Recommending Readings for #FinReg Observers

My position on financial regulation has dramatically changed in the past 2 years since I began following the TARP bailout debates. I think we need smarter regulation and in particular, a systemic risk regulator with tools and resources to prevent Too Big To Fail and future taxpayer bailouts from happening again.

I have spend many hours watching CSPAN hearings, searching in the Congressional Record for historic references to “derivatives,” working on the Crashopedia web site and reading several books on derivatives, the great depression, and economic history. I would recommend several books to others who are following this debate and wanted to be informed by scholars and by history itself about what we are really facing in this debate on Wall Street reform.

Books

13 Bankers: Wall Street Takeover; Next Financial Meltdown (2010) by Simon Johnson, James Kwak

A Demon of our own Design (2007) by Richard Bookstaber

Beckoning Frontiers (1951) by Marriner Eccles

The Big Short (2010) by Michael Lewis

Crisis Economics: A Crash Course in the Future of Finance (2010) by Nouriel Roubini & Stephen Mihm

Infectious Greed (2003) by Frank Partnoy

Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash (2007) by Charles R. Morris

Articles/Blogs

“Recipe for Disaster: The Formula That Killed Wall Street” by Felix Salmon (Wired Magazine, 2-23-09)

Intractibility of Financial Derivatives (Blog Post)

Why This Entrepreneur is Having a Sleepless Night

Dear World.

I bet if I were to ask everyone who knows me – including my family and all my entrepreneurial friends – to guess why I’m having a sleepless night – that no one would be right.

Some of my friends might speculate that I’m having a “platform epiphany” like I did 3 years ago in May when Mark Zuckerberg announced Facebook Platform and I couldn’t sleep until I blogged extensively about the Facebook opportunity for entrepreneurs. On that sleepless night, that blog post was my most successful of all time.  They may think I’m feeling that Google’s I/O announcements this week were keeping me up. But these friends would be wrong.

Some of my friends may know that my iPad 3G arrived this week, and that I couldn’t put it down until 1 am. I suppose I could have stayed up all night browsing the App Store and testing new iPad apps, but friends who think this sleepless night is gadget-induced would be wrong.

Some of my closest friends would know that FamilyLink has been going through our 2nd near-death experience in the past 2 years. (Read about our Dec 2008 near-death experience here.) The recent near-death experience was not caused by a bank loan being called as a recent of a global financial crisis (as the 1st one was), but rather by losing 85-90% of our advertising revenue over the past year as Facebook has changed its Platform, its policies, and taken away many of the most important viral marketing touch points and monetization opportunities that made so many developers happy to bet on the Facebook Platform in the first place. And then, on March 1st, they turned off our ability to communicate with 63 million of our 80 million users of our We’re Related/FamilyLink Facebook application. That was a body blow. We have literally lost $500k per month in revenue in advertising revenue, year over year. How does a startup possibly survive that kind of devastating loss? Well, fortunately we have 17 million registered user that we can still contact. And more fortunately, we had a side-business with 1.6 billion family history records and a subscription model that has been growing since 2006. I have had a lot of sleepless nights during the last 3 months worrying about how to turn on subscription revenue, but tonight is not one of those. We are about 50% there in transforming FamilyLink into a freemium business model, offering billions of family history records to our 17 million users, and turning thousands of them into paying customers, and I think we’ll be 90% there in about 4-6 more weeks. In fact, this was our best week ever for FamilyLink subscriptions and the future looks very bright indeed. With our new VP of Marketing turning on a ton of paid marketing channels in the next couple of weeks (so far 100% of our subscribers have come from our house email list), we see a path to profitability (for the 2nd time) in the next few months. In fact, I don’t think I’ll be losing much sleep about FamilyLink anymore.

So what is causing this sleepless night?

It is a subject so complex that I can almost never bring it up in real conversation without attracting a glazed-over look and body language that says I better change the subject soon because the person’s political fanatic-o-meter is starting to go off.

It is a subject that I have become absolutely passionate about during the past 2 years, so much so, that I’ve considered retiring from my 20-year life as an entrepreneur, forgoing a possible 2nd career as a venture capitalist, and spending my life in some kind of public service in hopes of helping prevent the next global financial meltdown from occuring (an infinitely harder task than building another company with a near-billion dollar market cap.) This is less likely to involve a run for the US Senate than it is to mean taking to qualify for a seemingly boring post in the SEC or CFTC or the soon-to-be-created Systemic Risk oversight committee in an attempt to study and understand and bring true regulatory reform to the currently insane OTC derivatives market.

