Wednesday, February 10, 2010
Derivatives: The $595 Trillion Time Bomb
Derivatives, or credit-default swaps, were the primary reason for the financial crisis that rocked the U.S. in the fall of 2008. That financial crisis morphed into the great economic crisis that the U.S. — and the most of the world — is still trying to recover from.
These derivatives, or swaps, are basically bets between companies and banks. In essence, they are insurance policies that Wall Street uses to protect themselves from unforeseen financial calamities.
Brooksley Born, head of the Commodities Futures Trading commission (CFTC) from 1996-1999, realized that there were trillions of dollars of essentially unregulated over-the-counter derivatives in world markets. Because they weren't regulated, the government had no idea what was going on in those markets.
During Ms. Born's tenure at the CFTC, derivatives amounted to a $27 trillion market that was being traded out of sight. The enormous sums of money being exchanged surreptitiously gave her pause.
"My staff began to say how big this was and how little information they had about it," said Born. "We didn't truly know the dangers in the market because it was a dark market. There was no transparency."
Derivatives contracts are unregulated. They aren't traded on exchanges. They are entered into between private parties and there is no oversight. There is no record-keeping requirement imposed on participants in the market. There is no reporting.
It's the perfect environment for fraud, gross speculation and economic disaster.
All of this made Ms. Born wonder. "What was it that was in this market that had to be hidden? Why did it have to be a completely dark market? So it made me very suspicious and troubled."
With trillions of dollars being traded and promised in secret, if something goes terribly wrong, the high-stakes derivatives market could take down the entire financial system. The largest financial institutions can go down like dominoes.
Though she tried to regulate the derivatives markets, it was all in vain. Born was staunchly opposed by Fed Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and Deputy Secretary Larry Summers. The power trio prevailed and squashed Born's attempts at regulation.
Then Long Term Capital Management started to collapse in 1998. Financial institutions that had bought derivatives believed they had insurance and wanted to collect their collateral.
What they didn't know, but soon discovered, was that many other parties were making the same claims on the same collateral.
Despite the implosion of Long Term Capital, which leveraged $5 billion into more than $1 trillion in derivatives, Greenspan and his cronies prevailed once again. There would be no regulation of derivatives.
By 2007, the OTC derivatives market had grown to $595 trillion. Yes, $595 trillion. It is a disaster of epic proportions waiting to happen.
Derivatives are insuring derivatives, which are based on yet more derivatives. The whole system is a huge Ponzi scheme just waiting to collapse. It was, and still is, a ticking time bomb at the center of the world financial crisis.
That crisis has been papered over by massive government and central bank intervention, but it has not gone away. It still lingers, hidden under the surface.
"I think we will have continuing danger from these markets and that we will have repeats of the financial crisis," says Ms. Born. "It may differ in details, but there will be significant financial downturns and disasters attributed to this regulatory gap over and over until we learn from experience."