[Congressional Record Volume 140, Number 145 (Friday, October 7, 1994)]
[Senate]
[Page S]
From the Congressional Record Online through the Government Printing Office [www.gpo.gov]


[Congressional Record: October 7, 1994]
From the Congressional Record Online via GPO Access [wais.access.gpo.gov]

 
               SENATOR DORGAN'S ARTICLE ABOUT DERIVATIVES

 Ms. MIKULSKI. Mr. President, I would like to bring to the 
attention of our colleagues an excellent article in this month's 
Washington Monthly written by our colleague, Senator Byron Dorgan. The 
article eloquently states that derivatives pose a danger for our 
Nation's financial institutions and taxpayers. Senator Dorgan outlines 
the huge risks that Wall Street is taking when they do high stakes 
gambling with derivatives, and warns of a possible market shakeup could 
put taxpayers on the line for another bailout.
  I am a cosponsor of Senator Dorgan's derivatives legislation because 
I do not believe federally insured deposits should fund high risk 
investments. This bill would prohibit banks and other federally insured 
institutions from investing funds insured by taxpayers in the 
derivatives market.
  I commend Senator Dorgan for his article, and hope my colleagues will 
add it to their reading lists.
  The article follows:

                [From the Washington Monthly, Oct. 1994]

                          Very Risky Business

                       (By Senator Byron Dorgan)

