What is wrong with US capitalism? Las Vegas-style gambling in the banking sector has outstripped the Silicon Valley tech sector.

John Doerr famously said that the internet was the “largest legal creation of wealth in the history of the planet.”

But that creation of wealth is dwarfed by the similarly legal creation of wealth we see through the unregulated trading of derivatives.

Bloomberg reported this morning on Wall Street’s lobbying effort to keep over-the-counter derivatives market, including credit default swaps, legal and unregulated.

Five US Commercial banks — including JP Morgan Chase, Goldman Sachs, and Bank of America — will generate $35 billion in profits this year from trading derivatives contracts, which are really bets on the outcomes of interest rates or securities.

Google, Yahoo, eBay, and Apple, and Cisco — five Silicon Valley technology companies that have created world-changing efficiencies in advertising and commerce and connectivity collectively generated $17.2 billion in profits in 2008. Throw in Microsoft, the world’s leading technology company to the mix, which generated $14.5 billion in their most recent fiscal year and you get about $31.7 billion in annual profits from 6 tech companies that have created enormous value touching nearly every consumer and business in the developed world.

What is wrong with this picture? Has the Las Vegas strip economy finally trumped the entrepreneurial Silicon Valley high-tech economy that so many of us are so proud of?

So-called “Casino capitalism” has thrived in the Clinton/Greenspan/Bush era. This kind of sophisticated capitalism allows banks and fund managers to trade hundreds of trillions of dollars in derivatives contracts and to pocket billions of dollars in profits and bonuses, while introducing massive systemic risk into the global economic system.

My hope is growing that the Obama administration will do something about this massive derivatives problem. It is still growing and it won’t go away without strong government intervention.

The Obama administration has proposed a clearinghouse for the derivatives market, but in my opinion, it doesn’t go far enough. CTFC Chairman Gary Genzler, recently nominated by Pres. Obama and confirmed by Congress, is proposing more strict regulation. Some experts are seeking to ban certain types of credit default swaps completely.

Journalism that sheds light on the actual causes of the global financial meltdown, like last night’s 60 Minutes program on “Financial Weapons of Mass Destruction“, will help to educate Americans and some legislators about the root causes that need to be addressed. Bloomberg’s report shows how outrageous it is that the banking sector can generate such obsence profits from derivative instruments that create systemic risk and toxic assets in their wake.

Why will Wall Street fight so hard? Why do they want to keep swaps and other derivatives legal? Because a large percentage of the financial sectors’ profits since 2000 have come from derivatives and other structured financial products that are complex and unregulated.

Derivatives contracts, since they are not based on actually owning the underlying financial equity or security that they are tied to, create the “toxic assets” on and off the balance sheet of the large financial institutions, hedge funds, and insurance companies (like AIG FP).

When former Treasury Secretary Henry Paulson requested $700 billion from the US Congress in the TARP program, he scared everyone into believing that the global economy would collapse if they didn’t act in just a few days. His plan (which was later modified) was to buy toxic assets (derivatives bets gone bad) from these large commercial banks.

Who thought, back then, that these same banks would continue to trade derivatives contracts (creating more potentially toxic assets) and they they would generate $35 billion in profits this year — after the economic collapse? That offends me, and ought to offend the sensibilities of every American.

The banks are not profiting from traditional banking — loans to Main Street, to Joe the Plumber, and to the small businesses or manufacturing companies that so many politicians talk about. They are making obsene profits from BETS on the outcome of stock prices, interest rates, and mortgage loan portfolios.

And like good bookies, they make money either way, when the markets are up or down, whether the bettors that they sell derivaties to win or lose. But because so many of these banks are “too big to fail,” the government (or the Fed) bails them out. In this environment, banking profits are privatized, but losses are socialized. Do you think any financial industry player who makes millions in annual bonuses for creating and selling derivatives, or because they work for a company that participates in the lucrative derivatives industry, wants to see this game come to an end? No way. They will fight tooth and nail, as they have in the past, to make sure they can continue to play the game.

I wish Congress had questioned Sec. Paulson about derivatives and how much he had personally profited at Goldman Sachs by the creation and selling of derivatives to buyers all over the world. I wish they had understood that the toxic assets he proposed to buy had actually been created by his quants and traders at Goldman Sachs and at a few other leading banks. I wish they had asked questions about how many new potentially toxic assets would be created in the months after the TARP package was approved.

But I know from my trips to Washington and discussions with legislators and staffers and scholars, that very, very few legislators understand what derivatives are, and how they are used to create huge profits for bankers, and high returns to buyers when bets are in the money, but how they spread calamitous risk far and wide to buyers who don’t really understand the bets they are making. They are intentionally complex financial instruments. The more complex they are, the harder they are to regulate. And the less average people care to know anything about them. Talk to your neighbor about “over the counter derivatives” and the causes of the global financial meltdown, and their eyes will likely glaze over within a few seconds.

