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The result: in just three decades, the volume of derivative contracts with U.S. commercial banks exploded, from practically zero in the early 1970s to more than $25 trillion today, an amount exceeding the size of the U.S., European and Japanese economies combined. Bankers quickly, and appropriately, point out that this figure really represents just the "notional" amount, or face value of the derivatives, and not what they could potentially lose. But the amount due, or at risk, is derived (hence derivative) from those vast notional amounts.
Parse the language and it means many banks have a new sideline: gambling. "Derivatives have turned the financial markets into a hi-tech, international, 24-hour casino," notes Richard Thomson, a former merchant banker and author of a book published in London, Apocalypse Roulette: The Lethal World of Derivatives. "Right now you have a small number of banks sharing a very large risk. But this could turn out to be a serious problem if these banks are in the wrong place at the wrong time."
Thomson points out that if one or two large Asian parties default on their derivative contracts, computer screens around the world can be hit within seconds and instantly threaten other contracts. "It's like a bunch of climbers on a mountain all tied by a rope. But if one climber slips and falls into a crevasse, he can quickly drag the other climbers to their end with little chance of time for rescue," says Thomson.
Foreign lenders have already been hit. One large European bank lost not only big money on derivatives but also possibly its independence as well. Union Bank of Switzerland took a $250 million beating from derivatives last year, one reason it rushed into the arms of Swiss Bank Corp.
The American bank that could have the most at stake is J.P. Morgan. Government examiners, who have access to internal bank records denied other mortals, put Morgan's total credit risk from derivatives at $116 billion at the end of last year, the largest of any U.S. bank. Should Morgan suffer a loss of just one-tenth of that from defaulting customers, the bank's equity could be wiped out.
That dam may have started to crack. While the U.S. banking industry pocketed record earnings last year, Morgan's fell 7%, to $1.46 billion. Derivatives are partly to blame. Morgan last year declared it had $659 million in nonperforming assets, 90% of which were defaults from Asian derivative counterparties. Among the defaulters were three South Korean companies, led by SK Securities, which early this year refused to pay $490 million that Morgan claims it is owed.
In this case, SK Securities entered into a currency-swap deal with Morgan in early 1997 whereby SK Securities in effect borrowed U.S. dollars and invested them in Thai baht. But within a year the baht plunged in value, from 25 to 48 to the dollar, and the Korean firms couldn't cough up the dollars to repay Morgan. They subsequently sued Morgan in New York and in South Korea, claiming they weren't properly advised of the risks associated with derivatives.