The greed of the financial institutions in our country caused the current recession. Financial derivatives have been around for a while but they were turned into a negative object when a new financial tool was created called credit default swaps. Although derivatives have been around for a long time, at least they were still regulated. The regulation ended at the end of 2000 and ever since then derivatives were used to make a quick dollar with no regard to the possible consequences. Derivatives are not the only thing to blame for our current recession, but they accelerated and exaggerated the problems to make the recession far worse then it would have been.
A derivative, according to investopedia.com, is a “security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties”. Anything can be put into a derivative which makes them large and complicated to find its true underlying value. Subprime loans and credit default swaps are two of the many things included in a derivative that make them so dangerous, when they are not regulated. Subprime loans are defined by investopedia.com as “a type of loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans”. These loans are given out to people that have lower credit and are more at risk to default than people that would qualify for a prime loan. Investopedia.com defines a credit default swap as, “A swap designed to transfer the credit exposure of fixed income products between parties”. A Credit default swap is the most complicated aspect of most derivatives. They are practically insurance policies on loans that allow the buyer to gamble on whether or not the owner of the loan will default. There are laws that protect the economy against insurance policies, but not credit default swaps.
A certain amount of easily accessible money that is not tied up in assets, also known as liquid money, must be held by the insurance policy holder to back up the policy. This protects the economy by making sure that the companies are able to pay out on those policies if needed, even if there is a large influx of policies that need to be paid out at one time. The problem with credit default swaps is that there are no laws protecting the economy if a large amount of loan defaults occur. Therefore a company does not have to have any liquid money to back up those types of policies and if too many of them need to be paid out at once then those companies holding the credit default swaps will not have the liquid money necessary. The type of loan that was used many times in those credit default swaps were subprime loans, this created a market for subprime loans. The banks gave out to many subprime loans to people that could not afford them which inevitably increased the amount of foreclosures until the market could not handle it anymore and the subprime market crashed.
NPR had an interview with a man named Frank Partnoy, called Frank Partnoy: Derivative Dangers, and in it he talked about how he sold derivatives for 2 years in the mid 1990’s for Morgan Stanley. He went on to talk about how they would make their derivatives so complicated that the buyer couldn’t understand them which gave them the freedom to sell them for extremely large prices. Some of the reasons why these derivatives were so complicated were the introduction of the credit default swaps. Those complicated derivatives were made attractive to buyers by convincing the credit agencies to rate them AA or AAA. The bad aspect of this is that the government turns to these credit agencies for regulation, but their validity is diminished as they are paid for their opinions and ratings. According to Frank Partnoy, this makes it difficult to regulate when the credit agencies that are relied on to regulate are paid highly for their ratings.
Derivatives used to be important financial tools that were used with respect and helped stimulate economies. Derivatives used to be much harder to put together because they took a long time to acquire the amount of assets needed to make the derivative large and attractive to sellers, but with the deregulation of the derivatives and addition of the credit default swaps derivatives became fast and easy to make. By adding credit default swaps to derivatives the financial institutions were able to decrease the amount of assets needed by filling up half of a derivative with un-backed insurance policies on assets in that derivative. This made it faster to make than acquiring the amount of assets needed to make a derivative package large enough to sell. This formed a new problem. The derivatives were being produced so fast that the sellers were having a harder time finding assets creating a market for subprime loans which the banks were more than happy to give out in greater numbers then ever before. With the increase of subprime loans came an increase in foreclosures and eventually the subprime market crashed. When the subprime market crashed the insurance companies (like AIG) had to pay out on the credit default swaps they made on subprime loans. Since their credit default swaps were not backed by any liquid money a vacuum was created that took liquidity out of the market and pushed us into the recession we are currently in.
The phenomenon is discussed in a Wall Street Journal article by Steven Gjerstand and Vernon L. Smith titled From Bubble to Depression? In that article they write, “The price decline started in 2006. Then policies designed to promote the American dream instead produced a nightmare. Trillions of dollars of mortgages, written to buyers with slender equity, started a wave of delinquencies and defaults. Borrowers' losses were limited to their small down payments; hence, the lion's share of the losses was transmitted into the financial system and it collapsed”. Democrat Rep. Gary Ackerman talked to AIG executives during the recent congressional meetings and he explained to them how absurd credit default swaps are, by saying, “There’s a great company called, ‘I Can’t Believe Its Not Butter’. At least they have the decency to tell you it’s not butter. I mean, this is insurance without being insurance because if they called it insurance they have to have money to pay you off. But, they don’t have the money to pay you off and their calling it credit default swaps because if they called it, ‘I Can’t Believe Its Not Insurance’, maybe nobody would buy it!” Rep. Ackerman went on to say that congress makes the laws and provide oversight, but they rely on the credit agencies for regulation. Although it is funny, this video also shows that the government relied on the credit agencies for regulation, the same credit agencies that get paid for their AA and AAA ratings as stated earlier. Having the credit agencies also be the regulators of the market is a conflict of interest and regulation should be in the hands of the Federal Reserve or a separate government funded agency that does not receive money from the financial companies that are affected by that regulation.