       Last spring, when the stock market took its hair-raising 
     ride, in one corner of Wall Street there was more than the 
     usual anxiety. In fact, there was stockbrokers-looking-for-
     upper-floor-windows kind of fright. In April, clients of the 
     giant Bankers Trust New York Inc.--including Procter & 
     Gamble--took multimillion dollar losses on a kind of trading 
     most Americans had never even heard of, called 
     ``derivatives.'' A rumor went around the Street: Maybe 
     something truly sinister was brewing. Maybe this was a . . . 
     derivatives collapse.
       The spring market panic hit just as the March issue of 
     Fortune--hardly a carping business critic--cast a dark pall 
     over derivatives, which are complicated futures contracts 
     based on mathematical formulas. Fortune called them an 
     ``enormous, pervasive, and controversial financial force.'' 
     The magazine added: ``Most chillingly, derivatives hold the 
     possibility of systemic risk--the danger that these contracts 
     might directly or indirectly cause some localized or 
     particularized trouble in the financial markets to spread 
     uncontrollably.''
       The headline on the Fortune cover was ``The Risk That Just 
     Won't Go Away,'' shown over a pool of alligators. With that 
     staring back at brokers and investors from their coffee 
     tables, the sudden dip in the Dow and the story of Bankers 
     Trust made people think, Hey, we really need to get a grip on 
     this. But the dip turned out to be a blip, and the crisis 
     passed out of the news. In typical fashion, the media moved 
     on the other matters, content that where there's no immediate 
     crisis, there can be no fire.
       Yet, this ``false alarm'' could turn out to be a harbinger 
     of a real financial conflagration--one that would make us 
     nostalgic for the days of the $500 billion savings-and-loan 
     collapse. In August, The Wall Street Journal declared that 
     derivatives were now a $35 trillion--that's right, trillion--
     worldwide market. The U.S. share is estimated at $16 
     trillion, which is four times the nation's economic output. 
     And the Journal estimates that since 1993 there have been 
     $6.4 billion lost in the derivatives game--$6.4 billion that 
     could have opened businesses and created jobs. Derivatives 
     are no doubt widespread: An Investment Company Institute 
     survey found that 475 mutual funds with net assets of $350 
     billion recently held derivatives; about two-thirds of 
     those assets were in short-term bond funds sold to average 
     investors. And here's the real kicker: Because the key 
     players are federally insured banks, every taxpayer in the 
     country is on the line.
       So what is this thing called a derivative? Bankers and 
     speculators maintain it's just hedging, a perfectly normal 
     practice to manage risk. Farmers hedge, so do banks and 
     businesses. So what's the big deal? Derivatives have become 
     much more than managing risk. They have begun, in some cases, 
     to look like a financial casino where the decisions are 
     wagering decisions, not business ones. Derivatives may well 
     be the most complicated financial device ever--contracts 
     based on mathematical formulas, involving multiple and 
     interwoven bets on currency and interest rates in an ever-
     expanding galaxy of permutation. Of course, what individual 
     investors knowingly do with their own money is their own 
     business. But when financial institutions are setting up what 
     amount to keno pits in their lobbies, it's something that 
     should concern all of us.
       Let me explain by example. One form of derivative--the most 
     simple--is a futures contract, which is the traditional 
     device for a company to lock in a price for materials at a 
     future time. Say a company that manufactures film--Company 
     X--needs to buy silver every year and wants to guard against 
     rising silver prices. So in 1994 it enters into a contract 
     with a mining company to pay the going 1994 rate in 1995. 
     This is a risk for X if silver prices tumble, because they 
     will be required to pay the higher price. But if prices rise, 
     X wins because it will be able to buy the silver for less 
     than the 1995 market price. Of course, speculators can buy 
     and sell such commodities contracts with no intention of 
     actually obtaining the commodity, hence gambling on the 
     fluctuation of prices. But this kind of traditional futures 
     trading takes place on organized exchanges that are well-
     regulated and well-understood.
       The troubling derivative deals are much different. They 
     take the basic futures idea a quantum leap further into a 
     netherworld of high finance. Let's take a simple example. Say 
     Company X is under an obligation to sell film in Japan next 
     year. Assume further that the company's analysts believe the 
     value of the yen will fall against the dollar. The analysts 
     would like to protect against the risk that silver and yen 
     prices may fluctuate over the course of the year, thus 
     hedging their original hedge. The company can't go to an 
     exchange in Chicago and get that precise deal, so it gets on 
     the telephone to its bankers and suggests that the bank write 
     a customized contract that is based on the delivery price of 
     silver in yen, not in dollars. This is called an ``over-the-
     counter,'' or OTC, transaction, since it does not take place 
     on an organized exchange.
       The new speculative twist is much, much riskier for both 
     Company X and the bank. It doubles the stakes: now, instead 
     of betting just on the price of silver, it is also wagering 
     on the value of the yen. Why would X do this? Because 
     doubling the bet may hedge their risk in both the silver and 
     yen markets. Why the yen? Because its analysts, in 
     consultation with the bankers, used complex mathematical 
     models and probability charts to decide the yen bet was a 
     good gamble.
       If the analysts were right about the yen, of course, it all 
     works out. But if they were wrong about the yen, and wrong 
     about the silver, too, the result would be like having two 
     lead weights slide to one end of a see-saw.
       Unlike a traditional future, moreover, these exotic 
     derivatives are almost impossible to sell if one of the two 
     bets goes south. They are especially tailored to X's needs, 
     and are therefore unattractive to other buyers.
       And that's a simple example. Currency fluctuations are just 
     the beginning. Interest rate gambles are common, too, and in 
     this volatile year have led to many of the big losses, 
     including the $700 million that Piper Jaffray, the respected 
     Minneapolis firm, lost on behalf of clients that included 
     small city governments and the local symphony association. 
     Piper Jaffray had decided on the basis of obscure 
     mathematical formulas that interest rates would not 
     rise. Unfortunately, the formula didn't anticipate the 
     Federal Reserve Board's rate hikes this year.
       More trouble comes from exotic new derivatives called 
     ``swaps.'' Say Company A has borrowed money at a floating 
     interest rate but is worried that rates might rise. It wants 
     to lock in the rates at the lower level. So it calls a 
     derivatives dealer--often a major bank--to find another 
     company, call it B, which is willing to bet that the floating 
     rates will be more favorable than the set rate. A swap 
