Tremors in Glass Towers : With executives jittery, it may be time to regulate ‘derivatives’ trading

Over the last three weeks enormously costly blunders by major companies using arcane financial instruments known as derivatives have sent shock waves through executive suites. What’s going on here? Has Corporate America been too lax in policing these sophisticated and volatile devices? Clearly it should do more.

Derivatives are financial contracts that derive their value from another asset, such as stocks, bonds or commodities. Their purpose is to diminish risk, and to achieve this they offer all sorts of contracts--”swaps” or “forwards,” to name a couple--that can be used to hedge against the normal fluctuations in interest rates, foreign exchange rates and commodity prices. However, big and sudden changes in interest rates, for example, can make for a bad derivative day.

Take the case of Procter & Gamble. The company disclosed in mid-April that it had to take a $157-million, one-time, pretax charge to close out two interest rate “swap” contracts. Betting that U.S. and German interest rates would fall, the company entered agreements with Bankers Trust New York Corp. to give the bank options to sell P&G; Treasury bonds and German government bonds at a fixed price in exchange for floating rate debt, akin to variable-rate mortgages. When those interest rates rose instead, P&G; had to close out the contracts, at a huge loss.

In another high-profile case, General Electric was forced to take a $210-million after-tax charge against first-quarter earnings because of problems arising from some derivative activity at its investment banking subsidiary, Kidder Peabody. As a result of the loss, Kidder fired the head of its government bond trading desk, alleging he created “phantom” trades using “forward” contracts that generated $350 million in nonexistent profits. Kidder later fired another trader for allegedly covering up $10 million in losses on a separate bond-derivative transaction.

These losses have cast a spotlight on the shadowy world of derivatives, which have become widely used by companies, banks, investment firms and mutual funds. With the face value of derivatives currently estimated at $15 trillion, the potential risks are daunting.

Used with care and intelligence, derivatives provide a means to manage and reduce borrowing costs. But they can be dangerous, especially if they are poorly monitored. Worse yet would be a company’s secret overuse of derivatives, which are not broken out on income statements or balance sheets.

Greater disclosure and accountability would help. The Financial Accounting Standards Board has proposed rules that would require companies to provide details of derivative strategies and the size of such holdings. Disclosure might prevent jolting surprises for management and for the millions of investors, large and small, who deserve to know what’s going on.