, in New York, lost $600 million; Kidder Peabody, $350 million; CS First Boston Inc., $40 million. Such debacles have led some leading Wall Street sages—Gerald Corrigan, the former president of the New York Federal Reserve; Felix Rohatyn, the investment banker; and Henry Kaufman, the bond guru, among others—to warn that derivatives are out of control. These men are not given to impetuous overstatement where finance is concerned. Nobody would care if these were just a few Donald Trumps taking a hit at a respectable financial casino.
But the truly scary thing is how losses like these could spread through the entire banking system. Suppose X, our film company, had entered into a swap with a New York bank. That bank in turn might then enter an offsetting contract with another bank which in turn might continue to pass along that risk on and on and on, perhaps using exchange-traded futures. So now a default by X could create a domino effect: X could not pay its bank, and its bank therefore couldn't make the payments on its offsetting contract, and so on until the chain of losses enters the exchange, where the originally esoteric bet can hurt real businesses. This is not mere fantasy. According to the Brady Report on the causes of 1987's Black Monday 508-point fall, the problem was worsened by automatic computer programs that kept ordering traders to sell stock index futures—which are, in essence, derivatives.
Making matters still worse is the concentration of big derivatives dealers. The General Accounting Office found this year that much of the big OTC derivatives dealing is concentrated among 15 major U.S. dealers—including federally insured banks—that are extensively linked to one another and to exchange-traded markets. The top seven domestic bank OTC dealers accounted for more than 90 percent of total bank derivatives action, and the top five U.S. securities firms accounted for 87 percent of all such activity in securities in the country. Add in the always-more-volatile foreign markets (tied to about $4 trillion of the U.S.'s $16 trillion) and we're talking real money.
"This combination of global involvement, concentration, and linkages," warns Charles Bowsher, the head of the GAO, "means that the sudden failure or abrupt withdrawal from trading of any of these large U.S. dealers could cause liquidity problems in the markets and could also pose risks to the others, including federally insured banks and the financial system as a whole."
If this seems a remote possibility, don't forget that financial implosions nealry always seem that way—before they happen. This kind has has happened before, albeit on a smaller scale. The S&Ls are the most notorious example, of course, but there are others. The failure of the Bank of New England, in 1991, cost taxpayers $1.2 billion, and the bank had a $30 billion portfolio of derivatives that had to be painstakingly unwound to avoid, in the words of the GAO, "market disruptions." And the feds have had to clean up non-banking financial messes as well. In 1990, when Drexel Burnham Lambert failed, the government had to insure payments that flowed between Drexel's sundry creditors and debtors to avoid a chain reaction. With a $35 trillion derivatives market, a crash would make these precursors look Lilliputian.
All that stands between the public and a financial disaster of this sort is the guardians of the banking system in Washington. Regrettably, they are outgunned by the derivatives dealers in several ways. For one, there are fewer examiners than dealers, and many examiners are young and inexperienced. Worse, exotic derivatives—the stuff the big boys are doing—just don't fit within the existing scheme of federal finance regulation. It's a little like asking traffic cops to stop the nation's computer crime.
Perhaps it seems that none of this concerns you directly, but in this spooky new financial world, there are basically three ways you could lose.
•You have money in a money market fund or a mutual fund. This is the scariest and most immediate prospect for most Americans. It's entirely possible—in fact, it's all too likely—that you wouldn't know whether your fund had money at risk. Two-thirds of the assets held by tax-exempt U.S. money market funds, which were created to give the small investor access to high rates of return, are now covered by derivatives. BankAmerica recently had to pump $67.9 million into its Pacific Horizon money market funds to make up for derivatives losses. As for mutual fund losses, ask Mound, Minnesota. When the public officials of the Minneapolis suburb wanted to tuck $2.5 million away to pay for new water meters and sewers, it chose an eminently respectable, reputedly conservative Piper Jaffray mutual fund that invests in U.S. government securities. But as The Wall Street Journal reported this summer, Mound lost $500,000 because Piper Jaffray was playing a derivatives game with the town's money, betting that interest rates would fall. Leaders of Moorhead, Minnesota, can tell you a similar story.
•A private investment goes bad. If you are a stockholder in a company that's trading in derivatives, and the bets turn out badly, the stock is going to take a hit. In one of the biggest cases so far, the German firm Metallgesellschaft, a mining, metals, and industrial company, took what may be a $2 billion loss on derivatives. One of the company's U.S. subsidiaries, MG Corp., which owns an oil refinery, bet on oil prices and lost badly. Several divisions of the company have had to be sold, and 7,500 out of 46,000 employees were laid off.
