Most Were Wrong

OK, I admit it. I don't understand derivatives. But I'm trying. I want to understand because Warren Buffett called them "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." He wrote this to Berkshire shareholders in 2002.

I want to understand because the derivatives market has reached an astronomical $531 trillion and has been credited by many as the major cause of our current economic meltdown.

So what are derivatives? Wikipedia defines derivatives as financial instruments whose values depend on the value of other underlying financial instruments. The main types of derivatives are futures, forwards, options and swaps.

At this point I need to post a disclaimer. I know hardly anything about the topic on which I'm about to write. What I know comes primarily from talking to trusted friends and my own personal reading. I reserve the right to change my mind at any time!

OK, back to derivatives. To fully understand how large the $561 trillion derivative market is, we need to put it in context. The following comes from Market Watch.

• The US annual gross domestic product is about $15 trillion
• The US money supply is about $15 trillion
• The current proposed US federal budget is $3 trillion
• The US mutual fund companies manage about $12 trillion
• The worlds gross domestic product for all nations is approximately $50 trillion
• The total value of the world's real estate is estimated at about $75 trillion
• The total value of the world's stock and bond markets is more than $100 trillion
• The 2007 valuation of the world's derivatives is now a whopping $516 trillion, up from $100 trillion in 2002

Throughout the 1990s some argued that derivatives had become so vast and intertwined that they required federal oversight to protect the financial system. Deviates are unregulated and have been referred to as the "shadow banking system" and the worlds largest "black market." The ultimate fear, as Fortune magazine put it, is that swaps and derivatives can cause a "financial Ebola virus radiating out from a failed institution and infecting dozens or hundreds of other companies."

Deviates were originally designed to lower risk for buyers and sellers, a form of safety net or insurance. But they created a false sense of security, allowing financial service firms and corporations to take more complex risks. And the contracts could be traded, further limiting risk but also increasing the number of parties exposed if problems occurred. And then all of a sudden, the virus began to spread.

When you or I get sick, we seek outside intervention. A good doctor and prescription can help us avoid acute illness and keep others from becoming infected. So what went wrong with the unregulated derivatives market?

Many, including the New York Times, pin the blame squarely on Alan Greenspan. Mr. Greenspan, a professed libertarian, expressed resolute faith that those participating in financial markets would act responsibly. As early as 1992, Edward Markey, a Democrat who led the House subcommittee on telecommunications and finance, asked the GAO to study derivatives risks.

The report issued two years later stated, "The sudden failure or abrupt withdrawal from trading of any of these large US dealers could cause liquidity problems in the markets and could also pose risks to others, including federally insured banks and the financial system as a whole."

Even Mr. Greenspan himself warned that deviates could amplify crises because they tied together the fortunes of many seemingly independent institutions. "The very efficiency that is involved here means that if a crisis were to occur, that that crisis is transmitted at a far faster pace and with some greater virulence," he said. But he called that possibility "extremely remote," adding that "risk is part of life."

Later in 1994, Mr. Markey introduced a bill requiring greater derivative regulation. It never passed.

In 1997, the Commodity Futures Trading Commission began exploring derivatives regulation. The commission, led by Brooksley Born, was concerned that unfettered, opaque trading could "threaten our regulated markets or, indeed, our economy without any federal agency knowing about it." In spite of Ms. Born's concern and even the near collapse of the hedge fund Long Term Capital Management, nothing was done.

In November 1999 Mr. Greenspan and others recommended that Congress permanently strip the Commodity Futures Trading Commission of regulatory authority over derivatives. In 2000 during Congressional hearings, Mr. Greenspan argued that Wall Street could be trusted and that Wall Street had tamed risk!

History has proved Mr. Greenspan wrong. Wall Street couldn't be trusted and Wall Street didn't tame risk. We live in a world full of risk, and with people bent on personal gain.

In retrospect, shared risk has evolved from a source of comfort into a virus. Mr. Greenspan doesn't give interviews and rarely speaks in public. He wrote the following in the epilogue of the paperback version of his new book:

"Risk management can never achieve perfection." The villains were the bankers whose self-interest he had once bet upon. "They gambled that they could keep adding to their risky positions and still sell them out before the deluge," he wrote. "Most were wrong."