From September 2008, when I realized a global financial meltdown was occuring (it felt like I was living through something on the scale of the Oct. 1929 market crash) till now, I’ve had dozens of sleepless nights doing research about over-the-counter derivatives. Taken individually (unless the packagers of them were selling them fraudulently by mis-representing why the CDOs or CLOs were being created), each individual derivative makes a lot of sense as a hedge or a speculation. Someone believes something about the future and wants to place a bet on an outcome. It makes sense to the buyer and seller to offset each others bets, and it makes sense most of all to the banks, who act as the bookies on these bets, and make tens of billions of dollars of profit annually selling OTC derivatives.

But taken as a whole, these unregulated derivatives add up to hundreds of trillions of dollars in notional value, and introduce systemic risk into the entire global financial system that is without precedent in world history. Too large of a concentration of derivatives bets gone bad (mainly because there was so much leverage and not enough capital reserve requirements) have led to several previous financial fiascos, including:

  • Barings Bank
  • Long Term Capital Management
  • Enron
  • AIG
  • Bear Sterns
  • Lehman Brothers

Taken individually, most derivative instruments make rational sense to the buyer and seller. They are often viewed as an insurance policy. They are often sold as a way to hedge risk. Like an earthquake insurance policy on your home, it might actually make sense for a company or government treasurer to use a derivative instrument to protect against a future interest rate change, or credit default by a large supplier, or the future price of a certain commodity – like jet fuel.

But would you buy an insurance policy on earthquake insurance for your home from the same company – without regard to their balance sheet – that sold earthquake insurance to all 100,000 other home-owners in the same fault-zone as you?

That would be utter stupidity. And yet that is what we have allowed to happen time after time after time after time after time after time. Since trillions of dollars of OTC derivatives (insurance policies on anything) are NOT exchange traded, don’t have adequate capital requirements, and have such concentrated counterparty risk they become as irresponsible as paying a premium for earthquake insurance on your home to a company that in the event of an actual earthquake of any sizeable magnitude, would have ZERO ability to pay off the policyholders.

AIG FP – one of about 17 or 18 units within a profitable traditional insurance company – was such an “insurer”. And without the AIG rescue by the US Government the failure of this one so-called insurer would have created a domino effect of such magnitude that the worldwide financial system may have freezed up, leading to a horrible worldwide depression.

But AIG wasn’t the only company using OTC derivatives to mint money while the getting was good. When Henry Paulson was CEO of Goldman, that firm was minting money – along with many other huge global banks – by creating all kinds of derivatives products. When these “assets” turned “toxic” – Secretary Paulson had to do something, and so he scared the living daylights out of our representatives in Washington, and against the will of the people, they passed the $700 billion TARP bailout package. Later, the $1.8 trillion purchase of “toxic assets” by the Federal Reserve (which didn’t even need Congressional approval) was viewed by the central bankers as necessary to prevent the whole house of cards from collapsing. Both of these moves may have been necessary – I really don’t know. But it’s the environment that led to the bailouts that I’m most worried about.

Through these bailouts, the US taxpayer became the “re-insurance” company that backed up the small number of insurers who had sold all the earthquake policies to all the home owners in the same fault-zones for years.

And we still have a financial house of cards. No regulatory reform has yet taken place. But the Senate has passed a bill this week, and the House previously passed a bill, and the bills are about to go into reconciliation.

And that is why I am having this particular sleepless night.

I know quite a few things that disturb me:

