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COLUMN ONE : Derivatives: Perils of Ingenuity : These computer-fueled deals are so esoteric--yet pervasive--that many investors pin fortunes to them but not many know how they really work. Regulators are watching closely.

TIMES STAFF WRITER

Out Dexter Charles’ 35th-floor window is a stunning view of lower Manhattan. In front of him, a flickering, color-coded array of computer screens gives a second-by-second read of the prices of securities in a half-dozen markets around the world.

But as he starts his workday, Charles’ attention is focused on a few pages in his hand--data showing what will happen to his $350-billion portfolio of complex financial deals at Chase Manhattan Bank if interest rates change by a hundredth of a percent. It’s a calculation so involved that it must be done overnight on a state-of-the-art computer workstation.

“We used to be able to use PCs to do this,” Charles says of the portfolio “stress test"--so called because every fraction of a percentage point change in rates places exacting strains on his holdings’ value. “But they’re not powerful enough anymore.”

This is the world of derivatives: deals whose value is based on the performance of an underlying stock, bond, commodity or index. Thanks to the influence of advanced technology, these transactions have become so esoteric--yet pervasive--that regulators fret that they are endangering the financial system’s stability and Congress muses over whether they should be banned outright.

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During the last few weeks, such august corporations as Procter & Gamble, Mead Corp. and Gibson Greeting Cards have reported major losses--$102 million, $7.4 million and $19.7 million, respectively--from derivative transactions gone sour. Securities and Exchange Commissioner Richard Y. Roberts says the SEC expects many more American firms to report heavy losses this year from similar deals.

Earlier, big investors like George Soros used derivatives to place huge speculative bets on the direction of interest rates. When the wagers proved wrong, their forced sales of assets to cover the losses aggravated this winter’s sharp drop in stock and bond prices. Some regulators and members of Congress are seeking to tighten government oversight.

Derivatives have been cursed as the ultimate in useless financial speculation and praised as indispensable management tools. Sometimes the praise and condemnation come from the same source: All three of the companies posting the most recent losses previously were content users, but all say the troubled deals were uniquely complex and did not belong in their portfolios in the first place.

That is important because almost everyone in the derivatives business agrees on one point: The transactions stand to become only more complex as users discover new needs and computers become powerful enough to design new solutions.

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“We’re in the early days in all of this,” says John G. Heimann, director of global derivatives trading at Merrill Lynch & Co.

The growing derivatives industry can be viewed as a case study of the life cycle of innovation on Wall Street. Like technological advances in many walks of life, derivatives have elicited fear, suspicion and blame for market crashes and heavy losses--a reputation many observers say is undeserved.

“It’s still possible to lose money in all the old familiar ways,” says Merton Miller, a Nobel economics laureate and professor of finance at the University of Chicago. The $751-million loss faced by Germany’s Deutsche Bank from a recent garden-variety real estate collapse, he notes, makes Procter & Gamble’s woes look minor.

“But derivatives are a novelty item,” Miller says. “And the very notion that some of it is done by computer has an ominous ring to it.”

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Still, derivatives over the last few years have quietly worked their way into the hearts of thousands of companies and investment firms. Precise figures are not available, but it seems likely that almost every major corporation in America uses them in some form.

Indeed, some large institutional investors are required by their bylaws to hedge certain risks using derivatives. The managers of New Jersey’s $350 million in state pension funds were not permitted to sink $35 million into foreign stocks until they came up with a way to hedge the investment against losses from currency fluctuations.

Until recently, such a hedge might have been difficult to find. But starting in the 1980s, Wall Street’s innovators learned how to assemble options, futures and other commitments in ways that allowed them to fine-tune hedges to the financial world’s ever more exacting specifications.

Instead of hedging against the simple risk that the British pound might rise over the next six months-- that can be accomplished using a derivative known as a currency forward--a company might want to hedge against the possibility of the pound rising against the Japanese yen under certain interest-rate conditions.

