16. Derivatives: Risky Business

Source: THE NATION, Date: December 25, 1995 Title: "Golden Fleece" Author: Arthur E. Rowse

SSU Censored Researchers: Brant Herman, Mark Lowenthal

According to a General Accounting Office (GAO) report last year, the face value of worldwide trades involving derivatives -- a high-risk type of financial contract whose value is derived from the performance of an underlying asset or market indicator (such as a price or interest rate) -- was estimated to be $34.5 trillion. Due to both the amounts involved and the global reach of corporate investors, the economic systems of the world could be severely impaired should these financial entities fail. And an economic failure related to the scope and fragility of derivatives could result in a federal bailout reminiscent of the savings and loan fiasco.

Derivatives are limited to large financial players due to several reasons. First, only those with large sums of money can become involved. Second, due to the leveraged nature of these packages, the financial rewards can be huge when successful, but dangerous if not. Furthermore (and again, due to the leveraged nature), losses in the marketplace can be covered by future investments -- creating a house of cards which could tumble at any time. The bankruptcy of Orange County, California a few years ago was directly related to their losses in the derivative market.

The danger in derivatives also stems from the fact that they are leveraged in both directions, up and down. They amount to huge bets stacked against the bettor, often with both buyer and seller inclined to cover losses with even bigger bets.

Yet despite the obvious risk derivatives pose, they are still widely used by corporations, mutual funds, and others wanting to hedge their interest and currency bets. Those who traditionally lose the most in the event of a derivatives failure are small investors, wage earners, pensioners, and taxpayers -- people who are not even privy to the derivative market.

The GAO is indeed quite worried about the fragility of derivative investments, especially since the concentration of derivatives is in the hands of only fifteen U.S. companies intricately linked to foreign markets. "The sudden failure or abrupt withdrawal from trading of any of these large dealers," warned the watchdog agency, "could cause liquidity problems in the markets and could also pose risks to the others, including federally insured banks and the financial system as a whole."

Furthermore, a year after the GAO issued a warning to bankers and investors regarding the danger of derivatives, little has been done. One key reason is the $100 million legislators have received in recent election cycles from banks, investment firms, and insurance companies-aimed, in part, at protecting derivatives.

Derivatives pose a serious threat to the economic health of the world since they lack a solid financial foundation and are limited in use to the largest players in the world economy. Moreover, the unwillingness of policy makers to recognize the threat these types of investments pose to the global financial market leaves the citizens of the world vulnerable to an annihilation of financial stability brought upon them by investors beyond their realm.

COMMENTS: According to Arthur E. Rowse, author of "Golden Fleece," the subject of risky derivatives "was almost completely ignored by the mass media, and when covered at all, it was relegated to the business pages. It continues to be ignored even though almost nothing has been done by regulatory agencies to prevent some of the disasters that have already occurred. The story of derivatives seems to be a lot like the savings and loan scandal. It's far too complex and local for all the business press and a few large newspapers and magazines to handle in a timely and competent manner. Some reporters such as Brett Fromson of the Washington Post and Carol Loomis of Fortune, have done competent work, but TV news has been out to lunch. The only major report was done by 60 Minutes a few years ago.

"Some nine months before the Orange County disaster occurred, the story was dumped in the laps of the Los Angeles Times and Orange County Register. They booted it. (See American Journalism Review, March 1995: 22-29.) When the feds fined Bankers Trust $10 million in December 1994, it got only a few lines in major newspaper business sections. When the shocking internal tapes from Bankers Trust became public, Business Week made it a cover story, but it didn't get far in the mainstream media even though the material was sensational and had an indirect bearing on all who deal with Bankers Trust (a new oxymoron)." Rowse did not check general newsweeklies for coverage.

"With more media exposure, legislators would have more incentive to either pass reforms or pressure business to institute more meaningful reforms of its own to protect the general public from catastrophic financial losses. It would also strengthen the backbone of the key agencies, the SEC and CFTC. Greater public exposure would also alert the general public, especially those now unaware of their involvement in derivatives through pension plans, mutual funds, brokerage accounts, banks, and other connections.

"The biggest dealers in derivatives, a small number of big banks such as Bankers Trust, benefit from the limited [media] coverage. Proof is the fact that BT is still prospering despite its extremely shabby treatment of its big derivative customers. Ordinary depositors are probably unaware of the extra risk they have taken and may continue to take by dealing with a bank so deeply involved in such shaky financial transactions."

Rowse says he hasn't followed the subject closely since he wrote the piece, which was a shortened version of an article submitted to The Nation six months earlier. "I am not aware of any large derivative scandals since then," he says. "Under some pressure by regulators, large dealers have instituted what they say are closer controls over such business in order to be able to react more quickly to danger signals. But the overall situation appears to have changed little, and the forebodings of the GAO continue to twist in the wind awaiting the next disaster, which everyone hopes will not become a worldwide meltdown."