I belong to a small non-partisan group called Americans Against Exotic Derivatives (AAXED). Our primary goal is to educate our elected representatives in Washington, D.C., about the conditions that led to the global financial melt-down.
Our first project is to get a copy of a very important book in the hands of all 535 members of Congress. The book “Infectious Greed” published by Frank Partnoy in 2003 documents all the major derivatives-related financial crises since the 1980s, and predicted (5 years before it happened) more and bigger financial meltdowns if the regulatory system didn’t change.
Frank Partnoy is a former derivatives trader, who teaches law at San Diego State University. He has appeared on NPR twice this year, and writes many articles and columns for publications such as the New York Times and Financial Times. I want our lawmakers, who create and oversee the regulatory agencies that are supposed to protect consumers and taxpayers against fraud and foolery in the markets, to learn what Frank Partnoy knows.
For example, Frank documents how a .25% increase in interest rates in 1994 by the Federal Reserve led to the bankruptcy of Orange County within a year. Orange County’s 70-year old treasurer Robert Citron had been using exotic derivatives (highly leveraged bets that interest rates would NOT go up) to generate the highest returns of any US county treasury for years. But as soon as .25% interest rate hit, Orange County lost that bet, and lost billions of dollars, which led to bankruptcy.
What happened to Orange County has now happened in one degree or another to hundreds or thousands of banks, corporates, and purchasers of “mortgage-backed securities” and other derivatives products. In addition, there are currently $57 trillion dollars in outstanding “credit default swaps”–another derivative product–that mean that some people profit big when companies like GM go bankrupt. So more collapses of more large corporations are sure to happen. Large players with huge incentives for one outcome or another have ways and means to influence things going their way. Manipulation of markets (and even national currencies) happened in the 20s and 30s and happens all the time today–on a small and large scale. It’s a free-for-all right now.
The international banking system has become a Las Vegas-style casino, where traders sells big bets to corporations, banks, insurance companies, pension funds, private equity funds, and hedge funds, who all want to make big bets on interest rates, currencies, markets, and all kinds of other variables, so they can get the higher-than-average returns that everyone wants. This is all about greed.
Meanwhile, our elected representatives in Washington DC (who don’t understand precisely how bankers and traders make such obsene profits from derivatives but receive huge campaign donations from the financial lobby to maintain the status quo) basically allowed the lobbyists from the finance sector to write the laws that deregulated all this stuff. The International Swaps and Derivatives Association (ISDA) in particular had a major hand in actually writing the legislation that allows for hundreds of trillions of dollars of OTC derivatives to go completely unregulated by any federal or state agencies.
Partnoy’s books and articles document all of this very clearly. His personal website links to much of his work.
I want my elected representatives to understand how laws and regulations can prevent future economic meltdowns. Regulations can prevent bankers and traders from creating and selling exotic derivatives and structured financial products that claim higher-than-average returns and lower-than-average risk but in reality create massive global systemic risk.
The Obama administration is now talking about some regulatory reform that could reduce the risk of a future global meltdown, but may not be going far enough. Charlie Munger (Warren Buffett’s straight-talking partner of 44 years) says the financial industry will unleash an “awesome” lobby effort to stop any real reform. Munger says we should ban 100% of the kinds of derivatives that led to the recent collapse.
The banking sector, whose profits over the past several years have been obsene as they have created and sold hundreds of trillions of over-the-counter derivatives to buyers world-wide, does NOT want regulatory reform to stop them or slow them down in any way. They like their billions of dollars in profits and millions of dollars in personal bonuses that come as Wall Street “quants” invent new structured financial products that promise high returns with low risks, but in reality created hidden “toxic assets” that eventually come back to bite.
We need your help. We are trying to get a copy of “Infectious Greed” (2003) by Frank Partnoy in the hands of every member of Congress by the end of June.
But we don’t want to just send 535 copies to Washington, D.C. Instead, we want an actual constituent in each congressional district, preferrably someone with serious business or finance experience and credibility to hand deliver a copy of the book (and an accompanying quick reference guide) to their elected representative in person. Preferrably while they are in their home state–and not while they are in Washington, DC.
We want to make sure that members of Congress take this seriously, and either read this book personally or assign a senior staffer to do so. Frank Partnoy spends a lot of his time in Washington trying to explain all these complex financial and regulatory issues to staffers in Congressional offices–but we need more help.
