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Credit risk is the problem that American banks are facing. Buried deep within the arcane bank statements filed with the Securities and Exchange Commission is evidence of a potential chain reaction of derivatives heading toward an explosion. "I've been an analyst for almost 20 years now," says Charles Peabody, of Mitchell Securities, a brokerage firm in New York City. "Analysts like myself are learning for the first time how derivatives behave in bad times. I think we've just seen the tip of the iceberg of the problems with derivatives."
The banks say analysts such as Peabody are overplaying the danger, and, following some minor calamities in 1994, their use of derivatives follows a prudent management scheme. But according to the Treasury Department's calculations, the iceberg is huge. The 25 American banks with the largest position have more than $350 billion in credit exposure to derivatives--that's more than enough to wipe out the $250 billion in equity capital that the same banks keep on hand as a cushion to absorb losses. Few believe that Asia's troubles could jeopardize the entire amount--that would take a global, systemic collapse--but the possibility for some big hits is real. And although the losses in derivatives last year were small and manageable ($125 million), "these losses tell me that banks are taking on more risks," says Mike Brosnan, director of the treasury and market-risk division for the Office of the Comptroller of the Currency (OCC), an agency that regulates U.S. banks.
A product of sophisticated math and computer software, derivative contracts are designed to help banks, corporations and countries hedge against financial uncertainties, such as changes in interest rates. But the banks found that they could make a killing by concocting more exotic derivatives that effectively bet on the future direction of interest rates, foreign exchange, commodities and stock indexes. And since banks aren't making much money from traditional lending these days, derivatives became the highway to new revenues and profits. Accounting rules made derivatives attractive too, since the contracts didn't have to show up on bank balance sheets and thus were beyond the prying eyes of investors and analysts.
The alchemy of derivatives rests on complex mathematical models that predict how markets and derivatives will behave under certain assumptions. The computer models use past market performance to portend the future, but they can't account for the unaccountable: every once in a while an asteroid does strike or countries blow up. These things aren't fully factored in the modeling. Besides, the global economy today is radically different from just five years ago. "Banks have been going out further and further on the risk spectrum, especially the big banks," says Furash. "They are all looking for bigger returns, since they aren't getting it through lending. The danger is that the expansion is to the point where big banks are engaged in risk warfare."