Philip Luhmann is a soft-spoken man, known for his crew cut, his conservative suits and his money handling skills.

For more than two decades, Mr. Luhmann oversaw the endowment of the City Colleges of Chicago, a vast system of seven community colleges and 83,000 students. So there was no surprise on the morning of Feb. 3, when he told the college's seven-member board that the system's finances were in good shape. After all, Mr. Luhmann had helped direct investments that made solid gains in the last two quarters of 1993.

Later that afternoon, however, the 62-year-old finance wizard walked into the office of Vice Chancellor Leonard Sippel to say he had omitted one fact from his report that morning: He had committed more money than there was in the endowment to risky investments -- about $100 million in all. Losses already reached into the millions and the college system had 24 hours in which to pay a $34 million loan.

The college's endowment had nearly been wiped out.

"Before that we had absolutely no indication what was going on," recalls Jacqueline Woods, vice chancellor for external affairs. "He was telling us that everything was OK."

Mr. Luhmann's free fall to disaster began when he began buying derivatives, the latest products cooked up by the Wall Street traders who last whipped up the junk bond craze.

Derivatives is a catch-all term for virtually any financial arrangement whose value is based on -- or "derived" -- from an underlying currency, index, future or equity security.

Money managers use derivatives to control their exposure to fluctuations in interest rates, currency markets and the stock market. Many of the latest products are just glorified barter arrangements. A firm can save money by trading or swapping currencies, debts or commodities just like at a neighborhood swap meet. For example, a company that is worried that the value of the dollar will fall overseas, might swap its dollar debts for debts in another currency. By doing this, it shields itself from the decline in the dollar.

While each swap may seem like a simple, straightforward trade, these days a single derivatives transaction may involve dozens of swaps, involving banks all over the world like the strands of a spider's web.

Investment banks need legions of specialists who use the latest high-powered computers just to keep track of swaps they have at any one time.

The problem is that instead of using these derivatives to avoid risks, investment banks, speculators and even mutual funds are increasingly using them to make huge bets in a form of financial gambling.

In Mr. Luhmann's case, he made a long-term bet that interest rateswould continue to fall. When they didn't, the market for his securities dried up. Their value went into free fall. Many experts in the field warn that there will be more massive wrecks like Mr. Luhmann's.

"With rapid growth in the industry, investment banks will be out there offering derivative products to a wider range of participants, who may have little understanding of them," says Lee Wakeman, a former finance professor who now heads the derivative firm TMG Investment Products in Greenwich, Conn. "That's a recipe for more explosions."

Derivatives seem tailor-made for such disasters:

* The market has exploded and continues to expand by more than 20 percent a year. Estimates on the amount of money already in derivatives ranges from $7 trillion to $16 trillion --

almost three times greater than the entire gross national product of the United States.

* Transactions are largely unregulated. With money flowing across dozens of international borders, the trade is virtually hidden and impossible to track.

* The investments are terribly complex and carry great risk. But with selling so aggressive, derivatives products are finding their way into the hands of investors, mutual funds and companies neither equipped to understand them nor capable of sustaining the huge losses that could befall them.

Some experts say a default at a major dealer could bring the whole system crashing down, wreaking havoc on markets that could dwarf the savings and loan crisis.

Big banks may have far more money in derivatives contracts than they have total assets. For example at the end of last year Bankers Trust in New York had $92 billion in assets, but over $1.9 trillion in derivatives contracts.

Those worries have not been lost on Congress, and many blame derivatives trading for exacerbating the recent stock market turmoil.

Citing the dangers derivatives pose to the stability of world markets, House Banking Committee Chairman Henry B. Gonzalez, D-Texas, introduced legislation last week to require banks and other derivatives dealers to disclose more of their activities, increase the enforcement powers of regulatory agencies and ask the secretary of the Treasury Department to work with other industrialized countries to improve international oversight.

Federal Reserve Chairman Alan Greenspan has also voiced concern about the risks, and a former president of the Federal Reserve Bank of New York has gone one step further -- warning of fundamental danger to the banking system.

Even billionaire investor George Soros, known for his risky investment strategies, has gotten into the act. Mr. Soros, testifying before the House Banking Committee last week warned that increasing use of derivatives could dangerously add to the volatility of the stock and bond markets.

"There are so many of them, and some of them are so esoteric, that the risks involved may not be properly understood even by the most sophisticated of investors," he said.

Regulatory responses are just in their preliminary stages. The Financial Accounting Standards Board, which sets corporate accounting standards, released a proposal on Friday that would require increased disclosure of derivative risks in financial reports.

An interagency task force on derivatives, which includes staff members from the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp., began meeting last fall to coordinate efforts to bring about better disclosure.

Mr. Gonzalez said that so far the regulatory response to hedge funds and other derivative gamblers has been far too week.

"To me, it's like an electronic Ponzi scheme that is eventually going to cause us some dangers," said Mr. Gonzalez, comparing the speculative use of derivatives to a pyramid gambling scheme.