  • I know that a few banks have tens of billions of dollars in annual profits to lose if they are prevented from using leverage and federal-backing to trade in OTC derivatives, whether they are exchange traded or not.
  • I know that the banking lobby is the biggest and most effective lobby in US history.
  • I know that the biggest donors to congressional campaigns are the financial services companies. Utah’s own Senator Bennett, who serves on the Senate Banking Committee, is (I think) the 4th largest recipient of donations from banks of anyone serving in the US Senate.
  • I know that 18 months ago – based on a private 90-minute meeting in his office on election day 2008, that global systemic risk and OTC derivatives regulation was absolutely NOT a priority for Senator Bennett, and I also know from reading hundreds of pages of the Congressional Record and watching hours of CSPAN hearings that most of his Republican and Democratic colleagues have been clueless until very recently about what derivatives even are. (I must say I have been impressed in the last few months in the rise of financial literacy by the members of several congressional committees.)
  • I know that Senator Byron Dorgan (D-ND), who has been one of fewer than a dozen members of Congress who have been consistently on the right side of the derivatives regulation debate since the early 1990s is retiring from the US Senate this fall.  (If you want to read a very prescient article written by Dorgan in 1994, click here.)
  • I know that the Commodity Futures Modernization Act of 2000, pushed hard by Senator Phil Gramm (whose wife Wendy was on the board of Enron), led to the complete deregulation of derivatives trading at the federal level and invalidated all the state anti-bucket laws (which were passed in the post 1907-crisis era) which could have prevented the 2008 crisis from occuring.
  • I know that Mark Brickell, the former head of the International Swaps and Derivatives Association, was friends with the Gramms, and led a very effective effort in 1994 to defeat any attempt to regulate derivatives using the exact same lies lines that we are hearing today from all the banking lobbyists, such as:
  • “if we don’t allow our banks to trade in exotic derivatives, we’ll lose all this business to Europe or Asia, and it will negatively affect the US economy”
  • “we need lots of exceptions to the exchange-traded requirement so large corporations who need custom derivatives will not be hurt”
  • “we have risk management standards in place, and we have the biggest motivation to self-regulate because if things go south, we are the ones hurt the most” (This lie line which worked extremely well for Mark in the 1990s but doesn’t work as well today, because we all know better now who has the most to lose.)

Last year I flew to Washington to watch an AEI debate on derivatives that featured Mark Brickell, the previously-mentioned former chairman of the ISDA, because I had to meet him in person after reading about his amazing one-man lobby. Frank Partnoy, a former derivatives traded turned law professor, whom I consider one of the fore-most authorities on derivatives, described in his excellent 2003 book “Infectious Greed,” how Mark Brickell almost single-handedly defeated congressional efforts to regulate derivatives back in 1994-1995.

I’ve gotten to know a bit about how legislation is written (largely by the lobbyists themselves), and how blind almost everyone in Washington and on Wall Street is to systemic risk (it’s nearly invisible). I’ve learned how few investors are both brilliant and honest enough to call for a ban on certain types of derivaties. One of those is Warren Buffett’s partner Charlie Munger. He said in May 2009 we should ban credit default swaps entirely. He said recently that no way should JPMorgan Chase be able to trade in OTC derivatives. He knows how corrupt the accounting industry has become in enabling all these shenanigans to continue. George Soros has also called for a ban on credit default swaps.

So here’s why I’m sleepless tonight.

I’m afraid of what is going to happen to the financial reform bill in reconciliation.

I’m afraid we’re going to miss this once-in-a-generation chance to properly reform our financial system to prevent the next global financial meltdown from happening.

I’m afraid that the several things that I have hoped might happen may not happen at all, and that the worldwide banking/betting industry will be free to create and sell exotic derivatives to their hearts content – making billions in profits – while continuing to introduce massive system risk into the global economy.

I am not a scholar and I don’t claim to have a prescription to solve this incredibly complex problem, but I have hoped that a few things would happen in financial regulatory reform.

  • I have hoped that all OTC derivatives would be forced to go onto exchanges – with no loopholes and exceptions
  • I have hoped that leverage would be dramatically reduced and capital reserve requirements increased tremendously for derivatives participants
  • I have hoped that as Charlie Munger and George Soros have both said, credit default swaps should be banned entirely
  • I have hoped that the spirit of the Glass-Steagall Act (Banking Act of 1933) could be returned, so that we could avoid “too big to fail.” I think Blanche Lincoln’s attempt to prevent bank holding companies from trading in derivatives is a courageous and bold attempt to bring back the spirit of Glass-Steagall.

I am afraid that the financial lobby is working around the clock to water down any of the really good provisions of the financial reform bill, and in particular, that they will pull out all the stops to eliminate or prevent Senator Lincoln’s prohibition.

I am worried there is little that any of us can do to influence our representatives, most of whom know very little about how the worldwide financial banking system works, to get things right.

I am afraid that global systemic risk will continue to be the major problem of our generation, and the most likely cause of future economic devastation and the potential collapse of life as we know it.

It is clear that our financial system is fragile. The situation in Greece is illustrative of how interconnected everything is.

It is also clear that we rarely learn lessons from history.

