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The ghastly dangers of unregulated derivatives trading

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According to NY Times economics columnist Gretchen Morgenson and Fed chief Ben Bernanke, using credit default swaps in a way that intentionally destabilizes a company or a country is counterproductive, and Bernanke says the SEC will be looking into it.

Credit default swaps, you will remember, are securities that are supposed to offer insurance-like protection. They are also the instruments that helped tip over the American International Group (AIG) in 2008 when it lacked enough money to make good on the massively mounting claims coming from the huge numbers of insurance contracts of this kind that it had so brazenly sold.

Now there are fears that the use of these insurance policy instruments or "swaps' may also help propel entire countries -- like Greece -- to the precipice and possibly over it. With the able assistance of Wall Street bankers, Greece employed such insurance policy swaps to mask the amount of its indebtedness. And now it appears that some traders are using such insurance policy "swaps" to bet that Greece won't be able to meet its debt payments and will as a result default on them.

Mr. Bernanke is undoubtedly an intelligent man, but his seemingly naive comment that it's merely "counterproductive" to use credit default swaps to crash an institution or a nation exhibits a certain willful blindness--or selective inattention? -- as to how the titans of finance operate these days.

Big bank high-octane trading is counterproductive to taxpayers, for sure -- but not to the speculators who win big when such transactions pay off. And let it not be forgotten: in the case of AIG the speculators got their winnings from the taxpayers!

The certainty that Mr. Bernanke expressed about the coming SEC inquiry into credit default swaps is willfully blind as well. The fact is that credit default swaps and other complex derivatives have proved to be instruments of mass destruction -- yet they still remain entrenched in our financial system three years after our economy was almost brought to its knees.

Derivatives in general are responsible for the collapse that cost taxpayers hundreds of billions of dollars for bailouts. Yet credit default swaps have been largely untouched by financial reform efforts. This is not surprising, given how much money is generated by the big institutions that trade these instruments. Nor is it surprising that these institutions are showering many millions of dollars on members of Congress as a means of protecting their very lucrative, taxpayer-protected gambling operations. (The Office of the Comptroller of the Currency reported that the revenue generated by the credit derivatives trading of America's biggest banks totaled $1.2 billion in just the third quarter of 2009 alone.)

Thanks to very generous campaign contributions from these big banks, congressional "reform" plans for credit default swaps are full of loopholes, guaranteeing that another derivatives-fueled financial crisis awaits us. And the banks can certainly afford to be generous when carrying out this kind of bribery where astounding amounts of monetary value are in play: According to the Bank for International Settlements, credit default swaps with a face value of $36 trillion were outstanding in the second quarter of 2009.

Credit default swaps are "a way to increase the leverage (borrowing ability) in the system, and the people who were doing it knew that they were doing something on the edge of fraudulent," said Martin Mayer, a guest scholar at the Brookings Institution and author of 37 books, many of them on banking. In 1999, he wrote an opinion piece for The Wall Street Journal entitled "The Dangers of Derivatives":

"These "over the counter' derivatives -- created, sold and serviced behind closed doors by consenting adults who don't tell anybody what they're doing -- are also a major source of the almost unlimited leverage that brought the world financial system to the brink of disaster last fall," he wrote, referring to the market turmoil of 1998. "The derivatives dealers' demands for liquidity far exceed what the markets can provide on difficult days, and may exceed the abilities of the central banks to maintain orderly conditions."

Calling credit derivatives "the most dangerous instrument yet," Mr. Mayer concluded in his article that neither banks nor bank examiners have any idea how to handle them. "The system is easily gamed, and it sacrifices the great strength of banks as financial intermediaries -- their knowledge of their borrowers, and their incentive to police the status of the loan," he wrote.

Mr. Mayer was asked for solutions to the problems that credit default swaps have created. He had several:

"Those trading in swaps must be forced to put up more capital to back them so that if a client asks for payment, the issuer actually has the funds on hand to do so.

"This is an insurance instrument and it must be regulated on an insurance basis with minimum reserves required, instead of making deals that don't even have a maintenance margin on them," he said. "Furthermore, it's an instrument that federally insured depositories ought not be allowed to hold or trade."

And yet United States commercial banks, those with federally insured deposits, held $13 trillion worth of credit derivatives by the end of the third quarter of last year, according to the Office of the Comptroller of the Currency. The biggest players in this Wall Street gambling emporium are JPMorganChase, Citibank, Bank of America, and Goldman Sachs.

All of these firms fall squarely into the category of institutions that are too politically well connected to fail. Because of the implicit taxpayer backing that accompanies such lofty status, derivatives become exceedingly dangerous to the American people.

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Several years after receiving my M.A. in social science (interdisciplinary studies) I was an instructor at S.F. State University for a year, but then went back to designing automated machinery, and then tech writing, in Silicon Valley. I've (more...)

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