Excessive trading of financial derivatives saddled huge losses on Orange County, Procter & Gamble Co. and now Barings, one of England's most venerable investment banks. Are there more derivative land mines ready to explode in the United States?
U.S. regulators, analysts and big American investment banks said Monday that a huge financial debacle is unlikely--at least the type of disaster that left Barings with more than $1 billion in losses and sent it into bankruptcy over the weekend.
"It's hard for me to imagine this happening with a U.S. bank, because the size of the (Barings) exposure was so large," said Philippe Jorion, a finance professor at UC Irvine's Graduate School of Management. "Somebody would have noticed."
Privately, though, some investment bankers said their methods of spotting dangerous trading--while much improved from a decade ago--still carry no guarantees.
"If anyone says their system is absolutely foolproof, you should be suspicious," one investment banker said.
Although Barings and British authorities are still investigating, it appears that a rogue Barings trader, 28-year-old Nicholas Leeson, placed huge sums on Asian financial futures and options--which are, in effect, bets on the direction of stocks and stock indexes--and lost when those securities went the opposite way.
Leeson's trading of options and futures meant he was using relatively simple versions of financial derivatives, which are not securities but rather financial arrangements derived from, or based on, the market movements of securities or financial indexes.
What astonishes many U.S. observers is how the Barings trader could have amassed such a position and not been detected before the markets went against him. "How could the hole get so big and so deep without anyone really noticing and intervening?" asked one senior U.S. Treasury Department official monitoring the Barings mess. "In the U.S. financial markets, we believe we have more controls."
American investment banks likewise asserted that their internal controls and surveillance policies, together with U.S. regulations, would have caught such heady trading before disaster struck.
"We think we have very effective and sophisticated procedures in place," said James Wiggins, a spokesman for Merrill Lynch & Co., which sold many of the derivatives to Orange County that led to the county's bankruptcy in December.
Bankers Trust New York Corp. and Morgan Stanley & Co., two other big Wall Street players in the derivatives market, also claimed to have sufficient internal controls to prevent such a setback.
For example, Bankers Trust has a "risk-management team" that not only monitors the bank's trading worldwide, but also "where it's being taken, in what instruments and by whom it's being taken, and it reports that data to senior management on a daily basis," spokesman Thomas Parisi said.
But the controls must be enforced to work, said Joseph Cherian, an assistant finance professor at Boston University who specializes in derivatives. "This kind of thing can happen in the U.S.," he said in reference to Barings, because it still "depends on what kind of controls you have and whether or not they're being implemented."
Indeed, lack of enforcing controls was in part a factor in the huge losses in Orange County. Efforts by the county's former treasurer, Robert L. Citron, to generate massive gains in the derivatives market last year drew little oversight from the county's leaders.
Fraud can also be a problem. In another case involving now-defunct Kidder Peabody & Co., its star government bond trader, Joseph Jett, allegedly concocted $350 million in phony profits in a scheme to hide trading losses last year. Jett denies the allegations.
Bankers Trust last year paid a $10-million civil penalty to settle government fraud charges that it lied to a customer about derivatives losses. The firm did not admit or deny guilt.
Although Cherian and some others said they don't see the need for more federal rules, a spokesman for House Banking Committee Chairman James A. Leach (R-Iowa) noted that the congressman is pressing for legislation that would provide more oversight for derivatives trading.
Leach's proposal would, among other things, create a federal derivatives commission that would establish more guidelines for supervising derivatives trading and require more public disclosure of the firms' trading activities.
A variety of U.S. regulators--including the Commodities Futures Trading Commission and the Securities and Exchange Commission--said they are watching the Barings matter closely, but otherwise they declined to comment on the potential for more derivatives trouble in U.S. or global markets.
White House press secretary Mike McCurry said the Barings collapse is "a source of concern to us," and that "we are going to watch this failure, this bankruptcy proceeding, carefully to see what implications, if any, might arise for the American people."
Jon Murchinson, a spokesman for Treasury Secretary Robert E. Rubin, said President Clinton's Working Group on Financial Markets, which Rubin chairs, is also monitoring the situation.
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
Barings Goes Under
Barings, London's oldest merchant bank, is known for financing the Napoleonic wars and the Louisiana Purchase. The institution, founded and held in part by one of London's wealthiest families, was placed in receivership Sunday following the disclosure that one of its traders in Singapore racked up losses of $1 billion or more in unauthorized trades. A brief profile of the 233-year-old London bank:
BARINGS AT A GLANCE * Headquarters: London * Chief executive: Peter Baring * Employees: About 4,000, with 1,650 in London and the remainder in offices worldwide * Ownership: The independent bank is owned by its senior managers and a charity foundation. * 1994 profit: $87.5 million * 1993 profit: $80.4 million * 1993 assets: $9.38 billion * 1993 capital: $460 million
Key stock markets fell worldwide Monday, hit in part by fallout from Barings' failure. But expectations of securities dumping directly related to Barings' collapse were exaggerated, analysts said.
Friday Monday Point Percent Market/stock index close close change change Mexico City/Bolsa 1,553.89 1,447.52 -106.37 -6.9% Buenos Aires/Merval 344.75 326.67 -18.08 -5.2% Tokyo/Nikkei-225 17,472.90 16,808.70 -664.20 -3.8% Taipei/weighted index 6,596.07 6,388.57 -207.50 -3.2% Kuala Lumpur/composite 970.45 953.79 -16.66 -1.7% Hong Kong/Hang Seng 8,218.95 8,126.65 -92.30 -1.1% Singapore/Straits Times 2,114.52 2,094.10 -20.00 -1.0% Frankfurt/DAX 2,118.64 2,099.25 -19.39 -0.9% New York/Dow industrials 3,981.66 3,988.57 -23.17 -0.6% London/FTSE-100 3,037.70 3,025.30 -12.40 -0.4%
A list of some other prominent securities firms that have failed or been sold in recent years: * Oct. 17, 1994: Kidder Peabody & Co. is acquired by PaineWebber Inc. for the bargain-basement price of $670 million only six months after Kidder announced that one of its traders inflated his trading profits by $350 million, causing major losses for Kidder. * March 12, 1993: Troubled American Express agrees to sell its Shearson brokerage firm to Primerica Corp., which owns Smith Barney. Primerica later changes its name to Travelers Inc. * Feb. 13, 1990: Drexel Burnham Lambert, which practically invented the junk bond market, files for Chapter 11 bankruptcy after pleading guilty to mail and securities fraud. * Dec. 3, 1987: E.F. Hutton & Co. agrees to be acquired by Shearson Lehman Bros. for $961 million, one month after it put itself up for sale and two years after its guilty plea to 2,000 felony counts relating to check-kiting charges.
Sources: Bloomberg Business News, "Major Companies of Europe," wire reports. Researched by JENNIFER OLDHAM and DAVID NEIMAN / Los Angeles Times.