The list of bankruptcies caused by derivatives bets gone bad has grown very large, but unless something changes in Washington, it will grow longer still.

Orange County went bankrupt in 1994 when the Fed raised interest rates by .25 because all the derivatives bets they had made and generated so much profit from in the previous few years were all based on the Fed NOT raising interest rates. Years of good returns were wiped out in an instant when the underlying index that the Orange County bets were tied to changed slightly.

The $35 billion in profits this year from the five US commerical banks look great to their shareholders and executives now. The stock market is way up this year, housing prices are even starting to rebound slightly. So let’s go out and place trillions of dollars of new derivatives bets on the fact that the recovery will continue.

What we are witnessing, my fellow Americans, as the commercial banks reporting these $35 billion in derivatives-related profits this year is the bulding of the next house of cards — a house that will collapse just as surely as the weight of runaway debt and public spending will slow our economic growth.

To me, reforming our corrupt financial sector is the #1 issue facing our country, because until it is fixed, until we can reign in derivatives trading and trust banks and Wall Street again to do their traditional work of partnering with the commercial sector to create real value — not fictitious profits. Until then, every time I see any corporation reporting any earnings, I have to wonder, how many of them are inflated by gains in their derivatives portfolio? Which company is the next Enron?

Until we reform our financial sector, you never know when a public company reports earnings how many are real and how many are related to derivatives bets they have made.

Even Berkshire Hathaway’s profits are now nearly impossible for an average investor to understand. Warren Buffett and Charlie Munger have always invested in businesses they could understand. BH’s profits were directly connected to things like utilities, insurance, Coca Cola, furniture, carpet, and more. But now, Berkshire Hathaway’s quarterly profits are tied directly to its huge derivatives bets portfolio.

Berkshire reported derivatives gains of $1.53 billion, or $976 per Class A equivalent share, during the latest quarter. That was over $1 billion more than during the same quarter last year.
Berkshire said the derivatives gains in the latest period mainly came from long-term put option contracts the company wrote on major equity market indexes. As stock markets rallied during the second quarter, the value of these contracts increased.
The market value of derivatives have to be recorded each quarter, so this can produce big swings in quarterly results. Operating earnings, which exclude this and other items such as realized investment gains and losses, give analysts and investors a better idea of the underlying performance of insurance companies.
Berkshire has a $37.1 billion portfolio of put option contracts on the Standard & Poor’s 500 Index, the FTSE 100 in the U.K., Japan’s Nikkei 225 and the Euro Stoxx 500 in Europe. The derivatives require Berkshire to pay its counterparties if these equity indexes fall below where they were when the contracts were signed.
Most of these agreements were set up more than a year ago, when stock markets were much higher.
However, the contracts don’t mature for 15 to 20 years, and Berkshire doesn’t have to post collateral to its counterparties. The company also got premiums of $4.9 billion for taking on these risks, and that’s money Buffett has been investing.

Berkshire reported derivatives gains of $1.53 billion, or $976 per Class A equivalent share, during the latest quarter. That was over $1 billion more than during the same quarter last year.

Berkshire said the derivatives gains in the latest period mainly came from long-term put option contracts the company wrote on major equity market indexes. As stock markets rallied during the second quarter, the value of these contracts increased.

The market value of derivatives have to be recorded each quarter, so this can produce big swings in quarterly results. Operating earnings, which exclude this and other items such as realized investment gains and losses, give analysts and investors a better idea of the underlying performance of insurance companies.

Berkshire has a $37.1 billion portfolio of put option contracts on the Standard & Poor’s 500 Index, the FTSE 100 in the U.K., Japan’s Nikkei 225 and the Euro Stoxx 500 in Europe. The derivatives require Berkshire to pay its counterparties if these equity indexes fall below where they were when the contracts were signed.

Most of these agreements were set up more than a year ago, when stock markets were much higher.

However, the contracts don’t mature for 15 to 20 years, and Berkshire doesn’t have to post collateral to its counterparties. The company also got premiums of $4.9 billion for taking on these risks, and that’s money Buffett has been investing. (Source: MarketWatch.com)

Say it ain’t so, Warren! Say it ain’t so.

I know you know you can make good money with these derivatives trades, but the tens of thousands of conservative value investors who own Berkshire Hathaway shares are now in the dark, and they are all violating your fundamental rule of investing only in things that you understand.

I agree with Charlie that many of these types of derivatives should be illegal. You are taking advantage of the fact that they are legal to make a huge profit ($1.53 billion in the last quarter), when you could be raising your voice along with Charlie to educate the legislators and regulators who are still in the dark about the insanity of derivatives. I know you are an investor, first and foremost, but given the risks to the world economy if the unbridled use of derivatives continues, please consider a change in your willingness to trade derivatives.

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For a summary of key dates in the development of the derivatives industry, visit Crashopedia.com, or read books and articles by Frank Partnoy, a law professor at SDSU whom I consider the leading expert on the problems that exists because of the derivatives industry.