•Government takes a hit—either directly or indirectly—through bank losses in derivatives. Mound's local taxpayers lost money; in Orange County, California, taxpayers had to meet a $140 million collateral call when some derivatives speculations started going bad. This is not the best use of the taxpayers' money. The federal government, too, is quietly but rapidly getting into the game. The Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation use exotic derivatives, as does Sallie Mae. And because these are federally chartered corporations, the possibility of the federal government getting stuck with clean-up costs is great.
In the peculiar market of recent years, successful exotic derivatives have been a miracle drug for bank balance sheets, not to mention the dealers who are shovelling in millions. It's not surprising, then, that these banks and dealers are resisting reform. What is surprising is that the Office of the Comptroller of the Currency (OCC) and the Federal Reserve agree, too, that legislative reform is unnecessary. "As far as the Federal Reserve Board is concerned," Chairman Alan Greenspan testified in May, "we believe that we are ahead of the curve on this issue as best one can get." Why would Greenspan, in light of the mounting evidence, soft-peddle the problem? Partly, it's the old story. Because the Federal Reserve, like other banking regulators, tends to think more like the people it is supposed to be watchdogging—in this case, the banks and the larger financial community—than they think like the rest of us. And in fact, in the case of the Federal Reserve, it is the industry it is supposed to oversee: The members of the Federal Reserve are bankers.
This does not augur well. Just a few years ago, the S&L crisis began with a trickle of bad news, a few seemingly unrelated belly-flops. A chorus of operators, experts, and federal regulators assured the public and Congress that nothing was substantially amiss.
Certainly the industry understands the parallel—enough, at least, to try to convince Congress that the parallel doesn't exist. The International Swaps and Derivatives Association, a trade group of the most exotic operators, recently hired one of the top Washington lobbying firms to make their case. And although some members of Congress are awake to the derivatives problem, it takes more than that to reach a critical mass.
That's where the press comes in—or should. But except for a few pieces, the national press has been cowed by the complexity of the subject. Instead of inquisitive reporting, we get reports of assurances from Greenspan and others. Part of the reason is that, as with the S&Ls, the disasters so far seem local: Piper Jaffray is a Minnesota story, etc. Back in the mid-eighties, when thrifts were beginning to collapse, it seemed as if it were a Texas story one day, a California story the next—never a national story. With the huge exception of The Wall Street Journal (and even it is more specialized a publication than, say, The New York Times or The Washington Post), a story like the S&Ls or derivatives only makes it off the business pages after disaster strikes and it's too late to rally public attention to reform.
Another reason is that much of this story lies in the pedestrian precincts of the regulatory culture. "It's a case where the government is outgunned and outmanned," says a senior GAO official. "One or two people at the top of the agencies are really knowledgeable, but I don't know how deep the talent goes. And at the big banks, you're going to have talent all the way down." At the Fed and the OCC, there are about 3,000 examiners but hardly any of them monitor derivatives. That task falls to small teams of about 10 to 15 examiners who go into major banks like Citicorp and are expected to track deals that the banks need up to 100 different analysts and traders to put together.
Dollars and sense
House Banking Chairman Henry Gonzalez wants to strengthen reporting requirements for derivatives trading—a sound step, but alone this keeps federal taxpayers in the line of fire. I think I have a better, cleaner idea. I have introduced S. 2123 in the U.S. Senate, which would prohibit banks and other federally insured institutions from playing roulette in the derivatives market. If an institution has deposits insured by the federal government, it should not be involved in trading risky derivatives. Of course, what investors do with their own money is their own business. (And of course, dealers must be required to tell their customers when derivatives are involved; in the Piper Jaffray debacle, customers did not understand what was happening.) But what banks do with money insured by the taxpayers is another matter entirely.
The classic purpose of deposit insurance, one of the enduring legacies of the New Deal, is to encourage saving and create a pool of capital to build homes and businesses and jobs. Deposit insurance is not supposed to underwrite airy speculation on Wall Street, and my bill will stop that.
Banks will argue that derivatives are good since they hedge risks they take by loaning money to real people. But my proposal would not affect traditional, conservative forms of hedging. And banks, so long as they created pools of betting money outside their federally insured deposits, could gamble to their hearts' content. But not with our money.
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Byron Dorgan is a Democratic senator from North Dakota.