Derivatives. Everyone has heard of these opaque financial instruments that only the wizards in Wall Street seem to understand, but what are they exactly? In the financial sense they are essentially a contract between two parties to trade an asset at a certain time or specific market condition. That is the explanation you will probably hear from someone on Wall Street right before the scoundrel forecloses on your home, but in reality a derivative is a bet.
If you have ever bet on a sports game or used the insurance option in game of blackjack congratulations, you have entered into a derivative contract. The bet made on, say, whether a certain team will win a basketball game is deriving its value off the outcome of the game. So in this scenario the bet is the derivative contract and the game is the asset, and whether your team wins or loses is the payment structure. Now you are probably wondering, “Well, if this is the type of business that is going on in Wall Street, how is it any different from gambling?” The difference is when you lose a bet you have to pay up and if you don’t there is a distinct possibility you might get your legs broken—that is if you’re dealing with the mob. But in Wall Street if bets go wrong Uncle Sam or rather the US taxpayer foots the bill and firms like Goldman Sachs leave with their legs intact. Derivatives like credit default swaps were created with the best intentions to hedge risk associated with market forces, but as the old saying goes: the road to hell is paved with the good intentions.
There are many types of derivatives; options and futures are some of the most well known and have been around for centuries. Yes, centuries. The first known futures contract took place in ancient Greece between the philosopher Thales and owners of olive presses. Thales predicted there would be a bountiful harvest of olives in the months ahead and negotiated a contract to buy the use of the olive presses in the future at a specified date. The owners agreed to the contract since they were going to be paid that day for their use sometime in the future. Thales prediction came true, and there was a large harvest of olives and he had control of all the presses which he rented out at exorbitant rates. On paper these financial machinations seem simple but their complexity lies in the details of the trade, and a credit default swap (CDS) is a prime example of a simple financial instrument with lurid details.
A CDS is similar to an insurance policy entered into between two parties. Say you are an investor who buys a bond but is uncertain whether the bond issuer will keep paying interest; you decide to enter into a CDS with American International Group (AIG). The contract states that as long as the bond keeps paying interest the investor will pay AIG an insurance premium for insuring the bond, and if that bond doesn’t pay out interest it defaults and AIG will pay the investor the amount owed to him after the default. Seems like a great deal—the investor gains protection and AIG gains premiums—it’s a win-win for everyone. Except in this contract AIG does not have put away money to pay the investor if the bond defaults and there lies the devil in the details.
According to a Frontline documentary, “Money, Power, and Wall Street,” CDSs were created in the 90s by a group of hot shot bankers at a conference in Florida. The purpose of these creations was to mitigate risk associated with loans. They were first put to use during the Exxon Valdez spill when Exxon took out a letter of credit from JPMorgan to serve as guarantee for lawsuits. Usually banks have to put aside funds to meet the obligation if Exxon does not pay, but in this case JP Morgan entered into a CDS contract with another bank, paying a premium to have the risk transferred to them.
That transaction led to creation of a portfolio of CDSs on various company bonds known as Synthetic CDOs. Synthetic CDOs are made of many CDSs with varying degrees of risk which parties can buy into and earn premiums from the bank as long bonds don’t default—the higher the risk, the higher the premium. The synthetic aspect is referring to the fact the investor does not own the asset but is betting on the future outcome of the asset. It were these instruments that were used in the Goldman Sachs-Abacus deal which reaped large profits for Goldman when the reference securities tied to the housing market became worthless.
There is a reason why insurance companies are some of the most highly regulated companies in the US—they provide protection to consumers from unforeseen circumstances, and to provide protection against calamities they have to be well capitalized to meet those obligations. A CDS is a form of insurance but thanks to heavy lobbying from big banks, CDSs and other types of derivatives were exempt from any type of regulation and were allowed to be traded in the Over-The-Counter or OTC market. AIG was a large player in the CDS game, selling them on CDOs (collateralized debt obligations)—securities made up of home loans—to anyone willing to buy naively, believing that the housing market will only go higher and higher. Moody’s and other rating agencies gave AIG an AAA rating, the highest rating of credit worthiness, which meant they did not have to set aside funds to pay those obligations if they came due. Then in 2008 the housing market crashed and CDOs became worth less than the paper they were printed on and AIG found itself indebted to a myriad of investors and institutions. The proverbial straw that broke the camel’s back was the failure of Lehman Brothers, which exposed AIG to large commitments it had promised to pay if Lehman went bankrupt and AIG could not pay. If AIG was allowed to fail it would have taken down the entire financial system with it and put us on the road to, as Wall Street super lawyer H. Rodgin Cohen dubbed it, financial armageddon.
By the end of 2010 the Bank of International Settlements valued the OTC derivatives at $601 trillion dollars, including CDSs and other derivatives. The Great Recession should have opened our eyes to the dangers of CDSs and the need for regulation in OTC derivatives market, but thanks to heavy lobbying from banks and investment firms regulation of these devices have been halted. Instruments like CDSs could have destroyed the entire financial system and the entire economy and still they are allowed to be traded freely. No wonder Warren Buffet called them “Weapons of Mass Destruction.”
Congress and the president need to act and bring this dark market to light. Rules need to be passed that regulate companies that issue CDSs and have them put aside collateral to meet their obligations even if they are AAA rated. The ratings agencies also need to be better regulated and a specific set of rules need to be set by the SEC for a company to receive a AAA rating. A primary rule should be that any firm who engages in CDSs must have enough collateral to meet all obligations if they came due at once and if they don’t they need to unwind their positions.
Another solution is to reinforce the Volcker Rule, which bans proprietary trading by banks. The original draft was only 10 pages, but thanks again to lobbying efforts by large banks it has now ballooned to 300 pages of exemption and loopholes. The Abacus deal performed by Goldman Sachs would have never happened if the Volcker Rule existed. Goldman chose the securities which they knew were toxic waste and, using Synthetic CDOs, traded the credit risk to unsuspecting clients who assumed the assets were safe and when the market crashed reaped huge profits. A clear conflict of interest which many would perceive as criminal yet no Goldman Sachs executives was ever charged with securities fraud.
If we don’t start to regulate the derivatives we could wake up one day and find ourselves in crisis similar to 2008 or worse. The purpose of derivatives was to mitigate and hedge risk. Lets make sure these instruments are being used the right way.