[ed. Also, if you're up for a good scare: The next financial crisis will be hellish, and it's on the way (Forbes).]
by William J. Quirk, American Scholar
In “Babylon Revisited,” F. Scott Fitzgerald’s 1931 short story about the aftermath of the 1929 Wall Street crash, Fitzgerald makes the point that such collapses are slips in morality as much as financial failures. Charlie Wales, the story’s emotionally fragile hero, returns to Paris in a desperate effort to regain custody of his nine-year-old daughter. “I heard that you lost a lot in the crash,” says the Ritz bartender. Implying his moral lapses, Charlie replies that yes, he did, “but I lost everything I wanted in the boom.” In fact, upper-middle-class people like Charlie hesitated during the first months of the market’s run-up—until early in 1928. That was when they joined the gambling frenzy, and that was when, as John Kenneth Galbraith wrote in The Great Crash, 1929, the “mass escape into make-believe, so much a part of the true speculative orgy, started in earnest.”
Eight decades later, stock-market investors like Charlie had no role in bringing on or profiting from the 2008 financial crisis. This time they stood on the sideline as major financial institutions engaged in a speculative orgy. Guided by no moral compass, the most sophisticated financial players in the world were betting big with one another about interest rates, commodity prices, and whether companies or governments would default.
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:
Read more:
Photo: New York Stock Exchange Advanced Trading Floor, New York, 2001 (Eduard Hueber, courtesy Asymptote Architecture)
by William J. Quirk, American Scholar
Eight decades later, stock-market investors like Charlie had no role in bringing on or profiting from the 2008 financial crisis. This time they stood on the sideline as major financial institutions engaged in a speculative orgy. Guided by no moral compass, the most sophisticated financial players in the world were betting big with one another about interest rates, commodity prices, and whether companies or governments would default.
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.
Read more:
Photo: New York Stock Exchange Advanced Trading Floor, New York, 2001 (Eduard Hueber, courtesy Asymptote Architecture)
