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The Dangers of Derivatives

Risky derivatives and leveraged securities were the primary cause of the Global Financial Crisis of 2008.  It’s no coincidence this happened after Congress repealed provisions from the Glass-Steagall Act, which was created during the Great Depression to protect depositors.  Without this protective legislation, banks were free to create and sell these types of securities, which later became known as “Toxic Assets”.  The bad news is that we are all still at risk from these securities.

Size of the Problem

The notional amount of outstanding positions in the derivatives market was almost $700 Trillion in 2007.  That’s about 11 times the combined GDP of every country in the world.  I don’t know how others feel about this, but it seems pretty irresponsible to me.   The recent explosion in the volume of derivatives highlights their profitability, but it also creates a lot of risks.

Why this is Risky

Gambling with DerivativesThere are way too many complex derivatives products and they are often used to gamble for profits, instead of being used responsibly for hedging.  Another problem is that over-the-counter trading is non-transparent and poorly regulated.  Also, there are some highly leveraged and naked securities, which have such a high loss potential they never should have been legal in the first place.

The only reason this is allowed to go on is because bankers and brokers are making a fortune off of these products. In case anyone thinks I’m overstating this problem, here are some examples.

High-Profile Failures

AIG Bailout Taxpayers are painfully aware that over 100 billion dollars was spent to bail out AIG.  What most taxpayers don’t understand is why.  AIG was engaged in the selling of Credit Default Swaps, which exposed them to total losses of around $100 billion.  Since they weren’t properly reserved or hedged against these losses, the Government stepped in to bail them out, with our money.

Bankruptcy of Orange County In 1994, Orange County, CA was bankrupted by Treasurer Robert Citron.  Citron purchased derivatives called Inverse-Floaters that were tied to interest rates.  When interest rates rose, these securities lost two billion dollars in value and the county was forced into bankruptcy.  Citron plead guilty to six felony counts, but never spent a day in jail.  Orange County taxpayers were stuck with the tab and 3,000 public employees lost their jobs.

Long-Term Capital Management LTCM was a high-profile hedge fund, which failed in 1998.  LTCM engaged in various leveraged trading strategies, including Fixed Income Arbitrage, Interest Rate Swaps and Pairs Trading.  The East Asian Financial Crisis and a Russian Bond Default caused liquidity problems for LTCM, resulting in $4.6 billion of losses.  The Federal Reserve engineered a bailout by a number of large investors to avoid further disruption to the financial system.

Failure in Regulation

Bank regulators don’t seem to have learned anything from their continuous series of failures, except how to unload the losses onto taxpayers.  Speculation-based bank defaults date all the way back to the Great Depression and the Bank Panics of the 1800s.  Yet, we seem no better protected today then we were back then.  Even as the Federal Reserve grabs for more power over our financial institutions, it has become obvious they are a source of the problems.

New Laws on the Horizon

According to Reuters, Congress is considering curbs on speculation in the Credit Defaults Swaps markets and they may ban naked swaps outright.  Congress also wants to shift oversight from the Federal Reserve to the Securities and Exchange Commission (SEC).

The Obama administration wants to curb over-the-counter trading, by forcing these derivatives through a clearinghouse, if they are not traded on an exchange.  This would make these trades more transparent to regulators.  The White House is expected to release this proposed legislation sometime today.

The Bottom Line

The bottom line is that financial institutions can’t be trusted when profits are at stake.  And, our banking systems will never be secure as long as high leverage is allowed for speculation.  Until we get some real oversight and practical limits on leveraged securities, we will all be at risk of more banking failures in the future.

We can’t allow bankers to regulate themselves.

“In gambling, the many must lose in order that the few may win.”

George Bernard Shaw – Irish Playwright

Recommended Reading

There was a fantastic article in Rolling Stone that details how Goldman Sachs manipulates the futures and commodities markets. The author Matt Taibbi also explains how Goldman Sachs uses it’s political clout to affect legislation and eliminate protections for consumers.  I shied away from describing commodities manipulation in my post, but the markets are definitely inflating the costs of items such as oil and we are paying for it.  If you want further evidence of how we are being taken for a ride by investment banks, this article is definitely worth reading.

This post was featured on the Carnival of Personal Finance. If you aren’t familiar with the Carnival of Personal Finance, it’s the premiere carnival of its kind. If you want to read informative articles from knowledgeable bloggers, this is the place.

3 comments to The Dangers of Derivatives

  • Mom

    Was the proposed legislation to curb derivatives (on July 30th) ever released? I’m surprised that the SEC doesn’t try to regulate these and also the commodities manipulation. What, exactly, is the function of the SEC if not to regulate the functions of the market?

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