Even conservative companies can get trapped. Last week, for instance, consumer products giant Procter & Gamble, parent company of Hunt Valley-based cosmetics maker Noxell Corp., announced it lost $102 million after getting caught on the wrong side of a derivative-based bet that interest rates would remain low.

"Derivatives like these are dangerous and we were badly burned. We won't let this happen again," said Edwin L. Artzt, chairman and chief executive officer.

But Joseph Bauman, a senior official in Citibank's global derivatives group, suggested that such failures should be blamed on poor management rather than dangers inherent in the derivatives themselves. Dire warnings about a possible collapse FTC of the banking system because of derivatives, he said, often are made by people who don't understand their complexities.

"It is a knee-jerk reaction to numbers that are very big and activity that has grown very quickly," said Mr. Bauman, who also is the chairman of the International Swaps and Derivatives Association.

These days most major companies feel derivatives are too valuablea tool to abandon.

"Anyone in my position, if they are not using them, or not seeing if they can use them, are not doing their job," said Edmund P. Reybitz, treasury manager for Bethlehem Steel in Bethlehem, Pa.

Careful use can save money

Careful use of swaps and other derivatives can save big money. For example, over the last few years, aerospace and engineering firm Allied Signal of Morristown, N.J., swapped fixed-rate debt with high interest rates, for variable rate debt, according to assistant treasurer Roger C. Matthews. As interest rates fell, the company was able to save millions of dollars on its $2 billion in debt, he said.

But others say that with so much derivatives users need to keep track of, bigger mistakes than those at City Colleges and Procter & Gamble are inevitable.

"It's only a matter of time before somebody of much higher profile than the City Colleges takes a bath," said Paul Spraos who publishes Swaps Monitor, a derivatives industry newsletter.

In fact, it has. In Harford County, the site of one of the more bizarre cases in recent financial history after a huge German metals and energy conglomerate chose to base its American derivative trading operation in a two-story brick building in rural Forest Hill.

Last year, the unit of Metallgesellschaft, or MG, began trading a huge volume of derivatives related to petroleum products -- gaining control of 150 million barrels of oil in a titanic bet that prices would rise. The maneuver was similar to the way the Hunt brothers tried to corner the silver market in the late 1970s.

But oil prices fell to a five-year low last fall, and by winter, the Metallgesellschaft unit had lost more than $1.3 billion.

The company maintains that traders in the squat building 30 miles from Baltimore, and in New York and Houston, misled the firm's board about their risky trading strategy. The traders deny the claim.

Speculation of mass damage

But one thing is sure, when the smoke cleared, a $15-billion company with more than 42,000 employees was on the verge of bankruptcy. The firm was only saved by a last-minute bailout by a consortium of international banks.

Some experts argue that if Metallgesellschaft, the 14th largest company in Germany, can be brought to the brink of collapse by an obscure trading operation, what's to prevent a renegade group of traders at one of this country's huge banking concerns from bringing the firm down?

"How can all the major players be so sure about what is going on in their own back yards?" asked Raymond F. DeVoe Jr., who directs market forecasting for Legg Mason Wood Walker Inc. in New York. "Who knows if there isn't some computer nerd out there building the equivalent of an atomic bomb with these things."

Others discount such a possibility. "It is an exaggerated concern,"said Mr. Bauman.

"Derivatives dealers have their livelihoods staked at understanding these risks," he said. "The reason we are around is financial risk, we pay careful attention to the threats that are there."

But the failure of so many savings and loans in the late 1980's gives little comfort that financial institutions can successfully police themselves. The reality today is that neither the skeptics nor proponents are sure about the extent of the derivative system's dangers.

"Nobody knows what could happen in the event of a default," said Mr. Spraos. "Would there be a domino effect? Nobody is even close to figuring it out."

A GLOSSARY

Derivatives are financial contracts whose value depends on -- or derives from -- an underlying financial security, such as future stock prices or interest rates. Some examples:

* Interest rate swap. An agreement to swap fixed-rate interespayments for variable-rate interest payments, or vice versa. For example, a debtor paying a variable rate may be worried about the threat of rising interest rates and may swap for fixed-rate payments as a hedge.

* Interest rate cap. A contract that allows the holder of variable-rate debt to be compensated if interest rates rise above a certain level.

* Forward foreign exchange transaction. A deal to lock in a future currency transaction at today's exchange rates. Often used by companies that make money overseas and want predictability in exchange rates.

* I/O, or interest-only contract. A deal to buy only the interest payments that a homeowner makes on the mortgage, usually priced at a discount. If interest rates rise, the I/O holder will get payments for years as the homeowner pays off the mortgage. If interest rates fall, the homeowner may refinance, ending the I/O holder's right to receive payments. The I/O holder's investment would be wiped out.

* P/O, or principal-only contract. A deal to buy only the principal portion of a mortgage. If interest rates fall and the homeowner refinances, the P/O holder will be paid off quickly and make out well. If rates rise, the P/O holder will have to wait for the money.