NEW YORK — Out Dexter Charles' 35th-floor window is a stunning view of lower Manhattan. In front of him, a flickering, color-coded array of computer screens gives a second-by-second read of the prices of securities in a half-dozen markets around the world.
But as he starts his workday, Charles' attention is focused on a few pages in his hand--data showing what will happen to his $350-billion portfolio of complex financial deals at Chase Manhattan Bank if interest rates change by a hundredth of a percent. It's a calculation so involved that it must be done overnight on a state-of-the-art computer workstation.
"We used to be able to use PCs to do this," Charles says of the portfolio "stress test"--so called because every fraction of a percentage point change in rates places exacting strains on his holdings' value. "But they're not powerful enough anymore."
This is the world of derivatives: deals whose value is based on the performance of an underlying stock, bond, commodity or index. Thanks to the influence of advanced technology, these transactions have become so esoteric--yet pervasive--that regulators fret that they are endangering the financial system's stability and Congress muses over whether they should be banned outright.
During the last few weeks, such august corporations as Procter & Gamble, Mead Corp. and Gibson Greeting Cards have reported major losses--$102 million, $7.4 million and $19.7 million, respectively--from derivative transactions gone sour. Securities and Exchange Commissioner Richard Y. Roberts says the SEC expects many more American firms to report heavy losses this year from similar deals.
Earlier, big investors like George Soros used derivatives to place huge speculative bets on the direction of interest rates. When the wagers proved wrong, their forced sales of assets to cover the losses aggravated this winter's sharp drop in stock and bond prices. Some regulators and members of Congress are seeking to tighten government oversight.
Derivatives have been cursed as the ultimate in useless financial speculation and praised as indispensable management tools. Sometimes the praise and condemnation come from the same source: All three of the companies posting the most recent losses previously were content users, but all say the troubled deals were uniquely complex and did not belong in their portfolios in the first place.
That is important because almost everyone in the derivatives business agrees on one point: The transactions stand to become only \o7 more \f7 complex as users discover new needs and computers become powerful enough to design new solutions.
"We're in the early days in all of this," says John G. Heimann, director of global derivatives trading at Merrill Lynch & Co.
The growing derivatives industry can be viewed as a case study of the life cycle of innovation on Wall Street. Like technological advances in many walks of life, derivatives have elicited fear, suspicion and blame for market crashes and heavy losses--a reputation many observers say is undeserved.
"It's still possible to lose money in all the old familiar ways," says Merton Miller, a Nobel economics laureate and professor of finance at the University of Chicago. The $751-million loss faced by Germany's Deutsche Bank from a recent garden-variety real estate collapse, he notes, makes Procter & Gamble's woes look minor.
"But derivatives are a novelty item," Miller says. "And the very notion that some of it is done by computer has an ominous ring to it."
Still, derivatives over the last few years have quietly worked their way into the hearts of thousands of companies and investment firms. Precise figures are not available, but it seems likely that almost every major corporation in America uses them in some form.
Indeed, some large institutional investors are required by their bylaws to hedge certain risks using derivatives. The managers of New Jersey's $350 million in state pension funds were not permitted to sink $35 million into foreign stocks until they came up with a way to hedge the investment against losses from currency fluctuations.
Until recently, such a hedge might have been difficult to find. But starting in the 1980s, Wall Street's innovators learned how to assemble options, futures and other commitments in ways that allowed them to fine-tune hedges to the financial world's ever more exacting specifications.
Instead of hedging against the simple risk that the British pound might rise over the next six months--\o7 that \f7 can be accomplished using a derivative known as a currency forward--a company might want to hedge against the possibility of the pound rising against the Japanese yen under certain interest-rate conditions.
