I want to offer a full endorsement of this PBS documentary from Frontline called The Warning. The story of the infamous “Over The Counter Derivatives Market” is one we are still living with today. As it’s described in the program, this is a “dark market”, unregulated, and virtually impossible to monitor as a result. While regulatory legislation has been proposed, the most powerful lobby in Washington has managed to hold it up— the finance lobby. Derivatives are described in somewhat euphemistic terms as “insurance policies” that, ironically, are supposed to hedge against all sorts of potential forms of loss. It seems a more common understanding of the concept of a derivative is that it’s a casino bet— and today, this casino amounts to a total market of hundreds of trillions:
According to the International Swaps and Derivatives Association (ISDA) survey, the outstanding notional amount of derivatives is over 454 trillion dollars at mid year 2009. The Bank for International Settlements puts the number at nearly $800 trillion worldwide. Using ISDA data, that is over 30 times U.S. GDP. According to the flow of funds data from the Federal Reserve, total credit market debt outstanding is just under $53 trillion dollars. Derivatives are not a minor dimension of U.S. or international capital markets. They occupy a dominant position. Continue reading…
In the documentary, the “warning” comes in the late 1990s from the head of the Commodity Futures Trading Commission, Brooksley Born, who identified how this “dark market” could lead to catastrophic financial losses. Her prophecy came true as early as 1998 when a premier investment firm called Long Term Capital Management was basically flipped on its head by losses in derivatives and was ultimately rescued by 14 investment banks who each picked up portions of the billions of dollars needed to prevent the collapse.
The story also focuses on the former regulators in place including Fed Chairman Alan Greenspan, Treasury Secretary Robert Rubin, Assistant Treasury Secretary Larry Summers, and Securities and Exchange Commission Chairman Arthur Levitt. According to the documentary, with a firm conviction toward reducing regulation and allowing markets to correct themselves, these regulators derailed efforts by Ms. Born to bring this dark market into the light. And even after the worst of Ms. Born’s predictions came true with LTCM, still no regulations of the market were subsequently enacted.
In February of 2008, former Federal Reserve Chairman Alan Greenspan testified before Congress on this subject after the biggest financial collapse since the 1930s had ensued— and his response to the committee’s questioning of his ideological choices about regulation:
The congressional committee’s Democratic chairman, Henry Waxman, pressed him: “You found that your view of the world, your ideology, was not right, it was not working?” Greenspan agreed: “That’s precisely the reason I was shocked because I’d been going for 40 years or so with considerable evidence that it was working exceptionally well.”
Still today, this market is unregulated. And still today, according to Brooksley Born’s statements in the program, the risk of catastrophic financial loss from this dark market remain.
I think there are few stories in today’s headlines as important as this one. Please take time to learn about this part of our financial system. It’s up to us citizens to demand that Congress takes responsibility for protecting the public from the perils of “dark markets”.