The Secret Money Machine

By John Greenwald

AN OLD POKER JOKE GOES LIKE THIS: If you look around the table and you can't spot the sucker, the sucker is probably you.

Looking around for places to invest their money, Americans in recent years have taken their seats at Wall Street's big casino as never before. Fewer than seven years after the crash, 61% of small investors' money is riding on publicly traded securities, up from a 46% share in 1987. More than $1.3 trillion has flowed into mutual funds since the 1990s began, bringing the total to $2 trillion.

Americans have had lots of good, sensible reasons for doing this. The economy finally seems robust, growing a vigorous 7% in the fourth quarter of last year. Corporations ranging from Sears to the papermaker Pentair, Inc. had + record profits last year. Low interest rates have made bank accounts less attractive, and real estate is no longer for those looking to get rich quick. Even after last week's turbulent retreat, the Dow Jones industrial average closed at 3636, 53.7% higher than in October 1990.

So to those gamblers nervously tracking the Dow last week: Don't fret too much; this could be a natural correction. The more unsettling news is happening off the casino floor. For it is there, in the back room, that the big boys have been playing an even faster and bolder game, the outcome of which can affect the little guy's winnings. Much of the smart money is really riding on computer-generated, hypersophisticated financial instruments that use the public's massive bet on securities to create a parallel universe of side bets and speculative mutations so vast that the underlying $14 trillion involved is more than three times the total value of all stocks traded on the New York Stock Exchange in a month and twice the size of the nation's gross domestic product. Collectively, these new financial instruments are called derivatives. Financially, they function like some giant unseen asteroid -- they influence the markets' movements with a powerful and dimly understood gravitational pull. And if they wobble out of orbit, they could conceivably come crashing into the sphere of day-to-day investments with cataclysmic effects.

Derivatives, which are based on such real assets as stocks and bonds, work like most professional betting games. They have a zero-sum outcome, always producing a winner and a loser. The bettors put up their money, and the people who run the casino -- a bank, a brokerage house or an insurance company -- figure out ways to pass on the risks. Companies use derivatives to hedge against changes in interest rates, foreign-exchange rates and commodities prices. Mutual funds and pension funds use them to protect their stock and bond investments. Major banks, brokerage firms and insurance companies write them for customers, inventing such exotic names as forwards, caps, collars, swaps, options and swaptions. Derivatives can be as straightforward as options to buy or sell securities or as fancy as unregulated and customized agreements to purchase oil futures in Nigeria while selling dollars in Indonesia and graphite in Madagascar.

They can also be dangerous, and that is their paradox. For while they were created to diminish risk, they can introduce more because of the sheer volume of money that rides on them. These side bets pull with them a real world of securities worth 30 times their value. Experts worried about the perils of such instruments have no trouble coming up with bleak scenarios. For instance, a utility company, trying to protect itself from an expected rise in oil prices, borrows lots of money to buy a derivative contract that will enable the firm to purchase oil in three months at current prices. But the price of oil goes down unexpectedly, and the utility is stuck with a commitment to buy oil at the higher price. That results in a big loss because the company not only has to pay more for oil than its competitors but also loses much of the money it borrowed to place the bet in the first place. The utility's stock plunges, leaving investors high and dry.

Even worse is a scenario in which one institution's troubles spread through the system. While that nightmare may be less likely than the first, it is the one that most experts are concerned about. Example: a major U.S. bank that deals in derivatives thinks it has covered all its bets around the world. But an unforeseen event, such as an earthquake in Tokyo or a coup in Latin America, sends markets crashing in some area. The bank's finely tuned hedging strategy is thrown off balance, and it has no choice but to default on its contracts. A whole chain of interlocking obligations snaps, setting off a series of uncontainable defaults that shake the world financial system. The remaining stock markets plunge, companies go bankrupt, and lots of people lose their jobs.

What inspires such worst-case speculation is the unprecedented size of the derivatives balloon. Its growth has prompted some Wall Street sages to warn that many of the newfangled instruments could be spinning far beyond anyone's control. The Jeremiahs include investment banker Felix Rohatyn, 65, one of Wall Street's elder statesmen, whose son Nicolas, 33, runs a J.P. Morgan department that uses derivatives to transact business in emerging markets in Asia, Eastern Europe and Latin America. "There's a whole different world in off-balance-sheet transactions that are potentially quite dangerous if people don't know what they're doing and a chain of financial commitments breaks down," says the elder Rohatyn. "These are interlocking commitments of trillions of dollars. As long as they remain solid and stable, everything is fine. But what do you do if something goes wrong?"

