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It all comes down to derivatives

Opinion: Here's the back story on the true villain of the global economic meltdown.

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.