I have heard from both bankers and legislative offices, “You must be one of only a handful of non-bankers in Utah that understand this stuff.” That is very scary to hear. I’m new to all this stuff. I first heard Warren Buffett warn about derivatives in 2005, but I didn’t start studying them in depth until last September. It is clear to me that if we don’t get enough of the general populous to understand how derivatives and structured financial products benefit traders and bankers while creating massive systemic risk (which puts taxpayers at risk for future bailouts and everyone at risk for future currency devaluation through inflation) and if we don’t get enough of our representatives to understand how they can prevent the markets from incenting traders to gamble with billions of dollars for short term personal gain, then we will be doomed to repeat history. The next global economic collapse will be years away, and it will be even bigger next time.
We need to find capable people with clout in every Congressional district in the country, who will at least hand deliver important scholarship to those in governing roles in our country, or will at most, personally spend time getting involved in researching the topic of derivatives and financial regulation and educating others.
We are looking for the following:
- More citizens to join Americans Against Exotic Derivatives (AAXED) –which is right now just a group on Facebook.
- Volunteers to help us identify business leaders in every congressional district who are interested in helping. We are using LinkedIn.com to find potential helpers in each district and are tracking all the congressional districts using a shared Google spreadsheet.
- A web site developer to turn the Facebook group and the Google doc into an interactive Web site, where people can join and get involved. We want people to be to tell us what congressional district they live in, and how they are connected to their congressional representative. (Who they know in congress, or who they know who knows someone in congress.)
- Donations to purchase more copies of “Infectious Greed.” We have about 30 copies already. (We don’t have a way to accept donations yet, but we can set that up quickly if someone wants to provide funds. It may be better just for people to buy the books and send them to us.)
- An editor to produce the Quick Reference Guide to Infectious Greed. We’ve already identified about 200-300 important passages that we want to capture, along with page numbers. We need someone to review this list, edit it, improve it, and lay it out into a simple card that can accompany the book.
- A volunteer to run a Twitter account where we will be tracking the discussion worldwide about derivatives and derivatives legislation. Since 117 members of Congress already use Twitter (or have a staffer that uses Twitter), we are confident that we can use Twitter (in addition to LinkedIn) to find people who are credible and connected to their representatives.
- Volunteers to maintain the Crashopedia website, which attempts to track the causes of the global financial meltdown, as well as efforts to regulate the derivatives industry, in order to prevent future collapses.
I understand that getting volunteers to organize a citizen lobby in such an esoteric subject area as derivatives regulation is nearly impossible. It’s not like recruiting a million people to protect their Second Amendment rights or to protest tax increases. The financial industry makes derivatives intentional complex, so that only insiders can understand how they work and what things mean. There are dozens of acronyms to describe the financial products that traders have been selling over the years–CBOs, SPEs, CDOs, CMOs, SIVs, CDSs, MBS, RBS, and many more. There are multiple regulatory agencies and government offices that average people don’t understand–the SEC, CTFC, GAO, CoC, OTS, etc.
And there are investment banks, holding banks, hedge funds, private equity funds, online clearing houses, exchanges, and millions of over-the-counter transactions that represent hundreds of trillions of dollars of “notional” value.
You need a college degree in finance, or experience on Wall Street, or hundreds of hours devoted to studying this topic to begin to get a sense of how dangerous and powerful unregulated derivatives are. Read the Wikipedia article on financial derivatives just to get a glimpse of how little you currently know about them–even though they are the biggest market in the world right now. By 2007 the Bank of International Settlements, which tracks the global derivatives industry said the total outstanding bets in this market were more than half a quadrillion dollars. A year later, they had grown by $167 trillion dollars — in just one year! This is absurd, to let the global financial system be completely dominated by derivatives bets. But “thar was gold in them thar hills” and still is, until something is done to stop this madness.
So it’s not easy to interest anyone in joining a citizen lobby for something like this. And it’s not easy to get members of Congress up to speed on these issues so that they can make legislative reform in this area a high priority for them. (Imagine how hard it might be for a member of Congress to find time to read or study a book. They don’t even have time to read the bills that they vote on.) Constituents will give them much more credit for getting an ear-mark stuffed into a spending bill that brings a new bridge or dam or highway to their home state. So they focus on what will get them re-elected, rather than on what the country (and world) needs most.
But even though it won’t be easy to get this done, we will try anyway, and hope to make a small contribution by trying to get the best articles and books on this subject in the hands of more people, particularly our representatives in Washington.
Please consider joining this effort. And if you use Twitter, please retweet my tweet about this blog post. You can find it at http://www.twitter.com/paulballen
Newsweek has a great article in the April 13th edition called, “The Senator Who Saw This Coming.” It is a brief interview with North Dakota Senator Byron Dorgan, about his effort to regulate exotic derivatives back in 1994.