The more I learn about the history of financial crises in the past few decades, the more I realize that we are more prone that ever before to have future crises on an unprecedented scale. I’m not happy that China is now getting into derivatives trading in a big way. (They don’t want to be left behind.) I’m alarmed that a huge percentage of “profits” from S&P 500 companies are coming from the financial sector – not from the real economy – and that we are all living a fiction when we focus on how the economy is improving, because the system risk that underlies everything else – the chance of an 8.0 or 9.0 magnitude financial earthquake – is as high or higher than ever before.

Yeah, so I’m kind of having a sleepless night, worrying about the reform bill, and all that hinges on it, and wondering if there is anything I can do to nudge this in the right direction.

I’ve been trying for 18 months, in my spare time, to get informed, and then to do some nudging.

Frank Partnoy was kind enough to send me about 30 copies of his book Infectious Greed, and with the help of a friend, I’ve been able to get this book in the hands of a couple dozen legislators in the past several months, hoping to contribute to their financial literacy.

For months I spent a lot of hours trying to document the roots of the 2008 financial crisis on a site called Crashopedia.com, but for the past six months, since Facebook hasn’t been so nice to me and my company, I’ve had almost no spare time to update this site. (At the end of this post, I’ll include a dozen or so of my Crashopedia entries listing what happened from 1993 to 1997 that helped contribute to the 2008 crash.)

Ok, so I think I’m finished.

I can go back to bed. And see if I can go back to sleep.

I haven’t accomplished anything except probably annoy all my readers who occasionally visit my blog for my usual posts about entrepreneurship, internet marketing, or less frequently on the genealogy industry.

But I have probably done enough to be able to fall back to sleep, knowing that I at least tried to share something that might be read by someone somewhere, and encourage them to take some time to study and try to understand OTC derivatives and what ought to be done someday, somewhere, by some informed legislators, to prevent a future worldwide economic collapse triggered by whatever is going to trigger it next time.

If you want to spend an interesting hour, just do a Google search on something like

financial crises ltcm barings enron aig

and then check out some of the more scholarly online articles and blogs posts such as:

http://www.finreg21.com/lombard-street/how-deregulating-derivatives-led-disaster-and-why-re-regulating-them-can-prevent-anot

and then ask yourself, is our Senate and our House going to actually pass a reconciled bill that will regulate derivatives adequately, and prevent the next global financial meltdown from affecting billions of people worldwide.

and if the answer to that question is “yes,” go back to sleep.

Goodnight. And sweet dreams.

– Paul

(Okay, as promised, here are some excerpts from Crashopedia.com)

November 1999, DerivativesStrategy.com: “Somebody Turn on the Lights,” By Martin Mayer. Regulators are hindering transparent markets.

Nov 12, 1999 Congress passes Gramm-Leach-Bliley Financial Services Modernization Act which repealed part of the Glass-Steagal Act of 1933 and allowed banks to offer investment, commercial banking, and insurance services. http://en.wikipedia.org/wiki/Gramm-Leach-Bliley_Act

Oct 15, 1998. Brooksley Born (CTFC Chairperson) gives speech on lessons from LTCM collapse, and need for OTC derivatives regulation

July 30, 1998 Brooksley Born, Chairperson of the Commodity Futures Trading Commission (CFTC) testifies before U.S. Senate Committee of Agriculture, Nutrition and Forestry. She says derivatives (including futures) have been regulated for three quarters of a century by the CFTC, and she wants to commission a study on derivatives, since they had changed significantly in the previous five years since the last CFTC study.

“Chairman Greenspan testified just last week before the U.S. House of Representatives Committee on Banking and Financial Services, “I have no doubt derivatives losses will mushroom at the next significant [economic] downturn as will losses on holdings of other risk assets, both on and off exchange.”

Washington Post article covers 1998 meeting of Brooksley Born (CTFC) with Treasury and Fed when she argued for regulation of OTC derivatives. They resist. Mark Brickell shows up here in 98, 99 opposing government regulation. There are transcripts to these meetings.