     results: Company A will pay a fixed rate of interest to 
     Company B, which will pay a floating market rate to Company 
     A. The risk to Company A is that rates will fall but A will 
     be obligated to pay the higher, fixed rate. The risk to 
     Company B is that B will end up paying higher rates than the 
     fixed rate it receives from A. If you had trouble following 
     that, then you are starting to get the idea. And all of this 
     can be done without anyone even knowing, since such 
     transactions can be done ``off book''--effectively concealing 
     them from stockholders and employees. Protector & Gamble 
     bought a floating rate deal like this from Bankers Trust, 
     losing a reported $157 million in the process.
       There has been a steady flow of such losses in past months. 
     The reports of recent derivatives disasters could be the 
     first trickles of water through a rickety dam: Askin Capital 
     Management, in New York, lost $600 million; Kidder Peabody, 
     $350 million; CS First Boston Inc., $40 million. Such 
     debacles have led some leading Wall Street sages--Gerald 
     Corrigan, the former president of the New York Federal 
     Reserve; Felix Rohatyn, the investment banker; and Henry 
     Kaufman, the bond guru, among others--to warn that 
     derivatives are out of control. These men are not given to 
     impetuous overstatement where finance is concerned. Nobody 
     would care if these were just a few Donald Trumps taking a 
     hit at a respectable financial casino.
       But the truly scary thing is how losses like these could 
     spread through the entire banking system. Suppose X, our film 
     company, had entered into a swap with a New York bank. That 
     bank in turn might then enter an offsetting contract with 
     another bank which in turn might continue to pass along that 
     risk on and on and on, perhaps using exchange-traded futures. 
     So now a default by X could create a domino effect: X could 
     not pay its bank, and its bank therefore couldn't make the 
     payments on its offsetting contract, and so on until the 
     chain of losses enters the exchange, where the originally 
     esoteric bet can hurt real businesses. This is not mere 
     fantasy. According to the Brady Report on the causes of 
     1987's Black Monday 508-point fall, the problem was 
     worsened by automatic computer programs that kept ordering 
     traders to sell stock index futures--which are, in 
     essence, derivatives.
       Making matters still worse is the concentration of big 
     derivatives dealers. The General Accounting Office found this 
     year that much of the big OTC derivatives dealing is 
     concentrated among 15 major U.S. dealers--including federally 
     insured banks--that are extensively linked to one another and 
     to exchange-traded markets. The top seven domestic bank OTC 
     dealers accounted for more than 90 percent of total bank 
     derivatives action, and the top five U.S. securities firms 
     accounted for 87 percent of all such activity in securities 
     in the country. Add in the always-more-volatile foreign 
     markets (tied to about $4 trillion of the U.S.'s $16 
     trillion) and we're talking real money.
       ``This combination of global involvement, concentration, 
     and linkages,'' warns Charles Bowsher, the head of the GAO, 
     ``means that the sudden failure or abrupt withdrawal from 
     trading of any of these large U.S. dealers 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.''
       If this seems a remote possibility, don't forget that 
     financial implosions nearly always seem that way--before they 
     happen. This kind has happened before, albeit on a smaller 
     scale. The S&Ls are the most notorious example, of course, 
     but there are others. the failure of the Bank of New England, 
     in 1991, cost taxpayers $1.2 billion, and the bank had a $30 
     billion portfolio of derivatives that had to be painstakingly 
     unwound to avoid, in the words of the GAO, ``market 
     disruptions.'' And the feds have had to cleanup non-banking 
     financial messes as well. In 1990, when Drexel Burnham 
     Lambert failed, the government had to insure payments that 
     flowed between Drexel's sundry creditors and debtors to avoid 
     a chain reaction. With a $35 trillion derivatives market, a 
     crash would make these precursors look Lilliputian.
       All that stands between the public and a financial disaster 
     of this sort is the guardians of the banking system in 
     Washington. Regrettably, they are outgunned by the 
     derivatives dealers in several ways. For one, there are fewer 
     examiners than dealers, and many examiners are young and 
     inexperienced. Worse, exotic derivatives--the stuff the big 
     boys are doing--just don't fit within the existing scheme of 
     federal finance regulation. It's a little like asking traffic 
     cops to stop the nation's computer crime.
       Perhaps it seems that none of this concerns you directly, 
     but in this spooky new financial world, there are basically 
     three ways you could lose.
       You have money in a money market fund or a mutual fund. 
     This is the scariest and most immediate prospect for most 
     Americans. It's entirely possible--in fact, it's all too 
     likely--that you wouldn't know whether your fund had money at 
     risk. Two-thirds of the assets held by tax-exempt U.S. money 
     market funds, which were created to give the small investor 
     access to high rates of return, are now covered by 
     derivatives. BankAmerica recently had to pump $67.9 million 
     into its Pacific Horizon money market funds to make up for 
     derivatives losses. As for mutual fund losses, ask Mound, 
     Minnesota. When the public officials of the Minneapolis 
     suburb wanted to tuck $2.5 million away to pay for new water 
     meters and sewers, it chose an eminently respectable, 
     reputedly conservative Piper Jaffray mutual fund that invests 
     in U.S. government securities. But as the Wall street Journal 
     reported this summer, Mound lost $500,000 because Piper 
     Jaffray was playing a derivatives game with the town's money, 
     betting that interest rates would fall. Leaders of Moorhead, 
     Minnesota, can tell you a similar story.
       A private investment goes bad. If you are a stockholder in 
     a company that's trading in derivatives, and the bets turn 
     out badly, the stock is going to take a hit. In some of the 
     biggest cases so far, the German firm Metallgesellschaft, a 
     mining, metals, and industrial company, took what may be a $2 
     billion loss on derivatives. One of the company's U.S. 
     subsidiaries, MG Corp., which owns an oil refinery, bet on 
     oil prices and lost badly. Several divisions of the company 
     have had to be sold, and 7,500 out of 46,000 employees were 
     laid off.
       Government takes a hit--either directly or indirectly--
     through bank losses in derivatives. Mound's local taxpayers 
     lost money; in Orange County, California, taxpayers had to 
     meet a $140 million collateral call when some derivatives 
     speculations started going bad. This is not the best use of 
     the taxpayers' money. The federal government, too, is quietly 
     but rapidly getting into the game. The Federal National 
     Mortgage Association and the Federal Home Loan Mortgage 
     Corporation use exotic derivatives, as does Sallie Mae. And 
     because these are federally chartered corporations, the 
     possibility of the federal government getting stuck with 
     clean-up costs is great.


