Hey, the new buzzword on Wall Strret is.... DERIVATIVES

April 17, 1994|By Joel Obermayer | Joel Obermayer,Boston GlobeSun Staff Writer

Philip Luhmann is a soft-spoken man, known for his crew cut, his conservative suits and his money handling skills.

For more than two decades, Mr. Luhmann oversaw the endowment of the City Colleges of Chicago, a vast system of seven community colleges and 83,000 students. So there was no surprise on the morning of Feb. 3, when he told the college's seven-member board that the system's finances were in good shape. After all, Mr. Luhmann had helped direct investments that made solid gains in the last two quarters of 1993.

Later that afternoon, however, the 62-year-old finance wizard walked into the office of Vice Chancellor Leonard Sippel to say he had omitted one fact from his report that morning: He had committed more money than there was in the endowment to risky investments -- about $100 million in all. Losses already reached into the millions and the college system had 24 hours in which to pay a $34 million loan.

The college's endowment had nearly been wiped out.

"Before that we had absolutely no indication what was going on," recalls Jacqueline Woods, vice chancellor for external affairs. "He was telling us that everything was OK."

Mr. Luhmann's free fall to disaster began when he began buying derivatives, the latest products cooked up by the Wall Street traders who last whipped up the junk bond craze.

Derivatives is a catch-all term for virtually any financial arrangement whose value is based on -- or "derived" -- from an underlying currency, index, future or equity security.

Money managers use derivatives to control their exposure to fluctuations in interest rates, currency markets and the stock market. Many of the latest products are just glorified barter arrangements. A firm can save money by trading or swapping currencies, debts or commodities just like at a neighborhood swap meet. For example, a company that is worried that the value of the dollar will fall overseas, might swap its dollar debts for debts in another currency. By doing this, it shields itself from the decline in the dollar.

While each swap may seem like a simple, straightforward trade, these days a single derivatives transaction may involve dozens of swaps, involving banks all over the world like the strands of a spider's web.

Investment banks need legions of specialists who use the latest high-powered computers just to keep track of swaps they have at any one time.

The problem is that instead of using these derivatives to avoid risks, investment banks, speculators and even mutual funds are increasingly using them to make huge bets in a form of financial gambling.

In Mr. Luhmann's case, he made a long-term bet that interest rateswould continue to fall. When they didn't, the market for his securities dried up. Their value went into free fall. Many experts in the field warn that there will be more massive wrecks like Mr. Luhmann's.

"With rapid growth in the industry, investment banks will be out there offering derivative products to a wider range of participants, who may have little understanding of them," says Lee Wakeman, a former finance professor who now heads the derivative firm TMG Investment Products in Greenwich, Conn. "That's a recipe for more explosions."

Derivatives seem tailor-made for such disasters:

* The market has exploded and continues to expand by more than 20 percent a year. Estimates on the amount of money already in derivatives ranges from $7 trillion to $16 trillion --

almost three times greater than the entire gross national product of the United States.

* Transactions are largely unregulated. With money flowing across dozens of international borders, the trade is virtually hidden and impossible to track.

* The investments are terribly complex and carry great risk. But with selling so aggressive, derivatives products are finding their way into the hands of investors, mutual funds and companies neither equipped to understand them nor capable of sustaining the huge losses that could befall them.

Some experts say a default at a major dealer could bring the whole system crashing down, wreaking havoc on markets that could dwarf the savings and loan crisis.

Big banks may have far more money in derivatives contracts than they have total assets. For example at the end of last year Bankers Trust in New York had $92 billion in assets, but over $1.9 trillion in derivatives contracts.

Those worries have not been lost on Congress, and many blame derivatives trading for exacerbating the recent stock market turmoil.

Citing the dangers derivatives pose to the stability of world markets, House Banking Committee Chairman Henry B. Gonzalez, D-Texas, introduced legislation last week to require banks and other derivatives dealers to disclose more of their activities, increase the enforcement powers of regulatory agencies and ask the secretary of the Treasury Department to work with other industrialized countries to improve international oversight.

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