Dangerous Derivatives

This has been sent to me by one of my students which I would like to share with you.
When the history of the financial crash of the past few years is written, the failure to regulate over-the-counter derivatives will serve as a centerpiece. Derivatives are investment tools that operate like bets -- in the way insurance functions like a bet. Buy fire insurance, and your house burns down: You win the bet. If not, the insurer wins. Big banks and investment house bet on whether the issuer of a bond might default.

The practice makes sense for hedging, a firm directly at risk seeking protection no matter the turn of events. The problem on Wall Street is that the use of derivatives spun into sheer speculation, gambling, laying down money on a prediction. No surprise then that the risk-factor multiplied at a frantic pace, the derivatives market totaling almost $600 trillion.

The deeper problem is: All of this trading took place in the dark. No transparency. No regulator enforcing accountability. Thus, when the speculative bubble burst, banks and others abandoned the credit market. They had no idea about the financial health of others playing the speculation game.

Taxpayers came to the rescue, pouring $180 billion into AIG alone. Now Congress is looking at how to regulate the derivatives market. Two House committees have taken important steps forward, imposing new rules and capital requirements, forcing trades onto clearinghouses. The proposed bills also include a troubling exemption for corporations looking to hedge against risks in their business operations. These firms may have a case. Unfortunately, the loophole invites yet another speculative binge.

Disturbing, too, is the absence (in one leading bill) of language permitting regulators to ban unsound financial products. Companies warn about the cost. Actually, the cost already is plain, starting with savings and retirement accounts. During the Clinton years, Democrats and Republicans looked the other way when events pointed toward the need to regulate derivatives. Let's not make the same mistake.