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Hedging such interrelated risks as interest rates and currencies requires exceedingly complex matches of options, futures and other securities. Just knowing what to charge customers for such transactions required banks and investment firms to employ the most sophisticated computers available. The same computers were needed to track the values of the hybrid derivatives, which theoretically could change second-by-second.

As befits products on the leading edge of financial innovation, derivatives have accumulated a correspondingly abstruse jargon. Among the more than 1,200 known varieties are swaps, caps, collars, swaptions, range forwards, quantos, IO’s, PO’s, death-backed bonds, limbos and heaven-and-hell bonds.

If those terms resemble the whimsical names, like “quarks,” which physicists give to the ever smaller particles into which they are slicing the atom, that is because derivative designers are engaged in the similar task of splitting financial risk into ever finer pieces. It is no surprise that some of the leading figures in the business got their education not in business school but in the engineering departments of places like the Massachusetts Institute of Technology--from which Dexter Charles earned degrees in both aerospace engineering and business.

It is also no coincidence that many of the more complex deals behave unpredictably when their underlying markets suffer shocks, as the interest-rate markets did this year. Just as Newtonian physics mysteriously break down at extreme high speeds and infinitesimal distances, conventional economic relationships break down at the border of financial turmoil.

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“In the bond market, you can easily get outside of the region where mathematical formulas work,” says John O’Brien of Leland O’Brien Rubinstein, the Los Angeles consulting firm whose esoteric formulas for deploying derivatives as “portfolio insurance” were blamed for exacerbating the 1987 stock market crash. “Things get beyond the point of predictability.”

The result of guessing wrong at the technological frontier can be a warp-speed wipeout. New York money manager David Askin lost $600 million of his clients’ money and his entire investment firm in virtually 24 hours this year when the “stripped” mortgage-back securities he was trading--thinly-traded securities derived from pools of mortgage loans--collapsed in value as interest rates soared.

Askin had used an elaborate mathematical formula to hedge his market risk using futures and options. But his portfolio was so exotic and the market for it so tight that he could not find a buyer for his holdings at a rational price. In other words, his hedge failed.

Such cases contribute to a public impression that some of Wall Street’s so-called “rocket scientists” are shooting new products into the air without enough concern about where they come down. And they add to the sense that regulators should be doing something about it.

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“We’re not keeping pace with the rate of innovation,” says Halsey Bullen, project director on derivatives for the Financial Accounting Standards Board, a private body that oversees corporate accounting regulations. “The rate of change is so great that you’re regularly presented with an instrument that makes you scratch your head to figure out what it is, what its purpose is and how do you break it down into something understandable?”

One place where the limits of financial innovation are tested daily is at Dexter Charles’ desk at One Chase Plaza. Charles, a 33-year-old vice president in Chase Manhattan’s global risk management group, uses the overnight portfolio run to tell him what new deals he can accommodate in his portfolio that day.

This is the essence of the derivatives business today. In its infancy 10 or 15 years ago, banks largely brokered deals between customers. If one had a floating-rate loan but wanted to lock in interest payments as if it were a fixed-rate loan, the bank would find a customer that wanted to exchange its fixed-rate loan for a floating-rate debt. The clients would swap their obligations; the bank took a finder’s fee.

Few deals today are done so directly. Now, bankers behave more like insurance companies. When you buy fire insurance for your house, your insurer assumes the risk and disperses it throughout its portfolio of policies--most of which will not result in claims. Similarly, a bank in the derivatives business assumes its clients’ financial risks, dispersing them through its pool of similar or opposing deals. It tries to hedge any excess risk through the futures and options markets.

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Charles’ key tool in managing his pool of deals is the overnight stress test. The numbers he reviews in the morning allow him to appraise every new deal--he might see 20 to 60 a day--by asking, as he puts it, “Will it mitigate the risk already in my portfolio or increase it? If it’s the first, I can offer the customer a lower price to do the deal than if it’s the second.”

To manage the calculations involved in this process requires something more than conventional bank training. On graduating from MIT, for instance, Charles designed helicopters at Sikorsky.

“A lot of the developments you’re seeing in derivatives are tied to developments in technology,” he says as he scans his screens.