I met with one of Senator Dorgan’s key staffers on a trip to Washington, DC in February. I had found through my research in the Congressional Record that Dorgan had tried to pass legislation that in my view would have preventing the global financial meltdown by preventing the massive credit and derivatives bubble that caused it. So I asked his legislative specialist, “why isn’t Senator Dorgan calling attention to all his earlier efforts and saying, ‘see, I told you so?’”
I found the answer tonight in this Newsweek article, “There’s very little solace in being right, given the carnage,” said Dorgan. “This is one of the most expensive lessons in American history.”
Senator Dorgan is a great America, representing a great state whose old fashioned values and conservative banking practices we can learn something from.
Recent news stories indicate that North Dakota is largely escaping the recession, because of its conservative banking practices and “midwest… sensibilities.” Large banks there apparently avoided sub-prime lending. There are almost no foreclosures and there is full employment still.
I started a citizen journalism effort several months ago called Crashopedia–an effort to document the root causes of the global financial meltdown and the key players in that story. I found that Senator Dorgan was on the right side every step of the way. But it was like David fighting a hundred Wall Street Goliaths–the most effective financial lobby in the history of the world–and we know who prevailed.
I was so impressed with his 1994 article in Washington Monthly Magazine called “Very Risky Business – Derivatives” that we made it the first link on the entire Crashopedia web site.
Dorgan tried from 1994-1999 to restrict the financial industry from selling exotic instruments. But the financial lobby prevailed. Since then, derivative bets first generated hundreds of billions of dollars of profits (and billions of dollars in bonuses for those who waged them) and hundreds of billions in toxic liabilities when the bets turned sour.
As the derivative industry started churning out hundreds of trillions of dollars in derivatives contracts, our whole economic picture turned bizarre.
I read one study that said that in the early 80s the financial sector generated about 8% of the total profits from the S&P 500. That’s a pretty understandable level. By 2006 it had jumped to nearly 40%. That’s insane! 40% of our profits in the S&P 500 (which represents 75% of the market capitalization of US companies) coming from banks? Banks hardly create wealth–entrepreneurs and businesses do–unless you count balance sheet wealth or insurance premiums from derivatives contracts (with no risk, of course) as reported by the financial geniuses running these companies.
It’s no wonder that Warren Buffett called derivatives “financial weapons of mass destruction” in his letter to shareholders in 2002. But amazingly Byron Dorgan saw this train-wreck coming 8 years before that letter, and more than 10 years before Buffett’s partner Charlie Munger said he’d be shocked if there wasn’t a massive derivatives blow-up in the next 5-10 years.
Perhaps if Newsweek and enough others tell the story of Dorgan’s attempts to restrict the financial industry from selling these very exotic instruments that generate huge reported profits in boom times but massive losses when they crash, maybe there will be a sequel–David and Goliath Round II.
And maybe this time, we’ll learn from our past mistakes, and back Dorgan in his efforts to make sure the 21st century banking industry returns to old fashioned values, where reserve assets are strong, leverage is small, and profits are lean.
Let’s put a rock in the head of the Wall Street casino that Dorgan warned us about where “quants” (Ph.D’s in mathematics) develop wild mathematical models that allow twenty-something traders to make millions in bonuses by selling seemingly low-risk derivatives instruments with higher than average yields to bankers all over the world. (See the March 2009 Wired Magazine article titled, “Recipe for Disaster: The Formula That Killed Wall Street.”)
I say lets rally behind Dorgan, and cheer him on in this second round of battles that still seem impossible to win, in part because the financial lobby seems to control so many seats in Congress and in part because the revolving door between Goldman Sachs and the Treasury Department and the Federal Reserve itself has kept the bad guys in charge even now.
At this point, we are still in big trouble, because creating and selling toxic and exotic derivative instruments is still as legal (and as unregulated) as it was a year or two ago, and bankers will create them once again (with a whole slew of new clever names and models) as soon as there is a market for them again.
As if to facilitate more of the same, the President and the Treasury Secretary are proposing (as Bush and Paulson did before them) to buy up to $2 trillion of these bad derivatives and get these “toxic assets” off the balance sheets of the largest banks.
It may be too late to punish the perpetrators of the scheme that has allowed the derivatives industry to pillage our economy for all these years and now harm our prosperity and threaten our very way of life, but it may not be too late to stand with Dorgan and make sure that it never happens again.