Institutional investors lost $9.6 billion using derivative instruments in 1994, more than double the amount lost the previous 10 years, a new report says.
The report from Capital Market Risk Advisors Inc., New York, shows almost all types of financial institutions lost money through derivatives last year, with big losses coming through both derivatives exchanges and over-the-counter transactions.
Corporate investors took the biggest hits - about $3.8 billion - while money managers lost about $2.2 billion. Governmental entities worldwide lost $2.3 billion, with $2 billion of that coming through the combination of leverage and derivatives at Orange County, Calif.
There were far more corporations and money managers that disclosed derivatives-related losses in 1994 than other types of investors, with about 20 institutions in both categories reporting multimillion-dollar losses. Insurance companies, credit unions, captive finance companies, and banks all reported losses.
1994 was different from other years mainly because of financial engineering and the ending of a strong bull fixed-income market, said Tanya Styblo Beder, principal for CMRA.
Financial engineering, which allowed investors to increase returns as interest rates fell, led to severe, unexpected losses as interest rates rose. Abrupt or unexpected moves in other investment markets also led to losses for leveraged derivative strategies.
Ms. Beder said most of the derivatives losses occurred in three types of securities: mortgage-backed securities; structured notes; and exotic, highly leveraged, OTC transactions.
In the mortgage-backed and structured note markets, "securities specifically designed to exploit a bull market" were the biggest contributors to derivatives-linked losses, Ms. Beder said.
Financial engineering had allowed investors to build leverage into a collateralized mortgage obligation or a structured note to significantly increase returns as interest rates fell.
After interest rates started rising, those securities started losing value as liquidity dried up and, in the case of some CMOs, the expected duration started to lengthen. A CMO is a repackaging of the cash flows from a group of mortgages and often carries a government agency guarantee against credit loss. The ultimate return of a CMO depends heavily on how the mortgage cash flows are structured and how quickly the mortgage borrowers pre-pay principal. As some tranches of a CMO are designed with more predictability, others become more volatile.
Meanwhile, money market fund managers were big buyers of structured notes that benefited from falling interest rates, and, of course, lost value as interest rates rose.
While the rallying bond market had raised the prices of fixed-income securities, the yields available in money market instruments were relatively anemic in late 1993, giving money market fund investors more incentive to goose yields with structured notes. (The one-year return on 90-day Treasury bills was 3.13% at the end of 1993.)
But after those securities lost value and threatened to push the price of several money market funds below the $1 level, many institutions elected to inject assets or buy the securities from the funds at above-market levels.
Subsequently, structured note use by money market funds is way down, and probably won't recover, given the unfavorable regulatory environment surrounding them, Ms. Beder said. A wide range of regulators, from the Comptroller of the Currency to the Bank of Italy, issued guidelines that limit their use by money market investors, she said.
And while it was in the OTC market where corporations such as Procter & Gamble Co. reported huge losses in exotic derivatives, corporations also took big losses involving exchange-traded futures, Ms. Beder noted. For example, Metallgesellschaft AG, which took losses of more than $1.3 billion, used exchange-traded futures as part of a failed strategy to hedge its operations.
The derivatives losses by users also increased attention to the potential for credit losses. Although there were no huge blowups, Ms. Beder said 1994's losses caused some worry for dealers with credit exposure to some of the big derivatives losers.
So not only did an investor end up taking much bigger losses than expected, but also dealers had much more credit exposure to the investor than was originally thought.
Going forward, Ms. Beder said the losses will lead to better disclosure of derivatives positions. Likewise, she said dealers of derivative instruments should provide end users with their pricing formulas, to improve an end user's ability to price the transaction under various scenarios. While some dealers claim their formulas are proprietary, they might need to provide them to get transactions done in the future, she said.