Take “basket options,” the latest innovation in Charles’ arsenal of risk-management tools. A basket option is a derivative that allows users to hedge against multiple related risks at a lower cost than hedging each risk separately.

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An airline might be concerned that a rise in interest rates would cause a damaging run-up in payments on its floating-rate bank debt. But rather than pay the high cost of using options to hedge against a rate rise, it might buy a cheaper hedge that kicked in only when both interest rates and another expense--say, oil prices--were climbing.

Linking those risks together increases the complexity of the deal geometrically. But Charles foresees a time soon when he can offer clients derivatives that manage three or more risks simultaneously.

It is this ability to construct such fine-grained hedges that is the key to derivatives’ usefulness, as well as their dangers.

As so often happens with financial innovations, many users, even conservative ones, now say they could not manage without derivatives. But as banks and investment houses search for clients and situations in which their expanding derivative-designing capabilities can be put to profitable use, regulators and other observers fear that they are trying to sell relatively unsophisticated users on extremely volatile, risky transactions.

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Many financial executives say they have been approached by banks over the last year or two with overly complex deals, or with transactions aimed at addressing less-than-pressing problems.

“These bank officers are dreaming up ways to accomplish things that couldn’t be done normally,” says Terry Griffis, treasurer of the Metropolitan Atlanta Rapid Transit Authority (MARTA).

For years, Griffis’ agency has employed a derivative known as a swap to lock in its diesel-fuel expenses a year at a time. And MARTA’s board, he says, still believes in the transactions, which have saved the agency about $1 million over the last three years.

But the recent spectacle at Procter & Gamble, like others elsewhere, “has had a negative impact on our willingness to look at” any more elaborate deals, Griffis says. “They’re more difficult to sell to the board.”

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There is no question that derivatives place an unprecedented premium on management skills. The issue raised by recent highly publicized losses is whether the transactions were so complex that corporate managers did not comprehend the risks. In other words: Did their bankers take them for a ride?

“I don’t agree with the premise that anything is being done that’s so complicated it can’t be understood,” says Joseph P. Bauman, recently appointed director of Bank of America’s derivatives business and the chairman of the International Swaps and Derivatives Assn. “If a company’s management can’t understand a transaction, they probably shouldn’t be entering into it.”

But even the skills of sophisticated investors can be challenged by some of the more esoteric devices.

“It’s very difficult for an outside investor, even one as big as us, to determine the true costs of some of these transactions,” says DeWitt Bowman, recently retired as chief investment officer for the $81-billion California Public Employee Retirement System, the nation’s largest public pension fund.

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In fact, derivatives are so complex that they could undermine systems of control and regulation that otherwise have survived decades of financial experimentation.

Accountants and regulators are looking for ways to ensure that risks from derivatives are somehow disclosed on a company’s annual report, for example. But no such efforts will overcome the fact that an annual report can be more than three months out of date by the time it lands in investors’ hands. In the world of derivatives, that delay might as well be a century.

“Regulation has always been based on slowly moving institutional structures,” observes Myron Scholes, a Stanford University finance professor whose 1970 formula for setting a price on options, developed jointly with his colleague Fischer Black, often is given credit for ushering in the age of financial complexity. “But if things are very fluid and dynamic, then perhaps the old institutions can’t be preserved.”

Others argue that the very history of finance is the story of regulators and government trying to keep up with such developments. As Merrill Lynch’s Heimann puts it, “Traders are always ahead of management, management is always ahead of the regulators, the regulators are ahead of the auditors and the auditors are ahead of the lawyers.”

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HOW DERIVATIVES WORK

A HYPOTHETICAL CASE

1) Albatross Airways wants to insure itself against two risks: a rise in interest rates that would boost the cost of its adjustable-rate bank loan and a rise in oil prices that would jeopardize its ability to buy jet fuel. Albatross can live with one or the other. But if both happen at once, the airline’s future will be threatened.

