The Devil's in the Derivatives

By John Greenwald

Even Marcia Stasch got caught. She had sold securities for a living and so, naturally, she read the prospectus and the brochures from the local brokerage of Piper Jaffray that came on heavy-card stock paper. They offered a government bond fund that seemed the perfect place to invest the $50,000 Stasch's 86-year-old widowed mother had made after selling her home in Minneapolis, Minnesota. Not only did Piper tout the triple-A-rated fund as a low-risk investment, but also said it would produce enough income -- $318 a month -- to pay her mother's rent. "I told Mom, 'This is your decision, but I'm comfortable with it,"' Stasch recalls.

When the first dividend check arrived for her mother in February, however, the investment was already worth several thousand dollars less. It shrunk even further in March. But it was not until the Mother's Day weekend in May that Stasch learned from a newspaper article what her mother had really bought: far from being a safe investment, the fund was loaded with volatile securities called derivatives that had gone into a free-fall when interest rates shot up. "I told my family not to panic, but I was thinking, 'My God, what did I get into?"' Stasch says. Fearing that her mother would lose all her money, Stasch dumped the fund -- at a $14,000 loss. "I'd never heard of derivatives," she says. "I cried and she cried."

In recent months a humiliating lesson has come to households, boardrooms and town halls across the country: derivatives can turn around and bite even those who think they know something about prudent investing. And this drubbing from derivatives is sure to continue. "The gunslingers may be lying low, but they haven't hung up their guns," declares Representative Ed Markey of Massachusetts. As chairman of a House subcommittee that oversees financial institutions, Markey has put forward a bill that would increase federal supervision of the largely unregulated derivatives dealers. "This wasn't a Maalox moment," he says of the recent run of financial setbacks. "It was a heart attack -- a warning." James Midanek, a financial expert whose firm Solon Asset Management helps victims of derivatives to minimize their losses, also sees more trouble ahead. "It's going to hit home a little more," he says. "We are going to hear more from local municipalities and colleges, and other less sophisticated investors who remain unaware of their exposure."

All of this financial wreckage was barely discernible when TIME warned last spring in a cover story that derivatives posed a new and little understood threat to U.S. consumers and companies. This risk is so apparent because of the swift rise in interest rates that the Federal Reserve engineered this year to forestall inflation. The abrupt increases reversed a four-year trend in which interest rates had steadily fallen, and in the process hammered bonds, money-market funds and other investments that relied on continued low rates to sustain their value. "In the long bull market in interest rates, people got sloppy and forgot that there would be a limit to that too," says Bruce Greenwald, a finance professor at the Columbia Business School.

Here is the astonishing range of investors who find themselves in that category:

-- Huge companies have taken big beatings. Procter & Gamble lost $157 million playing the derivatives market this year and ousted its corporate treasurer. British pharmaceutical giant Glaxo Holdings lost $115 million. Gibson Greetings in Cincinnati, Ohio, lost more than $20 million and last month sued Bankers Trust, which had sold the derivatives to the card company.

-- Municipalities, colleges and even an Indian tribe have suffered. Maple Grove (pop. 40,000), a Minneapolis suburb, has seen its $5 million investment in the Piper Jaffray fund shrink to about $3.6 million this year. "A number of people had had terrific experience with it," says Jon Elam, the city administrator of Maple Grove. "It was unbelievable to me when I found out what the fund was made up of. It was then that I realized it was basically a hedge fund, betting on the decline of interest rates. That's the reason it did so marvelously in the early '90s."

In Texas the former vice president for finance of tiny Odessa College poured virtually all the school's funds into derivatives. The staff and faculty of the two-year college watched in horror as the $22 million in investments lost nearly half their value, forcing the public school to borrow $10.5 million in emergency funds, raise tuition and jack up local property taxes. Meanwhile, the Shoshone Indians, a tribe of 3,000 in western Wyoming with a 70% rate of unemployment, purchased nearly $5 million of derivatives last year from a traveling financial salesman; the value of the purchases has since shriveled to about $3.5 million.

-- Mutual funds have been a particularly fertile ground for unexpected casualties because investors often don't know the full content of the portfolios into which they are buying. Funds run by such firms as PaineWebber, Kidder Peabody and BankAmerica have put up more than $500 million this year to bail out investments in derivatives. Just last week Arthur Levitt, chairman of the Securities and Exchange Commission, told Congress that an $83 million fund run by Community Asset Management Inc. of Denver had become the first money- market fund to shut down because of derivatives losses. The fund's 113 customers, consisting of banks and other institutions, will collect 94 cents for every dollar they invested.

-- Even the Wall Street firms that concoct these securities have taken a whipping. Bankers Trust, which relies heavily on derivatives for its profits, saw its earnings drop 28% to $ 181 million in the second quarter as clients stopped buying the risky instruments. The decline was particularly sharp in the division of the bank that uses computerized programs run by math whizzes -- who are known as "quants" -- to create the derivatives. Its earnings have fallen more than 50% since this year's first quarter.

