Q: The development of derivatives is largely driven by investor needs. What are some of those needs? A: A large number of investors are starting to realize that they face a huge reinvestment risk in the middle of the decade. If you remember, municipal issuance peaked in ~85 and ~86. Municipal bonds tend to be callable 10 years after they're issued, so we're just starting to see the beginning of a wave of redemptions. And that creates serious problems, particularly for some property-casualty insurance companies and for mutual funds. Q: Let's start with the insurance companies. How are they affected? A: Insurance companies reporting book income to their shareholders right now still include coupon income on higher-coupon bonds that they bought back in '84, '85, '86. They're reporting that income, and it goes into their per share earnings, and, multiplied by the multiple of the stock price, affects their stock price. Those earnings will disappear starting in ~94, ~95, ~96, ~97, and so on. A lot of insurance companies are beginning to anticipate some fairly substantial drop-offs in per share earnings in those years.
Since the equity analysts on Wall Street tend not to look very closely at an insurance company's bond portfolio in analyzing their earnings -- they tend to look at the underwriting results -- these declines in earnings will be a surprise to the Street and could have an adverse effect on stock prices. When you look at some of these companies, the numbers are pretty large. Q: How might an insurance company deal with this problem without using derivatives? A: If you have a lot of bonds maturing or being redeemed in ~94, ~95, ~96, you could sell them and buy longer-term bonds. That is a legitimate being to do. A lot of companies are considering it and some of them are doing it. But it creates two problems.