Derivatives: Not Always a Dirty Word
Despite losses, mutual-fund CEO defends their utility
WITH the failure of the British investment bank Barings PLC this week, it takes some courage to defend derivatives. But Addison Piper, chief executive of Piper Jaffray Companies, a 100-year-old Minneapolis investment house, does.
``It's a very important part today of the overall marketplace,'' Mr. Piper told the Monitor earlier this week in Seattle, where the brokerage firm sponsored an investment conference. Indeed, annual trading in derivatives worldwide amounts to about $12 trillion by one estimate, or roughly half the size of the global economy.
But derivatives can involve large risks. Barings lost more than $1 billion. Orange County, Calif., saw its investment portfolio ravaged by derivatives last fall.
Derivative investments in one of Piper Jaffray's mutual funds, though profitable in the early 1990s period of low interest rates, chalked up $139 million in losses last year.
Are there any lessons emerging from these fiascos? Are regulators or investment houses developing ways to avoid them in the future?
Financial experts see no quick fixes. Some derivative securities can be so complex that assessing or regulating the risk is difficult. Sophisticated derivative trading can require an understanding of computers, mathematics, and theories not in use a decade ago. Traders are often ``whiz kids'' betting large amounts on which way stocks, bonds, or commodities move. Big gains for the firm can produce million-dollar year-end bonus payments for the trader. Oversight may be lax because senior management can lack the experience or understanding of how some derivatives work; or, reports on trades arrive days or weeks after the event.
But there are signs that Congress wants to see higher standards. ``This lack of understanding [of derivatives], coupled with widespread use, can and will continue to bring about financial disasters if left unchecked,'' Rep. Marge Roukema (R) of New Jersey, said recently.
Not all derivatives are high-risk, Piper says: ``As the chairman of the Morgan Bank said, money is a derivative.'' A derivative is a financial instrument whose value is derived from some underlying index. A paper bill represents a certain purchasing power over goods, which generally changes only slowly.
But Piper has also seen how punishing derivatives can be when the underlying index changes quickly. As the Federal Reserve raised interest rates, 1994 became the worst year for bonds in almost 70 years. Piper Jaffray suffered losses of some $139 million on bond-based derivatives in its Institutional Government Income Portfolio, a bond mutual fund. Per share prices fell from a high of $12.23 in October 1993 to as low as $7.47. The value today is around $7.67 a share. The company settled a shareholder lawsuit two weeks ago for $70 million.
In this case, the derivatives were securities based on government-backed home mortgage loans. Generally these derivatives are thought to be relatively less risky.
The Piper Jaffray fund is a case study in how investors can be misled as to the risk of their investments, says Minneapolis attorney Vernon Vander Weide, who represented the shareholders. He says investors thought the fund was only modestly more risky than a money-market fund, which seeks zero change in share price and provides a relatively low interest-rate return. The fund focused on short-term bonds (which fluctuate in value less than longer-term bonds) and on government rather than corporate debt.
But what investors got, Mr. Vander Weide says, turned out to be a ``a highly speculative bet on the direction of interest rates.'' Shareholders had been informed that the fund could include derivatives. But, Vander Weide alleges, they were not told several crucial facts:
* The mortgage derivatives were actually longer-term investments than the rest of the fund, increasing the risk when interest-rates rose.
* At times, the mortgage derivatives amounted to more than half the portfolio's value.
* The securities were less liquid than regular bonds. They were more difficult to sell when interest rates began to change.
* The fund engaged in a form of leverage, essentially using debt to buy more investments than shareholder deposits alone would allow. ``Leverage can be great on the way up, and it can be horrendous on the way down,'' Vander Weide says.
* Mortgage-backed securities package thousands of mortgage loans and come with varying degrees of risk. The ones Piper Jaffray bought were on the more volatile side.
Piper defends derivatives as investment options but allows that ``the marketplace is a humbling place to operate. There's learning going on all the time.''