Derivative Speculation

I was deeply disappointed in the column by Joe Sullivan (whom I have hitherto followed with interest) urging readers not to overreact against bankers and financiers for the recent meltdown of the economy. ["Demonizing Wall Street," May 20, 2010] In particular, Mr. Sullivan defends the mysterious darling of bankers called derivatives. Derivatives are, to quote Johnson and Kwak (13 Bankers: The Wall Street Takeover and the Next Financial Meltdown), contracts whereby traders can transform (and thereby manage) fixed-rate into floating-rate transactions and thereby hedge against losses. Such contracts are vital in managing currency and loan transactions. In a sense, they are contracts and gambles against losses.

The beauty and trouble with such transactions is that they generate large fees for banks which, for example, take "a piece of every interest rate swap in fees" (J&K, 80). Derivatives have become so profitable that competition for fees has driven financiers and bankers to invent ever more sophisticated and arcane instruments of speculation (and profit) beyond the infamous "credit default swaps," which bankrupted AIG.

Now, mind you, these transactions were and are largely unregulated and the accounting procedures "controlling them" have lacked "standardization" and transparency.

The smoke and mirrors of such schemes were previously attacked by a newly appointed head of the Commodities and Exchange Commission, Brooksley Born, a lawyer with wide experience in derivative markets. Ms. Born quite reasonably proposed treating derivatives as commodities trading in futures, etc., which are regulated by the CEC.

The effect of Ms. Born's proposals to regulate derivative contracts in an orderly and transparent way immediately brought down the strenuous objections of Alan Greenspan, Larry Summers, and Timothy Geithner—each a proponent of Milton Friedman's now discredited theory that markets are self-regulating. As a result of this blitz, Ms. Born eventually resigned.

Mr. Greenspan has since gloomily recanted his theory that markets (including derivative trading) are self-regulating in view of the theory's disastrous economic effects; and his disciples Summers and Geithner have consequently been reduced to almost incoherent penitence.

What Johnson and Kwak as well as Nobel Laureate Joseph Stiglitz among others have made abundantly clear is the evils of the creation of complicated bundling of risky securities and of complicated derivatives, and the padding of profits by Wall Street as well as by American banks and businesses. Derivatives, moreover, quickly have become a means of speculation—of betting on market gains and losses. Why, one may ask, should banks actually lend money to interest-paying customers when they can play the market through derivatives? Further question: Are the profits and losses of speculative derivatives subject to taxes as income or as capital gains and losses?

Clear regulation demanding transparency, equitable corporate business rules, and clear purpose and accounting are necessary remedies of these abuses—abuses which have contributed to economic collapse, to widespread unemployment, to the sinking of housing markets and the dilution of home equities, to the drying up of capital, and to the destruction of saving in the 401k's and 403b's of millions of ordinary people.

Derivative speculation, of course, takes a humble place among the larger tricks of the bankers, brokers, and captains of industry—among the scheming of Enron, the collapses of large brokerage banks like Lehman and of commercial banks like WAMU, the robbery of Ponzi crooks like Madoff, the necessary bailouts of major corporations, and the grossly excessive pay of numerous bankers, brokers, and corporate officers.

In the midst of all this greed and wreckage, it is hard to imagine what Joe Sullivan means by "overreaction" in the regulation of derivatives (among other excesses of the market).

James E. Gill