Derivatives: How the Big Game Began

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THIS BUSINESS OF DERIVATIVES CAN BE TRACED BACK TO CHIcago, the old hog butcher for the world and stacker of wheat. Chicago learned it could make an easier living by selling pretend wheat and pretend hogs in the pits of the commodities exchanges. These imaginary creatures are called "futures." The point was you could buy a hog future and turn a nice profit before the real hog ever showed up. Or, if you were Hillary Rodham Clinton, you could make 100 times your money on cattle futures without ever having to put up with a cow.

Having taken the bother out of farming and changed it into high finance, Chicago then turned its attention to high finance itself, introducing futures and options so that investors could buy and sell pretend baskets of stocks. These baskets were a big hit among professional fund managers, who used the pretend stocks to hedge their positions whenever they were afraid they owned too many real stocks.

The whole shebang spread to New York City, where banks and brokerage firms hired roomfuls of geniuses and paid them handsome salaries to develop new lines of imaginary products. The geniuses stared up at the ceilings and came down with derivatives, some of which they called ELKS (equity-linked securities), YEELDS (yield-enhanced equity-linked securities) and CHIPS (common-linked higher-income participation securities), as well as LYONS, TIGRS and CMOs. A decade ago, if you wanted to work on Wall Street, you went to business school; but now you can study genetics and end up at Merrill Lynch, where instead of splitting genes to clone an elk, you can graft a share of Snapple (which doesn't pay a dividend) onto a dividend, thus creating the Snapple ELK -- a dividend-paying fictitious concoction that rises and falls in value along with Snapple itself.

The makers of derivatives like to say their products are used mostly by ; people who are trying to reduce risk in the market, but they also provide exciting betting opportunities for billion-dollar gamblers who are too big for Vegas. The potential payoffs are so huge that if the word gets out to the crowd at the track and the casinos, they'll give up horses and blackjack for oil straddles and currency swaps.

If you have a home mortgage, you can be involved in derivatives already without even knowing it. These days there's a good chance yours won't be kept in one piece by the banks that lent you the money. Instead, many mortgages are shipped off and bundled into packages called mortgage-backed securities, which in turn can become raw material for other derivatives such as REMICs (real estate mortgage-investment conduits).

It's possible that your mortgage has been chopped in half -- with the principal portion sold off and bundled up into a P/O, which stands for "principal only," and the I/O, "interest only," going another way. Bond funds use I/O derivatives to add yield to their portfolios and make aggressive bets on the direction of interest rates.