Squeezing Orange County.

WHEN Orange County's Treasurer bet that interest rates would continue to fall in 1994, he took a big risk. Rates were already at their lowest level in a generation. A rate rise would send the value of the county's interest-sensitive derivatives plunging. Worse still, these risky investments were financed with borrowed funds. Margin calls would quickly exhaust any cash on hand.

The predictability of Orange County's debacle--along with those of Procter and Gamble, Sears Roebuck, Gibson Greeting Cards, and a slew of other burnt derivative players--reinforces the common-sense view: culpability rests with financial managers at individual firms and governments. They have no one but themselves to blame for believing that a crash could never occur, for ignoring the risks of their investments, for failing to protect stockholders or taxpayers from clear and present danger.

No one but Orange Countians will bail out Orange County. Nevertheless, federal regulators want to restrict derivatives. They warn that a derivative-induced default by a major bank or securities dealer could spread rapidly throughout the financial system, creating an S&L-type crisis--or worse. Yet the derivative dealers (like the S&Ls of a decade ago) are already very heavily regulated. Firms, like Merrill Lynch, that sold their products to Orange County are regulated by the SEC. And the banks that do the vast bulk of the derivatives business are regulated by at least one and sometimes as many as three separate regulators. Where federal regulations don't reach (insurance companies that sell derivatives, for example) the market has regulated itself, setting up separate derivatives affiliates with triple-A credit ratings.

Years ago George Stigler warned us never to take regulators' explanations at face value. While professing a concern for the greater good, they're really looking out for number one. New financial rules will mean juicy new positions. Of course, this is peanuts if it means avoiding financial Armageddon. Yet impartial research suggests that derivatives, properly used, have been an important stabilizing factor, not the bogeyman portrayed by Washington.

Few people fully understand the derivatives markets, how they behave, or how they affect other markets. It's a sure bet, however, that the participants know more than the regulators. One leading academic observer, University of Chicago economist Merton Miller, argues that government regulation is the "sand in the oyster" that stimulates much financial innovation. It is a foregone conclusion that any such innovation will run circles around the regulators and congressmen rushing to squelch it.