Derivatives are causing all this havoc because they have swiftly become a linchpin of global commerce and the world's financial system. Companies regularly use a form of derivatives called swaps to protect against the risk of sudden changes in exchange rates, commodities prices or other costs when they trade overseas or build plants abroad. Like all derivatives, they function, essentially, as bets on the direction of particular markets. So coveted is such insurance that the total face amount -- or "notional value" -- of swaps and similar contracts has soared to an astronomical $11 trillion, up from $5.1 trillion since 1990.

While derivatives can take on many forms, they all share certain similarities. No matter how complex a derivative may be, it is at bottom a security that takes -- or derives -- its value from underlying things that can range from the familiar (stocks or bonds or interest rates) to the exotic (gold in Ghana or copper in Mexico). Moreover, those underlying things can be sliced and diced in all kinds of ways. Among the most popular derivatives in mutual-fund portfolios are the so-called interest-only strips, which pay interest that comes from pools of government-backed mortgages. These strips became hot when interest rates fell below the level they were paying. But as interest rates rose higher, these securities became less attractive and plunged in value.

When many fund managers bought these interest-only strips, the rates had been so low for so long that many on Wall Street had almost forgotten that rates could turn up again. But while the high returns on these strips lasted, they drew new investors, and that in turn boosted the pay of fund managers. The incentive was particularly tempting for managers of conservative money- market and short-term bond funds who are forced to play the money game with a limited range of low-yielding investments like U.S. Treasury bills. Suddenly interest-only strips, which qualify as government-backed securities but have sexier returns, made managers look good. "It is very hard to stand above your peers in the government bonds and mortgage markets," says John Markese, president of the American Association of Individual Investors. "So what you have to do is enhance your yields, and these derivatives do that."

Small wonder that some investors have become confused about the true nature of what they hold. Unable to parse the prose of the typical prospectus, fund clients must often rely on the advice of sales personnel who may know little about derivatives . "My broker didn't have the full story," asserts Andrea Lingenfelter, a Seattle Ph.D. candidate in Chinese history whose $200,000 divorce settlement has dwindled to $140,000 after a little more than a year in the Piper Jaffray fund. Her goal had been to park the money for several years until she got her degree from the University of Washington and settled into a house with her three-year-old daughter. "I could have bought a house, paid cash and had money to spare to pay the taxes," said Lingenfelter, who is suing Piper to recover at least some of her losses.

For its part, Piper says it regrets the hits that clients have taken in the now notorious Institutional Government Income Portfolio, whose value has fallen nearly 25% this year. Nonetheless, the firm insists that fund manager Worth Bruntjen invested the money precisely along the lines set forth in the prospectus, even though nearly half the fund's assets were in the form of volatile derivatives. In a gesture of good will, Piper put $10 million of its own money into the Institutional Government fund and continues to call it a sound investment.

Policymakers in Washington, however, are put off by the derivative debacles they have seen. The problem is that they are not sure what to do about it. Not only are most politicians unfamiliar with the financial techniques involved, but the whole field is evolving so rapidly that new legislation may be obsolete by the time it passes. "No one has any idea what the policy should be," says Bert Ely, a banking consultant who in 1989 correctly predicted that the savings-and-loan bailout would cost taxpayers about $150 billion. "It's a problem for all the industrialized countries. Computers are allowing the creation of purer and purer financial plutonium, and frankly, the regulatory process cannot keep up."

So far, Washington has largely contented itself with moves such as calling upon mutual funds to provide more disclosure of the derivatives they own or might consider buying. For example, the sec is mulling a proposal that would require funds to develop a standard way to measure the risks of a portfolio. Meanwhile, the General Accounting Office is urging regulators to tighten their scrutiny of derivatives dealers.

Some mutual-fund critics want the government to go further and ban altogether the use of derivatives in money-market portfolios and other low- risk funds. "We've seen that derivatives are simply not appropriate for funds that are supposed to be invested conservatively," says Barbara Roper, % director of investor protection for the Consumer Federation of America. "The reason for the bailouts is an acknowledgment on the part of the companies, whether they would say so in so many words, that investing in those types of instruments was not appropriate."

At least one firm has conceded that it recently sold derivatives that may not have been right for its clients. Prudential Securities said last month that it would buy back some $70 million of "risky" mortgage-backed bonds it had sold to 1,000 unwitting investors. Prudential blamed the sales on a trader who, the firm said, had been fired after misleading company brokers about the full extent of the risks involved in these derivatives. "These were good investments," says Charles Perkins, a company spokesman, "but people might not have wanted the risk and that's why we bought them back. The firm did this voluntarily. No one was aware until we informed them."

But countless investors, both large and small, have become keenly aware that derivatives can be dangerous. Marcia Stasch, for one, has nightmares in which she is haunted by the number $8.50. That is the price at which she dumped her mother's mutual funds, after paying $11.75 a share to buy them.

CHART: NOT AVAILABLE

CREDIT: [TMFONT 1 d #666666 d {Source: Capitol Market Risk Advisors}]CAPTION: BAD BETS ON DERIVATIVES

1994 pretax losses in millions

With reporting by Walter Parker/St. Paul, Stacy Perman and Sribala Subramanian/New York and Suneel Ratan/Washington