NO SKIN IN THE GAME:

Too Bad Not to Fail: Just what are derivatives, and how much more damage can they do? (William J. Quirk, American Scholar)

Until the 1990s, investment banks--the institutions that help corporations and governments raise capital by underwriting and issuing securities--were organized as partnerships. Under that setup, the general partners risked their personal net worth on the solvency of their firms and regulated the bank's activities with the knowledge that they were liable for any losses. When almost all the partnerships reorganized into corporations, investment banks became, in effect, liability casinos operated by croupiers unbridled by long-term financial responsibilities. The sole object was to maximize day-to-day profits.

Bankers bought and sold something few Americans had heard of before: derivatives. These instruments were hard to define, we were told, yet they were heralded as financial "innovations" designed to minimize risk and were reassuringly referred to as "insurance," "protection," or "hedging." Other strange terms--"tranches," "mezzanine," "regulatory arbitrage," and "repos"--surfaced at the same time.

What are derivatives? They are financial contracts whose value is derived from a security such as a stock or bond, an asset such as a commodity (crude oil, sugar, copper, etc.), or a market index. Derivative is used to cover contracts of many different kinds, some dating back hundreds of years; others, until the 1990s, were unknown to man. Midwestern grain farmers, in the early 19th century, sometimes sold their crops while they were still growing. That is a futures contract, a kind of derivative, the likes of which have been traded on the Chicago exchanges since Civil War times. They are helpful to all parties. Southwest Airlines, for an­other instance, can assure itself the price of jet fuel in the future by entering into a contract--a derivative.

A synthetic collateralized debt obligation (CDO), the subject of the Security and Exchange Commission's lawsuit against Goldman Sachs this April, is also a derivative. But before you can have a "synthetic" CDO, you have to have an actual CDO. What's that? Say that a person who is a poor credit risk takes out a mortgage he can't afford. Thousands of such mortgages are collected into a security--a mortgage-backed bond. Then a number of those bonds are collected into another security. This is a CDO that is sold to investors. A "synthetic" CDO refers to an actual CDO with no underlying asset, meaning, in this case, no mortgages. It is essentially a wager, and, like any bet, it requires two sides: a "long," who is betting that housing prices will go up, and a "short," who is betting that housing prices will decline. The short bettor, by means of a credit default swap (CDS), agrees to pay the interest owed to the long bettor. In return, the long bettor agrees to pay the principal of the CDO if it defaults. Goldman was the bookie who put the bets together; Rube Goldberg would have blanched at such a grotesque contraption.

The problems with derivatives are abundant and far-reaching:

There are no caps on the numbers, which generally are immense--big enough to bring down world markets. The derivatives market is $600-800 trillion--about 10 times the $70-trillion output of the world economy.

The terms are so complex that they are only dimly understood by the parties entering into them as well as by the regulators who are supposed to police them; in fact, no one knows how to regulate them.

By putting the economies of U.S. allies in jeopardy, they can too easily undermine American national interests.

September 2008 was when we learned that the big banks were earning most of their profits from dealing in derivatives and, by the way, that the financial statements they were issuing were worthless because derivatives were extensively used to evade accounting, legal, and regulatory requirements. The air of mystery and impenetrable lingo were no help when the banks went bust and put the real economy at so dangerous a risk that the U.S. government committed $23.7 trillion in cash and commitments to bail them out. The bailout was outrageous on its face, even before details about what the banks were doing were made public. Then we learned that the Federal Reserve and the Treasury Department, which are charged with regulating U.S. currency, and the Securities and Exchange Commission (SEC), whose mission is to protect investors and maintain fair, orderly, and efficient markets, hadn't adequately scrutinized the banks or their derivatives.

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