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Exotic Devices for Investing Worry Wall St.

October 29, 1987|MICHAEL A. HILTZIK | Times Staff Writer

NEW YORK — As the investment world tries to determine how much to blame the stock market crash on computerized program trading and stock index futures, suddenly the creative minds who produced them are under suspicion.

Critics worry that a raft of other exotic investment devices concocted by the same people--a set of highly educated engineers, mathematicians and even physicists known familiarly on Wall Street as "rocket scientists"--may harbor the same potential for financial calamity as the high-tech stock trading of the last few years.

For the handiwork of the "rocket scientists" extends far beyond the stock market. In New York, London, Tokyo and elsewhere, banks and securities houses now commit billions of dollars to trading of investment devices so new that less may be known about their true value than about the physics of a supernova.

In many cases, trading in these so-called "derivative" instruments--interest-rate swaps, floating-rate notes, stripped mortgage securities and their cousins--is far greater than in the conventional stocks and bonds to which they are related.

Especially nerve-racking to government authorities is the large proportion of bank assets devoted to holding and trading these offspring of the Wall Street space labs. One 1985 study of derivative securities and other esoterica owned by 15 major U.S. banks placed the total at well over $1.25 trillion, a sum that handily exceeded the $900 million at risk in Third World bank debt.

The instruments in which all this money is concentrated are so new that until recently none had run through a serious economic or market downturn in which their value and novel contractual provisions were tested. There have been several cases, however, in which they have magnified minor financial jitters into disasters for limited groups of investors. Critics say those were only harbingers of greater problems to come.

"It's like driving a racing car to work," one prominent regulator said. "It's efficient as hell, because you get there in a hurry; but, if a squirrel runs out in front, you wind up wrapped around a tree."

Moreover, there is little doubt that the offspring of the "rocket scientists" have exceeded the ability of market and banking regulators to oversee them.

"We have 21st-Century capital markets and 19th-Century regulatory authorities," said Paul M. Sacks, president of Multinational Strategies, a consulting firm specializing in global investment issues.

Regulation Difficult

To complicate matters further, many such instruments are traded in markets that cross national boundaries, remaining outside the jurisdiction of any single government.

As for expecting international financial agencies to exercise any oversight, "international organizations are only as strong as their most powerful member is prepared to let them be--and, in most cases, the buck stops with the United States," said Susan Strange, a professor of international relations at the London School of Economics.

Most of the new instruments were designed as answers to what is perhaps the financial world's leading headache: volatility, or the wild swings in price that have afflicted stocks, bonds and currency exchange rates in the 1970s and '80s.

Financial historians trace the current era of volatility to 1973, when President Richard M. Nixon uncoupled the U.S. dollar from the system of fixed currency exchange rates established among Western industrialized nations at the end of World War II. By allowing markets rather than governments to set exchange rates, Nixon believed he would reduce the economic strains produced by government-imposed revaluations and devaluations of money.

Instead, the change added a new strain to the system: currency risk. A U.S. business that accumulated a large position in Italian lire from sales of goods in that country, for instance, had to protect itself from the risk that the lira would lose value against the dollar, wiping out any sales profit. So the business would look for an offsetting hedge--a currency investment that would gain in value as the lira fell.

In no time, the volume of currency transactions undertaken to finance real trade outran trade itself. In 1986, when the value of world trade in goods and services was $4 trillion, the volume of transactions in foreign currencies was $65 trillion--meaning that every dollar of trade in material goods inspired, directly or indirectly, $16 in foreign-exchange hedging.

The complexity of hedging techniques and the introduction of powerful computers reached adulthood in the financial world together, fueling each other's growth. "There are new products that wouldn't even exist if we didn't have computers," Dexter Senft, a managing director and top "rocket scientist" at the investment firm of First Boston, remarked in an interview last year.

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