In 1985 the creation of ISDA (International Swaps and Derivatives Association) started the deregulation of derivatives lobby. Frank Partnoy talks about ISDA, and the people that worked for them that were able to eventually deregulate derivatives, in his NPR interview, Frank Partnoy: Derivative Dangers. According to Frank Partnoy the three major lobbyists are Wendy Gramm, Mark Brickle, and Senator Phil Gramm. When Wendy Gramm became a part of ISDA she started the aggressive lobby to deregulate derivatives. Later, she went on to become a board member of Enron. Mark Brickle also worked for ISDA and drafted legislation that helped deregulate derivatives. Brickle was not a lawmaker but was brought in by lawmakers as a consultant because the derivatives were so complicated. According to Frank Partnoy, “Senator Phil Gramm cemented the deregulation of derivatives”. Partnoy goes on to explain that Senator Phil Gramm added the provision to deregulate derivatives in the evening before the Christmas break; it was never debated in the house or the senate. Partnoy talked about the final step to deregulate derivatives which happened in the year 2000 and that “it (the provision) was shoved into an 1100 page omnibus budget bill and was unanimously passed by congress with no vote on December 14th and signed by Clinton on December 21st”. For the past eight years the financial institutions have been able to do whatever they wanted with derivatives ignoring the possible consequences for their actions just so that they could maximize profits.
In 2006 housing prices started to decline and then subprime foreclosures increased to a point where the subprime market eventually crashed. Credit default swaps on had to be paid off which took liquidity out of the economy. Once the liquidity was gone and debt increased in these insurance companies and financial institutions, individuals moved their money out of the stock market and into safer investments. As the stock market goes down people that did not move money watch as their investments plummet and their pensions (401k, IRA, etc…) decrease in value. Now everyone has to tighten their budgets, save money, and not spend as much. This affects the rest of the companies in the economy that depend on spending and has nothing to do with loans, derivatives, or credit default swaps. Many companies now have huge debt to profit ratios and have to make massive employee cutbacks to make up the difference. With unemployment increasing, liquidity gone, pensions decreasing in value, and the real estate and stock markets falling to their lowest values in decades it has now pushed our country into a deep recession.
Derivatives used to be a financial tool that was useful and made money but was not abused because there was regulation. The Cato Institute states in their article 10 Myths About Financial Derivatives, that derivatives have been used for years and that the first known derivative is written about by Aristotle in his story about Thales, who was a philosopher living poor in Miletus that created a “financial device, which involves a principle of universal application" (Aristotle). In that article The Cato Institute writes about many myths and the over all arguments is that derivatives are not new, help control risk, are used by many (not just large corporations), the risks are known ahead of time, and that banning them could hurt the economy. For the most part The Cato Institute is correct when saying derivatives do help control risk and help the economy by increasing liquidity that lenders can use to make loans, but the derivatives should be regulated. Zachary Karabell talks about that in his Newsweek article, The Case for Derivatives, where he writes about a Yale economist named Robert Shiller who describes derivatives as, “merely a risk-management tool the same way insurance is”. Also, derivatives help the economy when used well, but recently they have not been used correctly. Shiller warns those that are trying to get President Obama to banish derivatives, that it will “get us nowhere” (Karabell).
These articles show that the problems that arise with derivatives do not make them evil financial tools, in fact they are very helpful financial tools, but that the greed of the financial institutions that created them abused the privilege by getting derivatives deregulated so that they could maximize profits and increase the speed in which they could be created. When derivatives are properly regulated and priced correctly to reflect the risks involved then derivatives are a financial tool that has been proven to increase wealth of the investor and boost the economy. The financial institutions created credit default swaps, deregulated derivatives, and increased the subprime market to a size that was unmanageable. Greed is a strong motivator and usually results in self-interested decisions, the financial institutions in this country have proven that. Hopefully in the future they will have learned their lesson and will be more mindful in the future of their possible impacts on the economy, but it is doubtful. When the current recession is over and people become comfortable and complacent then greed will take over again and the financial institutions will find something new to make as much money as possible without considering the possible negative impacts on the economy. There will be other recessions, many recessions. Let’s just hope the average hardworking person and average investors learn our lesson for next time and not trust the financial institutions as much as we did before.
Works Cited:
Investopedia ULC, "Dictionary." 2009. Investopedia ULC. Web.16 June 2009.
http://www.investopedia.com/dictionary/default.asp
Partnoy, Frank. "Frank Partnoy: Derivative Dangers." NPR.org 25 March 2009 Web.17 June 2009.
http://www.npr.org/templates/story/story.php?storyId=102325715
Gjerstand, Steven and Vernon L. Smith. "From Bubble to Depression?." Wall Street Journal 06 April 2009 Web.17 June 2009.
http://online.wsj.com/article/SB123897612802791281.html
Rep. Ackerman, Gary. "Lashing out at AIG." CNN Video. 2009. CNN. Web.18 June 2009.
http://www.cnn.com/video/#/video/politics/2009/03/18/sot.akerman.aig.default.cnn?iref=videosearch
Karabell, Zachary. "The Case for Derivatives." Newsweek 24 Jan 2009 Web.27 Jun 2009.
http://www.newsweek.com/id/181266
Siems, Thomas F. "10 Myths About Financial Derivatives." Cato Institute 11 Sep 1997 Web.27 Jun 2009.
http://www.cato.org/pubs/pas/pa-283.html
Aristotle, translated by Benjamin Jowett. The Great Books of the Western World. vol 2. Chicago: University of Chicago Press, 1952. Print.