It all comes down to derivatives

If President Barack Obama really wants to show the other leaders at the G20 summit that he’s smartest guy in the room — and the one with the greatest vision of how to reform the world’s financial industry — he should mention just one word:


Derivatives have exacerbated losses across the globe for nearly 15 years. California’s Orange County declared bankruptcy way back in 1994 after losing $1.5 billion from derivatives contracts. Currency derivatives also hastened the collapse of the Mexican peso in 1994. The Asian financial crisis suddenly roared into view in 1998 after some banks had excluded derivatives from their balance sheets.

They came into use right around the time Diane Keaton, in the Woody Allen film "Manhattan," used the term to snootily disparage unoriginal art. It was an apt description.

A financial derivative is unoriginal in that it is a contract based on a primary asset, such as currency, commodities, stocks, bonds, or loans. Though unoriginal, derivatives can be very artful creations that can enable vast cross-border flows of credit while redistributing risk. They can result in huge losses as well as phenomenal gains. Perhaps because of their artfulness, they have been able to dodge significant regulation.

Frank Partnoy, a former derivatives trader, warned about the dangers of derivatives in his book, Infectious Greed, when it was first published in 1994: “Derivatives tightened connections among various markets, creating enormous financial benefits and making global transaction costs less costly — no one denied that. But they also raised the prospect of a system wide breakdown. With each new crisis, a few more dominoes fell, and regulators and market participants increasingly expressed concerns about systemic risk — a term that described a financial market epidemic.”

This time, it was credit derivatives that spread risk across borders and into the far corners of the world, which nearly collapsed the system.

Credit derivatives are based on mortgages, car loans, corporate loans and others that are bundled together, then sliced into units that are sold off. Buyers make money on the interest generated by the loans. Credit default swaps are sold as insurance against the risk that the loans may go into default.

Banks, hedge funds, investment banks, insurance companies, asset managers and corporations trade these derivatives, which are largely unregulated by governments. They are created, bought and sold largely outside of a transparent exchange and their details are frequently kept off of balance sheets — and away from the view of competitors, regulators, shareholders and, sometimes, top executives.

Derivatives are what AIG had in common with the French bank Natixis, Bear Stearns, Lehman Brothers, Germany’s IKB Deutsche Industriebank and England’s Northern Rock.

Derivatives did not cause the crisis, but they made it worse. The crisis was caused when financial companies did not have the capital to cover their bad derivative bets. Because derivative contracts are often made between private parties, it was not clear to anyone, not regulators or even the financial industry itself, which companies had the greatest exposure.

One of the reasons the bailout is costing U.S. taxpayers so much is that many of the corporations that got into derivative trouble were not regulated as banks. AIG Financial Products was a hedge fund that morphed out of an insurance company. GE Capital became a huge credit operation and hedge fund that grew out of a manufacturing company. In the future, these financial wings of American companies should be required to register and operate as U.S. banks.

If President Obama wants global reform, he should insist that governments require that all derivatives be traded in a transparent fashion, and that all the entities that originate, sell and buy them meet the regulatory and capital requirements of a bank. He should also argue that these entities pay their national governments insurance to both regulate the companies and rescue them if derivatives go wild again. This reform would help restore trust to the system, and set a uniform standard for advanced and emerging markets.

Last week Treasury Secretary Timothy Geithner proposed that standardized and non-standardized derivatives receive different regulations. This seems unwise. If governments only regulate credit derivatives, for example, investment bankers are likely to create some other form of derivative not yet thought of, just to avoid regulation.

In the U.S., the Federal Deposit Insurance Corporation (FDIC) has protected depositors since it was created in 1933, by taking over banks that are undercapitalized. It has handled 45 failed banks in the past year. If the government would expand this independent entity, increase its number of regulators, add more systemic risk evaluators and, yes, derivative specialists, it would be a better way of protecting taxpayers.

It would also provide a model for other countries to follow.

Susan E. Reed is a veteran journalist who has reported on business and international affairs from 34 countries.

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