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The turmoil in the bond derivative market, which has persisted since February, has troubled Wall Street watchers because it bears some of the hallmarks of the 1987 stock-market crash. That 508-point plunge on Black Monday was worsened by so-called portfolio insurance, which is computerized programs designed to bail investors out of stocks in a downturn by selling stock futures. But few buyers were willing to come forward while so many others rushed for the exits, and the decline accelerated instead of slowing down.
Such a scenario is what prompted the New York Stock Exchange in 1988 to add circuit breakers that temporarily halt automated transactions when the Dow Jones average rises or falls more than 50 points in a day. But even if the mechanisms work temporarily, some experts caution that all the computerized derivatives and other vehicles that Wall Street has developed since the Crash of '87 could keep shell-shocked buyers from returning to the market, out of fear of a new wave of selling. "A circuit breaker shuts off the overload," says Bruce Greenwald, a finance professor at the Columbia Business School and a staff member of the Brady Commission, which studied the Crash of '87. "But it doesn't come with an 'on' switch that can bring back buyers."
That's partly why U.S. lawmakers and regulators are stepping up their vigilance. Astonishingly, institutions like banks, insurance companies and brokerage houses now hold trillions of dollars of unregulated derivatives contracts that are not recorded on their books. Thus no one, including the firms themselves, knows just what pressures may be building up. In an effort to remedy that, Congressman James Leach of Iowa, the ranking Republican on the House Banking Committee, sponsored a bill last January to create a federal derivatives commission with broad oversight authority. And the Comptroller of the Currency has begun to require banks to disclose the dollar value of all the derivatives contracts they hold that have gone sour, much as they must list the total dollar volume of their bad loans.
Regulators have had two good excuses recently to push their oversight of derivatives. Typically, derivatives contracts make up anywhere from 2% to 10% of the assets of the mutual funds that hold them. But the managers of a $385 million government-bond fund called Hyperion 1999 Term Trust got carried away last fall. The trust put nearly one-third of its money into derivatives contracts that amounted to bets that interest rates would not drop anytime soon. When they did drop, the value of the trust's shares plunged about 25%. Just last week, a group of investment funds run by David Askin of Askin Capital Management was forced to liquidate its portfolio -- reportedly worth about $500 million -- after playing a similar game. The funds speculated on the price difference between two different sets of mortgage-backed securities. When interest rates rose quickly, the speculative scheme fell apart.