The next step: Quadrillions

One of the financial engineering products that like subprime mortgages has become often
synonomous with the economic crisis is a derivative. And one of the big problems is that
almost no one except a handfull of experts really understands what they are. Why is that
important? Because prudent estimates put the worldwide size of the derivate market at
$1.114 quadrillion! Or put perhaps more tangibly: $1,114 trillion or $190,000 for every man
woman and child on Earth.

A number of years back I came across a book on derivatives at my favorite London

bookstore, Hatchards. It took me a few seconds to realize this was an inordinantly complex
subject: page after page filled with calculus, differential equations, etc. The book looked more
like a 4 credit course in a doctoral program of mathematical models than a business book.

Only one book I found explains derivatives in layman’s terms. A classic by Frank Partnoy:
F.I.A.S.C.O, Blood in the Water on Wall Street. In chilling words he describes how ruthless
traders got major corporations and public organizations like Orange County to invest blindly
in derivatives and end up writing off big losses or going into bankruptcy. Of great signifigance
today: it was written in 1997!

An example of just one of the derivatives sold by Morgan Stanley, Partnoy’s employer at the
time, was PERLS. It was a bond-like security whose repayment was linked to various foreign
exchange rates and in fact were leveraged bets on foreign exchange rates!

Unlike bonds, however, which promise to pay the pricipal at maturity, PERLS promised to pay
the principal amount multiplied by some formula linked to various foreign currencies. Another
name for PERLS: a structured note, i.e., instead of a fixed coupon and principal either or
both may be adjusted by one or more complex formulas.

As Partnoy states, investors in PERLS had little in common except paying Morgan Stanley
enormous fees; many would lose a fortune on PERLS. In fact he states that despite
statements to the contrary by Morgan Stanley salesmen, the most a buyer could lose was
everything, whereas Morgan Stanley had nothing to lose, hedging its forex risk with other
banks and charging investors enormous fees.A few simple examples of derivatives best
describe why you couldn’t win.

Because PERLS looked like bonds, they masked the nature of the investor’s underlying bet.
For example one popular PERLS, instead o repaying the principal amount of $100, paid the
$100 principal amount multiplied by the change in the value of the USD + 2 times the change
in value of the British pound minus 2 times the change in value of the Swiss Franc! If the
currencies miraculously aligned precisely, and the probablility of that happening was that all 9
planets in our solar system perfectly align, you got $100!

A more bizzare example involves P&G. A Morgan Stanley salesman said he made millions
selling exotic derviatives to P&G, making $2.5 million on one trade involving purchase of a
"quantoed constant maturity swap yield curve flattening trade.“ No one at P&G knew what
they were buying and one top salesman said P&G was like a man whoe goes out on a date
with another man dressed like a „drag“ and when he gets in bed compains his date is a man!

Every once in a while derivatives show up in the financial section of newspapers as

politicians call for more control and monitoring of something they haven’t got a clue about! Is
this the next bubble to burst? Consider this: derivatives are unregulated, not traded on any
public exchange, without universal standards, dealt with by private agreement, not
transparent, have no open bid/ask market, are unguaranteed, have no central clearing
house, and are just not really tangible.