                               bank shots

       In the peculiar market of recent years, successful exotic 
     derivatives have been a miracle drug for bank balance sheets, 
     not to mention the dealers who are shovelling in millions. 
     It's not surprising, then, that these banks and dealers are 
     resisting reform. What is surprising is that the Office of 
     the Comptroller of the Currency (OCC) and the Federal 
     Reserve agree, too, that legislative reform is 
     unnecessary. ``As far as the Federal Reserve Board is 
     concerned,'' Chairman Alan Greenspan testified in May, 
     ``we believe that we are ahead of the curve on this issue 
     as best one can get.'' Why would Greenspan, in light of 
     the mounting evidence, soft-peddle the problem? Partly, 
     it's the old story. Because the Federal Reserve, like 
     other banking regulators, tends to think more like the 
     people it is supposed to be watchdogging--in this case, 
     the banks and the larger financial community--than they 
     think like the rest of us. And in fact, in the case of the 
     Federal Reserve, it is the industry it is supposed to 
     oversee: The members of the Federal Reserve are bankers.
       This does not augur well. Just a few years ago, the S&L 
     crisis began with a trickle of bad news, a few seemingly 
     unrelated belly-flops. A chorus of operators, experts, and 
     federal regulators assured the public and Congress that 
     nothing was substantially amiss.
       Certainly the industry understands the parallel--enough, at 
     least to try to convince Congress that the parallel doesn't 
     exist. The International Swamps and Derivatives Association, 
     a trade group of the most exotic operators, recently hired 
     one of the top Washington lobbying firms to make their case. 
     And although some members of Congress are awake to the 
     derivatives problem, it takes more than that to reach a 
     critical mass.
       That's where the press comes in--or should. But except for 
     a few pieces, the nation press has been cowed by the 
     complexity of the subject. Instead of inquisitive reporting, 
     we get reports of assurances from Greenspan and others. Part 
     of the reason is that, as with the S&Ls, the disasters so far 
     seem local: Piper Jaffray is a Minnesota story, etc. Back in 
     the mid-eighties, when thrifts were beginning to collapse, it 
     seemed as if it were a Texas story one day, a California 
     story the next--never a national story. With the huge 
     exception of The Wall Street Journal (and even it is more 
     specialized a publication than, say, The New York Times or 
     The Washington Post), a story like the S&Ls or derivatives 
     only makes it off the business pages after disaster strikes 
     and it's too late to rally public attention to reform .
       Another reason is that much of this story lies in the 
     pedestrian precincts of the regulatory culture. ``It's a case 
     where the government is outgunned and outmanned,'' says a 
     senior GAO official. ``One or two people at the top of the 
     agencies are really knowledgeable, but I don't know how deep 
     the talent goes. And at the big banks, you're going to have 
     talent all the way down.'' At the Fed and the OCC, there are 
     about 3,000 examiners but hardly any of them monitor 
     derivatives. That task falls to small teams of about 10 to 15 
     examiners who go into major banks like Citicorp and are 
     expected to track deals that the banks need up to 100 
     different analysts and traders to put together.


                           dollars and sense

       House Banking Chairman Henry Gonzalez wants to strengthen 
     reporting requirements for derivatives trading--a sound step, 
     but alone this keeps federal taxpayers in the line of fire. I 
     think I have a better, cleaner idea. I have introduced S. 
     2123 in the U.S. Senate, which would prohibit banks and other 
     federally insured institutions from playing roulette in the 
     derivatives market. If an institution has deposits insured by 
     the federal government, it should not be involved in trading 
     risky derivatives. Of course, what investors do with their 
     own money is their own business. (And of course, dealers must 
     be required to tell their customers when derivatives are 
     involved; in the Piper Jaffray debacle, customers did not 
     understand what was happening.) But what banks do with money 
     insured by the taxpayers is another matter entirely.
       The classic purpose of deposit insurance, one of the 
     enduring legacies of the New Deal, is to encourage saving and 
     create a pool of capital to build homes and businesses and 
     jobs. Deposit insurance is not supposed to underwrite airy 
     speculation on Wall Street, and my bill will stop that.
       Banks will argue that derivatives are good since they hedge 
     risks they take by loaning money to real people. But my 
     proposal would not affect traditional, conservative forms of 
     hedging. And banks, so long as they created pools of betting 
     money outside their federally insured deposits, could gamble 
     to their hearts' content. But not with our money.

                          ____________________