Gambles raise corporate antes

SUN JOURNAL

Derivatives: Trades on lightly regulated markets can make or break companies.

January 18, 2002|By Scott Shane | Scott Shane,SUN STAFF

Don't worry if your palms sweat and your eyes glaze over when, in reading about the Enron collapse, you spot the word derivatives. You have plenty of company.

But understanding derivatives can help you make sense not only of Enron, but of several other recent financial meltdowns. It gives a peek into an alternative universe where wheeler-dealers trade not stocks and bonds but bandwidth, bankruptcies, pollution and even weather, where transactions of brain-numbing complexity carry nicknames like "iron butterflies" and "shout options."

A place to start is with the ancient Greek philosopher-mathematician Thales, the Kenneth L. Lay of his time.

Like Enron Chairman Lay, Thales got rich on derivatives. Predicting a bumper olive crop, Thales paid owners of olive presses small deposits for the right to rent their presses during the harvest. When the harvest proved plentiful, Thales charged growers high prices for use of the presses "and made a quantity of money," according to that well-known business writer Aristotle.

Thales' deal was a kind of derivative - so-called because its value was derived from something else. The value of his rental scheme depended on the value of the olive harvest. Among common derivatives today are stock options and commodity futures contracts, which are traded on established exchanges.

But the fastest-growing part of the market is over-the-counter derivatives, which are traded off exchanges and are largely unregulated. Enron grew from a ho-hum energy company into one of the biggest and most innovative players in over-the-counter derivatives.

Derivatives have boomed worldwide in recent decades, driven by deregulation, wildly fluctuating commodity prices and the advent of computers with the number-crunching power to figure out the deals, said Henry T.C. Hu, a University of Texas law school professor who studies them.

Ironically, given their association with financial disasters, derivatives are used chiefly as a means of controlling risk. But they are also used to speculate, since they permit investors to parlay a small investment into huge profits - or equally big losses. And they can be as impenetrable as they are risky.

"You're much more likely to hurt yourself seriously playing with a gun than a knife," said Hu. "And you ought to understand what you're playing with."

He notes a moment in August when Lay told a New York Times reporter asking about Enron partnerships, "You're getting way over my head."

"If senior management had difficulties understanding their own products, it's much harder for them to keep their people in check," Hu said.

The causes of Enron's collapse are not all clear, and opinions vary on the role derivatives might have played. Some analysts say Enron took a severe blow when price controls imposed last year on California's troubled electricity market slashed its huge profits on power derivatives. Others say the company hid its debt off the books because accurate reporting would have hurt its credit rating, crashing its derivative business.

Virtual, cashless world

While derivatives date to the origins of commerce, they became widely used in the 19th century with the opening of commodities exchanges in Chicago and elsewhere. But real growth began in the 1970s and took off in the 1990s, as more investors and industries discovered their multiple uses.

"What drives derivatives is market volatility," said Alex Triantis, a University of Maryland finance professor. "That's because with volatility people are trying to manage their risks. But it also allows people to speculate to try to make a lot of money."

Derivatives create a sort of virtual world that parallels the real, cash world. A wheat farmer might hedge by signing a futures contract to deliver wheat eight months from now at a certain price. By locking in that price, he protects himself against losses if the price of wheat plummets. His loss selling real wheat on the cash market will be offset by his profit on the futures contract, which exists only on paper. So, his futures contract works as a sort of insurance policy.

Similarly, an airline can use fuel derivatives to protect against high jet-fuel prices next year. If fuel prices rise, the cost to the airline can be compensated by its profits on fuel derivatives.

Speculators are, in effect, on the other side of such deals, trying to predict what will happen to the underlying commodity. If their bet is right - if the wheat price soars or the jet-fuel price drops - they can turn a modest stake into a killing. If they are wrong, they can lose far more than their investment.

In recent years, the same principles have been applied to a remarkable array of less tangible things, with Enron often leading the way. At Enron Online, which became by some measures the world's biggest e-commerce company, customers could trade derivatives in credits owed by bankrupt companies, allowances for air pollution, capacity on fiber-optic cables or next year's weather.

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