More on Derivatives

Much has been written, said and shouted recently about the resurgence of the financial services industry. It appears to have re-surfaced in much the same form that it collapsed a short 30 months ago. Profits are flowing in, the market is flowing up, and bonuses are flowing back to the same managers who brought the world-wide financial structure to near-collapse.

Much of the controversy revolves around derivatives, which have been recognized as a large component of the structural risk in the market. It seems obvious enough that this instrument, convoluted and opaque to public scrutiny, should be regulated either out of existence or at least into submission. Why has this not been done?

Derivatives may take a number of forms. In Financial Disservices, Robbinsense, Feb ’09, we briefly described a derivative as a contract for an option to buy an instrument at a future time for a given price. Since it varies with the rate of return on a separate financial instrument, it “derives” its value from the other. To explain this a little clearer, let’s use a couple of examples.

Many are familiar with the commodities market, or at least the concept of “futures”. Because farmers have a one-year production cycle and there are many variables in bringing harvest to market, a futures market developed around agriculture. In an effort to bring stability to his production, the farmer attempts to reduce the elements of chance surrounding such factors as weather and fuel costs. The farmer attempts to buy essential products such as seed, fuel, fertilizer on the “futures” market, that is, he buys a future commitment to sell these commodities at a given price. If he can then sell his harvest ahead of time on the same market, he can be assured of a certain level of profit, so long as the weather cooperates enough to bring harvest to market.

One can see why farmers (with a large contingent of congressional support) might resist regulation or change to this system. As “end users” of the product there is some justification that these “derivatives” be allowed to continue. Another example is in the airline industry. Airlines don’t sell their product in a store; they sell it usually electronically, often months in advance. As such, they quote a price and need some confidence in what fuel will cost at the time of the flight. Without this, passengers would face last-minute refunds or surcharges. Airlines buy fuel on the futures market to “hedge” their costs. As such, airlines are “end-users”.

Not surprisingly, every industry has its own stake in continuation of this system, pressing congress to exempt it from regulation. Finally, we arrive at what is presently our largest (as well as until recently, fastest-growing) industry: financial services. Well, guess what, derivatives are also an “end-product” for this industry, and it makes a ton of money on them (especially when they’re insured by the national treasury). It may not appear “logical” to you and me that the many forms of these volatile instruments should be protected for this industry, which adds nothing to our GNP, but when you consider that the “case” for continued deregulation of these instruments is accompanied by hundreds of million of lobbying money, suddenly it all makes sense.

For all intents and purposes, congress is paralyzed in the face of the blizzard of lobbyists and money thrown into this effort. This brings us back, of course, to “business as usual”.

The public is ambivalent about regulation of the financial services industry, largely because of "conditioning". In the 1950s we were led to believe that "What's good for GM is good for America." Over the last 15 years, with the "liberal" media (oh sure!) blitz to support it, we've come to actually believe that's what's good for Wall Street, or The Dow Jones Industrial Average, is good for America. Actually, what's good for the financial sector is good for corporations and our moneyed elite. This does not make it necessarily good for America, and in some cases just the opposite. The financial services industry has pumped over $2.33 Billion into lobbying since 1989; we know they get their money's worth. Goldman Sachs in 2006 (the year before the collapse) paid a whopping 10% tax on income, which is taxed as capitol gains, while their own janitors pay far more.

In the face of a "typical" decade producing 20% to 30% growth in jobs, the "aughts" generated no job growth. Essentially, we have the "Stockholm Syndrome" in play here, with our lower classes being grateful for any crumbs thrown down by this giant squid of an industry.

Leadership from the president has the potential to break up this log-jam and produce meaningful regulation...if he steps forward. Keep your eyes on the debate.