The danger of derivatives is compounded by the fact that this fantastic % system of side bets is not based on old-fashioned human hunches but on calculations designed and monitored by computer wizards using abstruse mathematical formulas that even their bosses at major trading houses do not really understand. "None of us really knows what the implications are, because nothing like this has ever happened before," concedes financial- market analyst Lowell Bryan, a partner in the consulting firm McKinsey & Co. Concurs a senior partner in a financial firm that is heavily invested in the derivatives market: "Whenever we get a new product and it's working and hasn't been tested, Wall Street won't ever try it for just $5 billion or $10 billion. It's got to go for $20 billion, $50 billion or $100 billion without knowing what will happen under certain market circumstances. They have the numbers, but they don't have either the judgment or the experience to understand them."

This latticework of contracts may seem isolated in a kind of financial cyberspace, but it produces real victims. In Japan the accounting director of Nippon Steel Chemical leaped to his death beneath a train last May after he lost $128 million of the company's money by using derivatives to play the foreign-exchange market. In Chile a derivatives trader named Juan Pablo Davila lost $207 million of taxpayers' money last fall, instantly earning himself a place in Chilean infamy, by speculating in copper futures for the state-owned mining company. In Germany the giant conglomerate Metallgesellschaft dwarfed even those losses when it dropped $1.3 billion last year by betting the wrong way on oil-futures contracts. Only a last-minute bailout by the company's banks saved it from bankruptcy.

Derivatives have clearly heightened the anxiety in stock, bond and currency markets around the world in the weeks since the U.S. Federal Reserve began raising interest rates for the first time in five years. The Fed's move on Feb. 4 led the aggressive speculators who run high-rolling investment vehicles called hedge funds, which use derivatives in daily trading, to dump billions of dollars' worth of bond futures and thereby drive down the prices of the underlying bonds. The worst fallout occurred in Europe, where bond prices plunged and interest rates, which move in the opposite direction of prices, climbed about one full percentage point. The biggest loser amid the global turmoil was legendary Wall Street investor Michael Steinhardt, who as of last week has lost $1 billion since the beginning of the year, or a quarter of the funds under his management. Another big-name investor, George Soros, got caught in the February mayhem, which people inside his Quantum hedge fund called the "St. Valentine's Day Massacre." Soros lost $600 million on Feb. 14 by wrongly betting that the U.S. dollar would rise against the yen. (Don't cry for Soros, though. He reportedly earned $650 million in 1992 and at least as much last year, eclipsing Michael Milken's 1987 record of $550 million.)

The turmoil in the bond derivative market, which has persisted since February, has troubled Wall Street watchers because it bears some of the hallmarks of the 1987 stock-market crash. That 508-point plunge on Black Monday was worsened by so-called portfolio insurance, which is computerized programs designed to bail investors out of stocks in a downturn by selling stock futures. But few buyers were willing to come forward while so many others rushed for the exits, and the decline accelerated instead of slowing down.

Such a scenario is what prompted the New York Stock Exchange in 1988 to add circuit breakers that temporarily halt automated transactions when the Dow Jones average rises or falls more than 50 points in a day. But even if the mechanisms work temporarily, some experts caution that all the computerized derivatives and other vehicles that Wall Street has developed since the Crash of '87 could keep shell-shocked buyers from returning to the market, out of fear of a new wave of selling. "A circuit breaker shuts off the overload," says Bruce Greenwald, a finance professor at the Columbia Business School and a staff member of the Brady Commission, which studied the Crash of '87. "But it doesn't come with an 'on' switch that can bring back buyers."

That's partly why U.S. lawmakers and regulators are stepping up their vigilance. Astonishingly, institutions like banks, insurance companies and brokerage houses now hold trillions of dollars of unregulated derivatives contracts that are not recorded on their books. Thus no one, including the firms themselves, knows just what pressures may be building up. In an effort to remedy that, Congressman James Leach of Iowa, the ranking Republican on the House Banking Committee, sponsored a bill last January to create a federal derivatives commission with broad oversight authority. And the Comptroller of the Currency has begun to require banks to disclose the dollar value of all the derivatives contracts they hold that have gone sour, much as they must list the total dollar volume of their bad loans.