July 17, 1998 Mark Brickell, JP Morgan Securities, sends letter to Congress opposing derivatives regulations

May 7, 1998 Greenspan: “the major expansion of the over-the-counter derivatives market has occurred in [a] period of unparalleled prosperity. . . [in] which losses generally, in the financial system, have been remarkably small . . . And as a consequence of that, I don’t think that one will fully understand or know how vulnerable that whole structure is until we have it really tested. And eventually that’s going to happen.” (Cite Source)

1997 GAO Report “The 1997 GAO Report, entitled OTC Derivatives: Additional Oversight Could Reduce Costly Sales Practice Disputes, chronicles 360 end-user losses, of which 58% reportedly involved sales practice concerns.” (Brooksley Born, 1998 senate hearing)

1995: Senate votes on Balanced Budget Amendment. Sen Paul Simon on Charlie Rose: http://tinyurl.com/3sbv8k. American public “overwhelmingly support balanced budget amendment.” Wirthlin poll 76%.

1995: Charlie Rose interviews Mark Brickell after Baring Bank failure

October 1994 cover story in Washington Monthly, “Very Risky Business” by North Dakota Senator Byron Dorgan, warns of future financial disasters if derivatives are not regulated. Dorgan wanted to prevent federally insured banks and financial institutions from speculating in these exotic instruments.

July 1994 Article in CPA Journal, “Derivative financial instruments: time for better disclosure.” http://www.nysscpa.org/cpajournal/old/15611641.htm

June 1994: SEC asked to study derivatives by Markey

May 1994 GAO releases 190 page report entitled “Financial Derivatives: Actions Needed to Protect the Financial System”

April 12, 1994: Rep. Henry Gonzales introduces legislation (HR4170) “Derivatives Safety and Soundness Act of 1994” which would require “insured depository institutions to include information on derivative financial instruments” in reports

April 7, 1994: OTC derivatives study called for by Edward Markey (D-MA)

1994 Derivatives regulation legislation introduced by Edward Markey (D-MA):

1994: Credit default swaps invented by JP Morgan bankers on a Florida off-site retreat (Newsweek article).

“I’ve known people who worked on the Manhattan Project,” says Mark Brickell, who at the time was a 40-year-old managing director at JPMorgan. “And for those of us on that trip, there was the same kind of feeling of being present at the creation of something incredibly important.”

“Like Robert Oppenheimer and his team of nuclear physicists in the 1940s, Brickell and his JPMorgan colleagues didn’t realize they were creating a monster. Today, the economy is teetering and Wall Street is in ruins, thanks in no small part to the beast they unleashed 14 years ago.”

1994: Jim Leach introduces legislation to regulate derivatives. A lobby led by Mark Brickell defeats the attempt. (Source: “Infectious Greed,” by Frank Partnoy.)

Nov 3, 1993 SEC Commissioner J. Carter Beese speaks at the International Swaps and Derivatives Association Conference in Washington, DC. “A Roadmap to SEC Regulation of Derivatives Activities.” He said, “I do not believe that derivatives will be the next S&L crisis.” He explained the 4 general themes to SEC regulatory oversight of derivatives activies: 1) risk assessment–the SEC required “securities firms to report on a quarterly basis the size of their derivatives exposure in terms of both notional amount and replacement cost value;” 2) the SEC was seeking public comment relating to the “appropriate capital treatment of derivative products under the Commission’s net capital rule;” 3) since “settlement values under derivatives contracts are largely contingent . . . current accounting rules do not require settlement values to be reflected in firms’ balance sheets,” so he encouraged international efforts to harmonize off-balance sheet accounting, and he mentioned recent FASB rules and also SEC requirements for public companies with “material exposures from derivatives to discuss the commitments and uncertainties” in their reports, under Regulation S-K, Item 303; and 4) coordination between regulators and market participants. He said the CTFC had recently issued a study on derivatives and recommended the formation of an “interagency council” to fulfill this coordination function.

Similarly, in an extreme market stress environment, the liquidity of the nation’s equity markets could be strained by the sell-off of stocks and futures by derivatives dealers trying to adjust their hedges to accommodate rapidly changing market risks. . . . I do think it is safe to say these would be low probability high impact events.

1993: Group of 30, with help from Mark Brickell, prepares recommendations for internal risk management, including daily mark to market. The derivatives lobby used this “best-practices” document for years to avoid regulation by claiming that self-regulation was sufficient and preferrable to government regulation. http://www.riskglossary.com/link/group_of_30_report.htm

Sept 8, 1993 According to EIR, John Hoefle testifies before House Banking Committee, discusses bailout of Citicorp in 1990, and Committee Chairman Henry Gonzalez responds by railing on the speculatives derivatives industry and accuses the participants of creating a mega-Las Vegas. (Find actual transcript of the Committee hearings.)

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.