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Non-Tech : Derivatives: Darth Vader's Revenge -- Ignore unavailable to you. Want to Upgrade?

To: James F. Hopkins who wrote (207)	9/30/1998 4:50:00 PM
From: Worswick	Read Replies (1) \| Respond to of 2794

No.No. No. Pirates never had a code of honor. I know I have every book ever written on pirates. Maybe Captain Kidd was an honorable man but he was betrayed by his "backers" in the English government and they were the real pirates. At any rate the following appeared today on the op ed page ofthe NY Times. (C)NY Times For Private Use Only September 30, 1998 Playing Roulette With the Global Economy By FRANK PARTNOY AN DIEGO -- Derivatives, those risky financial contracts that rocked the markets with billion-dollar losses in the mid-1990's, are coming back to haunt us. And the sequel may be far more terrifying for the average investor. Consider the latest casualty, Long-Term Capital Management, now known as the hedge fund that didn't hedge. It bought and sold derivatives representing $1.25 trillion of underlying securities. The company's losses, at least $4 billion, and its $80 billion in leverage are a splashy story. But why, beyond the gawking, should most investors care about, or even blink at, a few Nobel laureates and financial rocket scientists in Greenwich, Conn., losing their shirts? There are a couple of reasons. For one, if our markets are going to crash, the most likely spark will be hedge funds and derivatives, whose values rise and fall with the price of underlying bonds, stocks, currencies and interest rates. Banking regulators will not allow large commercial banks to fail, and pension and mutual funds invest in diverse markets and aren't highly leveraged. Hedge funds are more likely candidates to collapse as a group because they borrow aggressively and make similar bets. There are an estimated 4,000 such funds trafficking in trillions of dollars of derivatives. Moreover, investment in hedge funds has increased just as the number of good ponies in the financial race has declined. Modern finance theory teaches that sure winners evaporate as speculators discover and copy each others' strategies. Hedge funds, like cockroaches and wolves, are rarely alone: the bet in July 1997 was that Asian currencies would not be devalued; the bet in July 1998 was that emerging market bonds would recover. Most recently, Long-Term Capital gambled, along with other hedge funds, that spreads between high-yield (remember "junk"?) bonds and United States Treasury bonds would not increase. They all used derivatives to leverage these bets. Another reason to fear these funds is that even if whole markets do not crash, the average investor will bear the costs of derivatives-related bailouts. If you own a mutual fund, you may own shares in one of the dozen banks paying $3.75 billion to save Long-Term Capital. The Fed, by supporting this bailout (at least indirectly, by providing a swanky boardroom for the banks to meet in and unrelenting pressure), has created incentives for other financial institutions to continue to place similar leveraged bets. Because the law does not require much disclosure from these funds, such bets are concealed in the underbelly of investment portfolios. No one suspected huge "off-balance sheet" trades by Yamaichi Securities, the fourth-largest brokerage firm in Japan, until it announced $2 billion in losses and went under last year. No one knew of billions of losses last year at National Westminster Bank and UBS A.G., and this year at Tiger Management and now Long-Term Capital, until it was too late. Of course, the same was true in 1994 when Orange County, Calif., declared bankruptcy after suffering $1.6 billion in investment losses. And with Proctor & Gamble's $150 million loss that year on derivatives it bought from Bankers Trust. And in 1995 when the 233-year-old Barings Bank was brought down by the gambles of a 27-year-old trader. Congress held hearings on derivatives in 1994 but was overwhelmed by Wall Street lobbying, and the instruments have remained largely unregulated. Opinion about derivatives trading is sharply divided. George Soros has said that those who trade in them are to blame for the severe market instability -- instability that he has warned could "destroy society." Merton H. Miller, a Nobel laureate in economics, has said that derivatives "have made the world a safer place." At least one of them is wrong. Still, whichever side you believe, two conclusions are unavoidable: Derivatives are playing an important behind-the-scenes role in recent financial market manias, panics and crashes; and no one -- not even these two gurus -- understands how or why. Does this scare anyone? Frank Partnoy, an assistant professor of law at the University of San Diego, is the author of "F.I.A.S.C.O.: Blood in the Water on Wall Street."