Regulators have had two good excuses recently to push their oversight of derivatives. Typically, derivatives contracts make up anywhere from 2% to 10% of the assets of the mutual funds that hold them. But the managers of a $385 million government-bond fund called Hyperion 1999 Term Trust got carried away last fall. The trust put nearly one-third of its money into derivatives contracts that amounted to bets that interest rates would not drop anytime soon. When they did drop, the value of the trust's shares plunged about 25%. Just last week, a group of investment funds run by David Askin of Askin Capital Management was forced to liquidate its portfolio -- reportedly worth about $500 million -- after playing a similar game. The funds speculated on the price difference between two different sets of mortgage-backed securities. When interest rates rose quickly, the speculative scheme fell apart.

Even though derivatives clearly increase market volatility, Wall Street seems to be rushing headlong into financial cyberspace, where few traders, or their bosses, have ever gone before. Many of the derivatives that have raised concern are those based on untested mathematical formulas developed by so- called quants, short for quantitative analysts, who are rapidly gaining ascendancy in the trading rooms of banks and securities firms. But their computerized risk-assessment models, which monitor global transactions on a moment-to-moment basis and tell the quants when to buy or sell to balance vast portfolios, are based on historical patterns that cannot foresee all the worldwide selling pressures that could build up in a crisis.

Such unknowns could throw billion-dollar decisions, and even the financial soundness of the firms that make them, right back into the laps of executives who could find themselves ill prepared to deal with what the rocket scientists have wrought. "These mathematical models, they are not dealing with statistically definable facts that can tell you with certainty that if a market moves this amount, this is precisely what will happen," acknowledges Stephen Friedman, the chairman of investment-banking giant Goldman Sachs. "In the last analysis, you need to have people with common sense who can understand enough of what the rocket scientists are saying to translate it up the line," says Friedman, whose firm earned $2.7 billion before taxes last year, more than any other firm on Wall Street. "When there is a crisis, I want to have someone, like one of the heads of our fixed-income departments, sitting there at the trading desk with his shirt stuck to his body with sweat and interpreting for me what the rocket scientists are saying."

There were actually sound business reasons for the rise of derivatives, which first became popular in the 1980s. Money was moving around the globe like never before. The demise of communism in Europe expanded markets for American investors in countries such as Russia, Hungary and Poland. On the other side of the world, China lurched toward free enterprise. At the same time came the liberalization of economic policies in Latin America from Chile to Mexico and the rapid growth of the newly industrialized countries of Asia's Pacific Rim. The world was suddenly ravenous for American capital.

But American corporations and other prospective investors faced risks ranging from exchange-rate fluctuations to possible political coups. To underwrite the hazards, Wall Street began issuing over-the-counter derivatives contracts, which investors snapped up as security blankets. Such deals could be as simple as an agreement to buy German marks in six months' time at today's prices, or as Rubik's Cube-like as a single contract that covered the purchase of European bonds together with the sale of several foreign currencies and the acquisition of an option to buy U.S. dollars.

Investors could purchase these contracts directly from such dealers as Merrill Lynch or J.P. Morgan, or the dealers could arrange for swaps between investors; either way, the dealer got a fee. Such transactions could take place anywhere. A Texas manufacturer with a $1 million fixed-rate loan who suspected that interest rates would soon fall could swap the loan with a Michigan company that had taken out a floating-rate note but was worried that rates were headed higher. The Texas firm would be the loser if rates did rise, since after the swap it would hold the floating-rate note that called for larger interest payments. "The fundamental advantage of derivatives is that they let you buy the risks you want and hedge the risks you don't want," says Columbia's Greenwald, "and that's an extraordinarily useful function."

This also helps explain how derivatives can be both conservative and highly speculative investments. Because there are two sides to each transaction, one party can pass along the risk he does not want to a speculator who will gladly take it. Such trades can often turn on fraction-of-a-point changes in currency rates or interest charges. "The speed of money is faster than it's ever been," says Laleen Doerrer, the co-founder of a one-year-old Chicago derivatives firm. "It seems like every day someone has created a new contract and a new swap option. We are almost equally divided between two groups of customers -- one that wants to protect everything it has and the other that wants to make a 200% killing overnight."