2) The airline’s bank agrees to protect Albatross against the double-barreled risk. It offers Albatross the equivalent of a put option on U.S. Treasury bonds, giving Albatross the right to sell T-bonds at a given price at some time in the future. The value of the option rises as interest rates go up and bond prices fall. That means any money Albatross makes on the option would offset its higher loan costs as interest rates rise. To keep the costs of this insurance policy down, the bank offers the option only if oil prices also rise above a certain threshold price. That way, Albatross is protected only if both interest rates and oil prices rise.

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3) Now the bank, not Albatross, faces the risk that oil and interest rates will rise. If Albatross exercises its option, the bank will have to buy Treasury bonds from the airline at the option price. But it could only sell them at a lower market price, leaving the bank with a loss.

4) So the bank takes steps to hedge that risk--that is, to insure itself against the cost of paying off Albatross’ insurance:

* 1. To hedge against the risk of a drop in bond prices (the same as a rise in interest rates) the bank sells Treasury bond futures on the Chicago Mercantile Exchange. As Treasury prices fall, the value of the T-bond position rises, creating a gain that counters the bank’s loss on the option held by Albatross. To hedge against rising oil prices, the bank buys oil futures on the New York Mercantile Exchange. As oil prices rise, so will the value of the bank’s oil futures; that covers its potential loss in the oil market.

* 2. But the futures play is only a temporary step. As soon as it can, the bank finds a client needing to insure against risks that are just the opposite of those faced by Albatross--in other words, a company that would be damaged by falling interest rates and falling oil prices.

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WHAT CAN GO WRONG

Derivatives plays don’t always work out, as recent market turmoil has underscored. Here’s what can happen to the participants:

THE AIRLINE

Albatross could buy an option for more oil than it actually needs, perhaps because its business ebbs and it needs less jet fuel. In that case, it has overhedged its oil needs, which is tantamount to making a speculative bet on the future direction of oil prices. To avoid this danger, the airline needs to restructure its option to reduce the amount of oil covered.

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THE BANK

The bank’s formula showing how oil prices and interest rates are linked--its basis for balancing its trades in the T-bond and oil futures markets--could prove wrong. In that case, the combined trades would not produce enough income to offset its obligations to Albatross. The bank then would record a loss.

GLOSSARY

DERIVATIVES--Options, futures, or combinations thereof. “Exchange-traded” derivatives are offered for sale on regulated exchanges around the country, which theoretically guarantees that buyers and sellers can always be found at some price. “Over the Counter” derivatives are designed by banks and investment firms and tailored to the hedging needs of sophisticated customers. But because they may be unusual or even unique, there is no easy way to set a value on them.

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CALL OPTION--A contract allowing, but not requiring, the holder to buy a given commodity at a set price (the “strike price”) by a certain date. If the strike price is higher than the cash price of the commodity at the expiration date, no sale takes place and the option simply expires. If the strike price is lower than the cash price, the owner of the option exercises his right to buy the commodity; he then could immediately sell it at the higher price, pocketing the gain.

PUT OPTION--A contract allowing, but not requiring, the holder to sell a given commodity at a set price (the “strike price”) by a certain date. If the strike price is lower than the cash price of the commodity at the expiration date, no sale takes place and the option simply expires. If the strike price is higher than the cash price, the owner first buys the commodity at the lower market price and then immediately exercises his right to sell it at the strike price. The difference is his profit.

FUTURES--Contracts obligating the buyer to purchase a given commodity from another party on a certain date. Among other things, the underlying commodity can be grains, other foodstuffs, oil, bonds, stocks, or baskets of stocks that make up a stock index. Most futures are traded on regulated exchanges in Chicago and New York. In most cases, delivery of the underlying commodity never takes place; the deal is closed out by the sale of an equivalent future.

CAP--A derivative that allows a user to set a ceiling on his or her risk. For example, a company may want a cap that protects it from paying interest on its debt over a certain level.

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FLOOR--The opposite of a cap. A user might be seeking protection from the effects of interest rates falling below a certain level.

T-BONDS--U.S. Treasury bonds with terms of 30 years. Considered the safest long-term investments in the U.S. financial markets.


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