These breakneck deals are possible because Wall Street today has transformed itself into a virtually seamless network of computer-linked brokers, dealers and exchanges around the globe. It is no longer (if it ever really was) defined by the canyons of buildings surrounding the New York Stock Exchange near the southern tip of Manhattan. The trades take place in an electronic neverland that can be entered from anywhere in the world. Billion-dollar transactions involving derivatives or other securities that once took hours or days to handle are now routinely completed in seconds -- with all the potential risk or reward that comes with instant gains and losses.

Chicago trader Peter Dunne, who works and sleeps to the sound of bond futures markets buzzing from Frankfurt to Tokyo, can attest to the global expansion of derivatives trading in the past four years alone. Dunne's working day has lengthened four hours over that stretch: he rises at 4:30 a.m. to get to the Chicago Board of Trade by 6 a.m. to begin the business of trading that can last until 9 p.m. The trading day for stocks and bonds has grown to marathon proportions as well. Sophia Ulanday, who sells U.S. stocks for Lehman Brothers in Hong Kong, begins her workday at 7 a.m. and frequently toils until 1 a.m. to stay in touch with the home office in New York.

With banks and brokerages striving to create ever more exotic derivative products, it is hardly surprising that the markets have begun to show signs of overheating. "Some of the dynamics are too fast for the fastest players," says Doerrer. Concurs Bruce Hauptman, a Fairfield, Iowa, money manager who handles $800 million in derivatives investments: "You're going to have people getting blown out, and there is going to be bloodshed."

This happened to the German metals and mining concern Metallgesellschaft last year after it charged into the derivatives market. The company bought oil futures for a subsidiary -- just before oil prices collapsed -- leaving it < with $1.3 billion in losses and triggering a national scandal. Prosecutors have been investigating the role of fired CEO Heinz Schimmelbusch, who has denied doing anything wrong. Nonetheless, bank creditors demanded the layoff of 7,500 ofMetallgesellschaft's 46,000 employees and the sale of several divisions as the price for rescuing the company.

But while some people have lost their jobs, Wall Street has become richer. Thanks to record sales of everything from derivatives to new stock and bond issues to merger financing, the pretax profits of U.S. brokers and investment banks zoomed to an unprecedented $8.9 billion last year. "I see no reason why 1994 won't be better than 1993," exults Sanford Weil, chairman of Travelers Cos., which owns Smith Barney Shearson. "We're having a great time."

By no coincidence, Wall Street's big winners have been firms that are leaders in designing and selling derivatives. Record earnings at Goldman Sachs brought joy to its 161 partners, who each reportedly got $5 million or more in profit sharing, which they can withdraw when they leave the company. The results brought even greater glee to 10 senior partners, who are believed to have got more than $25 million each in profit sharing. At Merrill Lynch, which raked in $1.3 billion after taxes, directors awarded chairman Daniel P. Tully $9.6 million in salaries and bonuses in 1993, an increase of more than one- third from the previous year.

Wall Street is also spending lavishly to provide its whiz kids with all the tools they can use to build ever more elaborate toys. The arrival of powerful computer workstations in the late 1980s gave the quants the number-crunching capacity they needed to bring forth their brainchildren. Now Goldman Sachs, J.P. Morgan and Morgan Stanley each spend anywhere from $800 million to $1.2 billion a year to hone their derivatives operations. The money goes for the computers and software it takes to design and monitor derivatives contracts, and for the salaries of the quants who pilot the equipment.

And what has Wall Street finally wrought at the end of the day? Like nuclear power, derivatives perform a useful function. But they also contain a great deal of risk that must be carefully controlled. "Are derivatives here to stay?" asks Friedman of Goldman Sachs. "Certainly they are. Like many other instruments, they can be used to excess. But they can also be used for extremely beneficial purposes." It will be up to watchdogs in government and on Wall Street to ensure that the beneficial side of derivatives prevails, and that they do not follow pyramid schemes and savings and loan deals into the lexicon of American financial bubbles that burst.

With reporting by Massimo Calabresi, Thomas McCarroll, Sribala Subramanian, Jane Van Tassel/New York and William McWhirter/Chicago